September 28, 2008
Poser on Securities Fraud
Securities Fraud and the Common Law, by Norman S. Poser, Brooklyn Law School, was recently posted on SSRN. Here is the abstract:
In early cases, the federal courts held that securities fraud was not limited to common law fraud when a broader reading was deemed necessary to protect investors. But now the courts are holding that securities fraud is narrower than common law fraud, and that it is not the role of the courts to imply private rights of action. The author gives an overview of the cases, beginning in the 1940's, and concludes that, with a few exceptions, on balance the investor has been the loser.
Ball on Accounting Scandals
Market and Political/Regulatory Perspectives on the Recent Accounting Scandals, by Ray Ball, University of Chicago, was recently posted on SSRN. Here is the abstract:
Not surprisingly, the recent accounting scandals look different when viewed from the perspectives of the political/regulatory process and of the market for corporate governance and financial reporting. We do not have the opportunity to observe a world in which either market or political/regulatory processes operate independently, and the events are recent and not well-researched, so untangling their separate effects is somewhat conjectural. This paper offers conjectures on issues such as: What caused the scandalous behavior? Why was there such a rash of accounting scandals at one time? Who killed Arthur Andersen - the SEC, or the market? Did fraudulent accounting kill Enron, or just keep it alive for too long? What is the social cost of financial reporting fraud? Does the US in fact operate a "principles-based" or a "rules-based" accounting system? Was there market failure? Or was there regulatory failure? Or both? Was the Sarbanes-Oxley Act a political and regulatory over-reaction?
Cox on Survival Strategies for the SEC
Coping in a Global Marketplace: Survival Strategies for a 75-Year-Old SEC, by James D. Cox, Duke University School of Law, was recently posted on SSRN. Here is the abstract:
Notwithstanding cynicism to the contrary, data bears witness to the fact that government agencies come and go. There are multiple causes that give rise to their disappearance but among the most powerful is that conditions that first gave rise to the particular agency's creation no longer exist so that the regulatory needs that once prevailed are no longer present or that there is a better governmental response than Congress' earlier embraced when it initially created an independent regulatory agency to address the problems needing to be addressed. Certainly the more rigid the regulatory authority conferred on an agency has much to do with its ability to survive changes in the social, economic, commercial and scientific forces that shape its environment. One of the great illustrations of the vibrancy of the regulatory agency model, and particularly the notion of equipping such an agency with "quasi-legislative" authority through broad enabling statutes, is the Securities and Exchange Commission. But can an agency created and operating through most of its years in the internationally insulated environment of U.S. capital markets survive in a world that is light years away from the environment that existed a few years ago, not to mention 75 years ago when the SEC was created?
Gerding on the Subprime Crisis
The Subprime Crisis and the Outsourcing of Financial Regulation to Financial Institution Risk Models: Code, Crash, and Open Source, by Erik F. Gerding, University of New Mexico - School of Law, was recently posted on SSRN. Here is the abstract:
The lens of cyberlaw scholarship provides perspective on how the crash of computer-based "codes," particularly risk models, triggered the subprime mortgage crisis and on ways to mitigate risks posed by these codes. This lens reveals a critical flaw in financial regulation; regulators outsourced vast regulatory authority to the proprietary codes of financial institutions, without examining defects in those codes.
Financial codes now drive:
* the types of mortgages and other financial products that financial institutions market to consumers;
* the manner in which financial institutions securitize those products;
* how institutions that purchase asset-backed securities hedge risks; and
* overall risk management by financial institutions.
At each of these nodes in the financial network, regulators relinquished significant oversight responsibility to the "new financial code." This continues despite the subprime crisis.
The Article unpacks the dangers of this deference by examining the failures of code in the subprime crisis, using insights from computer science, finance, behavioral economics, and complexity science. These insights have policy and scholarly implications, including:
* Regulators should promote open source in code used to market consumer financial products, price securitizations and manage financial institution risk.
* Consumer financial protection must be reconceived as protection from systemic risk. This connection became apparent when errors cascaded from codes that lenders used to market consumer mortgages to the models financial utions used for portfolio management.
* Bank regulators should delay implementing Basel II, which allows certain banks to set capital requirements according to internal risk models.
Velasco on Shareholder Ownership
Shareholder Ownership and Primacy, by Julian Velasco, Notre Dame Law School, was recently posted on SSRN. Here is the abstract:
According to the traditional view, the shareholders own the corporation. Until recently, this view enjoyed general acceptance. Today, however, there seems to be substantial agreement among legal scholars and others in the academy that shareholders do not own corporations. In fact, the claim that shareholders do own corporations is often dismissed as merely a theory or even a naked assertion. And yet, outside of the academy, views on the corporation remain quite traditional. Most people - not just the public and the media, but also politicians, and even bureaucrats and the courts - seem to believe that the shareholders do, in fact, own the corporation.
Why this disconnect? I believe it is because contemporary scholarship has done a better job of critiquing shareholder ownership than of disproving it. In this article, I will provide a defense of the traditional view by evaluating many of the arguments commonly raised against shareholder ownership and showing how they fall short. I will then explain why the issue matters. As a theoretical matter, the issue of ownership is necessary to a proper understanding of the nature of the corporation and corporate law. As a practical matter, it is an important consideration in the allocation of rights in the corporation: if shareholders are owners, the balance of rights is likely to tip more heavily in their favor, and against others, than if they are not. Ownership may not settle any specific question of corporate governance, but it will make a significant difference in the analysis. Thus, the issue is important regardless of the normative desirability of shareholder rights. Advocates on both sides should be concerned, albeit for very different reasons.
Bebchuk on Plan for Addressing Financial Crisis
A Plan for Addressing the Financial Crisis, by Lucian Arye Bebchuk, Harvard Law School; National Bureau of Economic Research (NBER), was recently posted on SSRN. Here is the abstract:
This paper critiques the proposed emergency legislation for spending $700 billion on purchasing financial firms' troubled assets to address the 2008 financial crisis. It also puts forward a superior alternative for advancing the two goals of the proposed legislation - restoring stability to the financial markets and protecting taxpayers.
I show that the proposed legislation can be redesigned to limit greatly the cost to taxpayers while doing much better in terms of restoring stability to the financial markets. The proposed redesign is based on four interrelated elements:
* No overpaying for troubled assets: The Treasury's authority to purchase troubled assets should be limited to doing so at fair market value.
* Addressing undercapitalization problems directly: Because the purchase of troubled assets at fair market value may leave financial firms severely under-capitalized, the Treasury's authority should be expanded to allow purchasing, again at fair market value, new securities issued by financial institutions in need of additional capital.
* Market-based discipline: to ensure that purchases are made at fair market value, the Treasury should conduct them through multi-buyer competitive processes with appropriate incentives.
* Inducing infusion of private capital: to further expand the capital available to the financial sector, and to reduce the use of public funds for this purpose, financial firms should be required or induced to raise capital through right offerings to their existing shareholders.
Compared with the Treasury's proposed legislation, the alternative proposal put forward in this paper would provide a far better way to use taxpayers' funds to address the financial crisis.
FINRA Proposes Increase in Amount for One-Arbitrator Cases
FINRA announced it has filed a proposed rule change with the SEC to have investor cases with claims of up to $100,000 in dispute heard by a single public arbitrator, an increase from $50,000. One arbitrator would be assigned to cases involving $25,000 to $100,000, under the proposal, unless all parties in arbitration agree to a three-person panel. Claims of $25,000 or less would continue to be heard by a single arbitrator, while three would continue to be assigned to cases involving more than $100,000 in dispute.
If approved, the new rule is estimated to double the percentage of cases heard by a single arbitrator - from approximately 17 percent to 34 percent - and would restore this figure to what it was when the three-arbitrator threshold was last increased in 1998.
The proposed threshold change comes during a rise in the number of arbitration claims filed with FINRA Dispute Resolution. Through mid-September 2008, FINRA has received 3,203 arbitration case filings, compared to 2,226 cases for the same period in 2007, a 44 percent increase. Claims initiated by customers have increased by 67 percent during this period.
Cox Ends CSE Program; SEC's Inspector General Criticizes SEC Oversight of Bear Stearns
On Sept. 26 SEC Chair Cox announced that the Consolidated Supervised Entities (CSE) program, created in 2004 as a way for global investment bank conglomerates that lack a supervisor under law to voluntarily submit to regulation, was ending. This is not surprising since the 5 major investment firms that were not regulated by the Federal Reserve are now defunct (Bear Stearns, Lehman) or are now coming under Federal Reserve regulation (Merrill Lynch, Goldman Sachs, Morgan Stanley). Chair Cox also admitted that SEC's oversight of these firms failed. While it would be hard to deny that fact in the face of two reports by the SEC's Office of Inspector General that identify the SEC failings in the context of the Bear Stearns collapse, it is somewhat refreshing to hear a government official candidly admit failure. Cox blames the failure on the voluntary nature of the program, stating:
The last six months have made it abundantly clear that voluntary regulation does not work. When Congress passed the Gramm-Leach-Bliley Act, it created a significant regulatory gap by failing to give to the SEC or any agency the authority to regulate large investment bank holding companies, like Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns.
Because of the lack of explicit statutory authority for the Commission to require these investment bank holding companies to report their capital, maintain liquidity, or submit to leverage requirements, the Commission in 2004 created a voluntary program, the Consolidated Supervised Entities program, in an effort to fill this regulatory gap.
As I have reported to the Congress multiple times in recent months, the CSE program was fundamentally flawed from the beginning, because investment banks could opt in or out of supervision voluntarily. The fact that investment bank holding companies could withdraw from this voluntary supervision at their discretion diminished the perceived mandate of the CSE program, and weakened its effectiveness.
While it is true that the CSE program was "voluntary" because it was not mandated by U.S. law, nevertheless, the 5 investment banks needed the CSE program so that, for purposes of EU regulation, they would be regulated by U.S. regulator (the SEC only has statutory authority over the broker-dealer entities). Thus, Chair Cox's assertion that the firms could opt out of the CSE program at any time, thus undermining the agency's effectiveness, strikes me as a bit too facile an explanation.
It is worth taking a look at the two reports of the SEC's Office of Inspector General. One, entitled SEC Oversight of Bear Stearns and Related Entities: The Consolidated Supervised Entity Program, looked at the CSE Program with the emphasis on the agency's oversight of Bear Stearns. The report's findings are blunt. Finding it "indisputable that the CSE program failed to carry out its mission in the oversight of Bear Stearns," it noted "serious deficiencies" in the program and "significant questions" about the adequacy of the CSE Program requirements. In addition, it found that the SEC's Division of Trading and Markets (TM) became aware of "numerous potential red flags" prior to Bear Stearns' collapse, including (among other things) "its concentration of mortgage securities, high leverage, [and] shortcomings of risk management in mortgage-backed securities," but took no action.
The second report, entitled SEC's Oversight of Bear Stearns and Related Entities: Broker-Dealer Risk Assessment Program, follows up on OIG's 2002 report of the SEC's Risk Assessment Program and to determine whether improvements were needed. In particular, the report focuses on Section 17(h) of the Exchange Act and temporary rules 17h-1T and 17h-2T that require broker dealers that are part of a holding company structure with at least $20 million in capital to file with the SEC disaggregated, non-public information on the broker-dealer, the holding company, and other entities within the holding company. One of the significant recommendations of the 2002 report was to update and finalize these two temporary rules, which still have not been accomplished. As a result, "several aspects of these rules are not effective mainly because they do not require firms to file pertinent information with the Commission and many filings are not reviewed by TM staff." In addition, only 20 of the 146 firms filing 17(h) were filing electronically; the rest filed paper documents. (This during the watch of the technology-loving SEC Chair?) The Report concludes:
TM's failure to carry out the purpose and goals of the Broker-Dealer Risk Assessment program hinders the Commission's ability to foresee or respond to weaknesses in the financial markets. This may impact TM's ability to protect customers from financial or other problems experienced by broker-dealers.