April 11, 2010
How Good is the SEC's Compliance Program?The SEC recently announced the appointment of its first Chief Compliance Officer, to streamline and centralize oversight responsibility for agency employees' securities transactions and financial disclosure reporting. However, Suzanne Barlyn notes that the new compliance officer does not have the independence and responsibility that effective compliance programs in the private sector have. The SEC's officer, for example, is not among the agency's "top-level" management and does not report directly to the SEC Chair. SEC’s “World Class” Compliance Falls Short
FINRA Warns About Misleading Disclosure in Bond FundsFINRA reportedly has sent letters to broker-dealer affiliates of bond funds that it is getting tough on the use of weighted-average bond ratings that have not been assessed by credit rating agencies and called the practice misleading. The notices may be a consequence of the Morgan Keegan enforcement proceedings brought by FINRA, the SEC and several states, alleging that the firm mispriced its bond funds. InvNews, Finra cracks down on credit disclosure
Did Morgan Keegan Hide the Smoking Gun?Attorneys representing Morgan Keegan customers in arbitrations claim that the firm did not turn over in discovery relevant internal documents in which Morgan Keegan employees questioned the level of risk in bond funds that lost most of their value in 2007-08 after the collapse of the real estate market. The documents surfaced in the enforcement actions, announced this year, brought by state regulators. InvNews, Is internal e-mail the smoking gun in Morgan Keegan case?
Sjostrom on Underwriting Compensation Regulation
The Untold Story of Underwriting Compensation Regulation, by William K. Sjostrom Jr., University of Arizona - James E. Rogers College of Law, was recently posted on SSRN. Here is the abstract:
The Article examines the regulation of underwriting compensation by the Financial Industry Regulation Authority. Although the regulation dates back almost 50 years and impacts virtually every U.S. public offering of securities, its propriety has received zero attention from legal scholars. The Article fills the gap in the literature. In that regard, it provides a history and overview of the regulation and critiques its policy justifications. The Article finds the justifications deficient and the regulation’s costs conceivably quite large. Consequently, it contends that the regulation should be abolished.
Dam on International Perspectives on the Subprime Crisis
The Subprime Crisis and Financial Regulation: International and Comparative Perspectives, by Kenneth W. Dam, University of Chicago - Law School; Brookings Institution, was recently posted on SSRN. Here is the abstract:
Most economic and legal discussion of the subprime mortgage loan crisis (and the follow-on financial crisis) focuses on the United States. However, many other countries participated in the subprime securitization aspect of the crisis, not just by buying U.S.-originated consumer mortgage-backed securities but also by using off-balance sheet entities in connection with such securities. The experiences of the United States and of Germany are examined in some detail. In the case of Germany the role of publicly owned banks, such as the Landesbanken, is discussed. With respect to the underlying economic and regulatory issues, European banks tended to use more leverage than U.S. banks and many European countries experienced housing price inflation, just as did the United States. The focus of this research is on the resulting regulatory issues and on various proposed reforms.
Tuch on Multiple Gatekeepers
Multiple Gatekeepers, by Andrew Tuch, Harvard University - Harvard Law School ; University of Sydney - Faculty of Law, was recently posted on SSRN. Here is the abstract:
In the context of business transactions, gatekeepers are lawyers, investment bankers, accountants and other actors with the capacity to monitor and control the disclosure decisions of their clients – and thereby to deter corporate securities fraud. After each wave of corporate upheaval, including the recent financial crisis, the spotlight of responsibility invariably falls on gatekeepers for failing to avert the wrongs of their clients. A rich vein of literature has considered what liability regime would lead gatekeepers to deter securities fraud optimally, but has overlooked the phenomenon that multiple interdependent gatekeepers act on business transactions and thus form an interlocking web of protection against wrongdoing. To date the literature has adopted a unitary conception of the gatekeeper, assuming that a single gatekeeper acts on a transaction or, where multiple gatekeepers are involved, that each is independently capable of deterring securities fraud.
This article explains the pattern of multiple gatekeeper involvement that characterizes business transactions. It analyzes why gatekeepers exist at all and why corporations turn to a multiplicity of them for most transactions. It then extends gatekeeper liability theory to account explicitly for the possibility that the fraud-deterrence capacity of gatekeepers will be interdependent, and not simply independent. In doing so, the article draws on optimal deterrence theory and analogizes the position of multiple gatekeepers with that of joint tortfeasors. The article also assesses the U.S. federal securities law regime from the perspective of the prescriptions of gatekeeper liability theory, identifying gaps in the regime that arise from the fragmentation of gatekeeping services and suggesting reforms designed to compel cooperation among gatekeepers to fill them. The theory has implications for the post-financial crisis reform proposals that would impose gatekeeper liability on credit rating agencies, which the article specifically considers.
Hill on The Subprime Crisis
Who Were the Villains in the Subprime Crisis, and Why it Matters, by Claire A. Hill, University of Minnesota, Twin Cities - School of Law, was recently posted on SSRN. Here is the abstract:
This essay argues for the necessity of dealing with the market actors involved in the financial crisis - actors who committed no crimes, and cannot appropriately be demonized or viewed simply as bad agents making decisions in their short term interest but against their principals’ interests. Without these actors the crisis would not have occurred. It is therefore critical to try to understand why they acted as they did in this case, and how their behavior might be influenced to minimize the chance of future crises. To that end, this essay provides an account of the mindset of market actors other than “villainous” ones, and considers in broad brush what sorts of mechanisms might be employed to affect such actors’ behaviors in ways that might make crises less likely.
Hill on Credit Rating Agencies
Why Did Rating Agencies Do Such a Bad Job Rating Subprime Securities?, by Claire A. Hill, University of Minnesota, Twin Cities - School of Law, was recently posted on SSRN. Here is the abstract:
Why did rating agencies do such a bad job rating subprime securities? The conventional answer draws heavily on the fact that ratings are paid for by the issuers: Issuers could, and do, “buy” high ratings from willing sellers, the rating agencies.
The conventional answer cannot be wholly correct or even nearly so. Issuers also pay rating agencies to rate their corporate bond issues, yet very few corporate bond issues are rated AAA. If the rating agencies were selling high ratings, why weren’t high ratings sold for corporate bonds? Moreover, for some types of subprime securities, a particular rating agency’s rating was considered necessary. Where a Standard & Poor’s rating was deemed necessary by the market, why would Standard & Poor’s risk its reputation by giving a rating higher (indeed, much higher) than it knew was warranted?
Finally, and perhaps most importantly, giving AAA ratings to securities of much lower quality is something that can’t be done for long. A rating agency that becomes known for selling its high ratings will soon find that nobody will be paying anything for its ratings, high or low.
In my view, that issuers pay for ratings may have been necessary for the rating agencies to have done as bad a job as they did rating subprime securities, but it was not sufficient. Many other factors contributed, including, importantly, that rating agencies “drank the Kool-Aid.” They convinced themselves that the transaction structures could do what they were touted as being able to do: with only a thin cushion of support, produce a great quantity of high-quality securities. Rating agencies could take comfort, too, or so they thought, in the past - the successful, albeit short, recent history of subprime securitizations, and the longer history of successful mortgage securitizations.
Baxter on Universal Banks
How Big Became Bad: America's Underage Fling with Universal Banks, by Lawrence G. Baxter, Duke Law School, was recently posted on SSRN. Here is the abstract:
In little more than a decade gigantic new financial institutions have emerged in America. These organizations are quite different from their predecessors in that they share the highly complex, diversified characteristics of foreign “universal banks.” They are still in the process of developing experienced and mature operational and risk management systems. During this same period, the regulatory framework necessary to match the size, power and hazards generated by these new universal banks remains underdeveloped, and the primary framework around which the system is being constructed, namely Basel II, lies in tatters in the wake of the financial crisis of 2007-08. Given the size and interconnectedness of these universal banks, it is dangerous to permit their continued growth unless and until we develop a proper regulatory framework for supervising them.
This article suggests that such a framework can only be developed fully once a single regulator, such as the Federal Reserve System, acquires comprehensive power to supervise large universal banks. Pending such reform, the article offers three actions that current regulators could take to slow the growth of universal banks down to a safe level. These are merger approval conditions that would require: (i) the filing and approval of a detailed, binding implementation and operation plan for any proposed combination; (ii) the filing and approval of a dissolution plan for the entity, should the combination run into difficulties; and (iii) the development and publication by the primary regulator of a regulatory plan for the new combination, detailing the resources required, where these resources would come from, and the methodology to be adopted in supervising the proposed entity.
Barth et alia on Comparability of Accounting Standards
Are International Accounting Standards-Based and US GAAP-Based Accounting Amounts Comparable?, by Mary E. Barth, Stanford Graduate School of Business; Wayne R. Landsman, University of North Carolina at Chapel Hill - Accounting Area;Mark H. Lang, University of North Carolina at Chapel Hill; and Christopher D. Williams, University of Michigan - Stephen M. Ross School of Business, was recently posted on SSRN. Here is the abstract:
This study documents the extent to which application of IFRS as applied by non-US firms results in accounting amounts that are comparable to those resulting from application of US GAAP by US firms. We operationalize comparability by assessing accounting system comparability and value relevance comparability. Accounting system comparability metrics are based on the difference between predicted stock prices (stock returns) resulting from applying US GAAP and IFRS pricing multiples to each firm’s earnings and equity book value (earnings and change in earnings). Value relevance comparability metrics are based on differences in value relevance of these accounting amounts between US and IFRS firms. IFRS firms have higher accounting system and value relevance comparability with US firms when IFRS firms apply IFRS than when they applied non-US domestic standards. In addition, comparability is higher for IFRS firms that adopted IFRS mandatorily, for firm-year observations after 2005, and for IFRS firms domiciled in countries with common law legal origin. Additional findings indicate US firms generally have higher value relevance of accounting amounts than IFRS firms. However, value relevance is not significantly higher for US firms than for IFRS firms that adopt IFRS mandatorily and those domiciled in common law countries, which indicates value relevance comparability for these firms. Overall, the findings suggest widespread application of IFRS by non-US firms has enhanced financial reporting comparability with US firms, but differences remain for some firms.
Buxbaum on Global Business Networks
National Jurisdiction and Global Business Networks, by Hannah L. Buxbaum, Indiana University School of Law-Bloomington, was recently posted on SSRN. Here is the abstract:
This is an edited version of a lecture on the use of local litigation as an instrument of global regulation. It asks whether the increasingly global aspect of business networks, and of the harms those networks can cause, demands a reexamination of the paradigm that we use to articulate the role of national courts in the global arena. In addressing this question, the lecture borrows the concept of scalar analysis from the literature on political geography. It uses that concept to analyze the ways in which global economic misconduct is situated before the courts of one particular country, and to illuminate the political space that U.S. domestic courts occupy when – through the exercise of judicial and legislative jurisdiction – they assert regulatory control over events and conduct that cross geographic areas. It draws on examples from the areas of competition, insolvency, and securities enforcement. The lecture does not conclude that the global nature of business networks requires a correspondingly global view of jurisdiction in domestic courts, but simply that it requires a more textured view of those courts’ sphere of engagement.
Bartlett on Derivative Disclosures
Inefficiencies in the Information Thicket: A Case Study of Derivative Disclosures During the Financial Crisis, by Robert P. Bartlett III, University of California, Berkeley - School of Law; University of Georgia Law School; University of California, Berkeley - Berkeley Center for Law, Business and the Economy, was recently posted on SSRN. Here is the abstract:
Conventional wisdom concerning the causes of the Financial Crisis posits that insufficient disclosure concerning firms’ exposure to complex credit derivatives played a key role in creating the uncertainty that plagued the financial sector in the fall of 2008. To help avert future financial crises, regulatory proposals aimed at containing systemic risk have accordingly focused on enhanced derivative disclosures as a critical reform measure. A central challenge facing these proposals, however, has been understanding whether enhanced derivative disclosures can have any meaningful effect given the complexity of credit derivative transactions.
This Article provides an empirical examination of the effect of enhanced derivative disclosures by examining the disclosure experience of the monoline insurance industry in 2008. Like AIG Financial Products, monoline insurance companies wrote billions of dollars of credit default swaps on multi-sector CDOs tied to residential home mortgages, but unlike AIG, their unique status as financial guarantee companies subjected them to considerable disclosure obligations concerning their individual credit derivative exposures. As a result, the experience of the monoline industry during the Financial Crisis provides an ideal setting with which to test the efficacy of reforms aimed at promoting more elaborate derivative disclosures.
Overall, the results of this study indicate that investors in monoline insurers showed little evidence of using a firm’s derivative disclosures to efficiently resolve uncertainty about a monoline’s exposure to credit risk. In particular, analysis of the abnormal returns to Ambac Financial (one of the largest monoline insurers) surrounding a series of significant, multi-notch rating downgrades of its insured CDOs reveals no significant stock price reactions until Ambac itself announced the effect of these downgrades in its quarterly earnings announcements. Similar analyses of Ambac’s short-selling data and changes in the cost of insuring Ambac debt securities against default also confirm the absence of a market reaction following these downgrade announcements.
Following a qualitative examination of how investors process derivative disclosures, the Article concludes that to the extent the complexity of CDOs impeded informational efficiency, it was most likely due to the generally low salience of individual CDOs as well as the logistic (although not necessarily analytic) challenge of processing a CDO’s disclosures. Reform efforts aimed at enhancing derivative disclosures should accordingly focus on mechanisms to promote the rapid collection and compilation of disclosed information as well as the psychological processes by which information obtains salience.
Campbell on Repealing NSMIA
Dear Senator Dodd: Don't Repeal NSMIA: It Will Hurt Small Businesses and the Economy, by Rutheford B. Campbell Jr., University of Kentucky - College of Law, was recently posted on SSRN. Here is the abstract:
As presently proposed, Section 926 of the Restoring American Financial Stability Act of 2010 (the Act) amends the National Securities Markets Improvement Act of 1969 (NSMIA) in a manner that effectively permits states and state securities administrators once again to exercise authority over securities offerings under Rule 506 of Regulation D.
Enacting Section 926 into law will hobble the legitimate capital formation efforts of our small domestic businesses. The Section will increase significantly and unnecessarily the costs of raising capital for small domestic businesses B a vital part of our national economy B by saddling them with expensive, unnecessary, and multiple regulatory regimes. Indeed, if enacted into law, the impact of the Section will be precisely contrary to one of the principal purposes of the regulatory reform in the Act, which is to ensure the flow of capital to small domestic businesses and thus provide fuel for the recovery from our recent economic crisis.
At the same time, Section 926 will provide no meaningful protection for investors from the sharp practices that caused our recent financial crisis. Presently, investors in small business offerings under federal Rule 506 are protected by tough state and federal antifraud provisions, each carrying significant civil liabilities and criminal penalties. Rule 506 also requires all investors to be either: (a) "accredited"; or (b) sophisticated and provided with the same information that they would receive in a registered offering. In many cases, therefore, investors in Rule 506 offerings actually are accorded more protection than investors in registered offerings.
As a result, subjecting Rule 506 offerings by small businesses to fifty additional state registration regimes B which will be the impact of Section 926 B adds no meaningful protection to investors. It only raises transaction costs on small business capital formation, and does so in a disproportionate, unfair and inefficient manner.