Author: Lawrence Cunningham

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Two Visions on Financial Reform

We may have more ideas than money, judging by the proliferation of proposals for financial system reform amid continuing declines in our personal and societal net worths. At least five notable formulations for financial reform are in circulation. Others are forthcoming, including two that I’m working on (one a law review article with David Zaring and another a Washington-based policy formulation project).

Perhaps the most prominent and detailed proposals yet are two that may be seen as arch-competitors: one created by former Bush Treasury Secretary Hank Paulson and another led by former Fed Chair and Obama advisor Paul Volcker.

In addition, the Committee on Capital Markets Regulation (Harvard law professor, Hal Scott) offers

proposals that tend to resemble many of those Paulson endorsed. The Center for Capital Markets Competiveness (Chamber of Commerce) lays out some broad goals and policy preferences and the Government Accountability Office contributes general statements of principle that should guide reform design.

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Good Bye Mr. Cox

SEC Seal.gifYesterday was Christopher Cox’s last day of a 3.5 year term as Chair of the Securities and Exchange Commission, the United States federal agency charged with investor protection. Investors may be tempted to feel some relief. He leaves the agency weakened and its staff demoralized. But he also leaves its continued existence in doubt, given its manifest failures and contributions to the global financial crisis. It may be undiplomatic to say, but it is possible that his tenure was among the worst in the agency’s history.

Despite the agency’s primary mission of investor protection, Mr. Cox mostly ignored or subordinated that mission in preference to elevating other goals, such as promoting capital formation and engagement with technology and globalization. Headline dramas illustrating these problems include how, during Mr. Cox’s tenure, the SEC:

• failed to interdict Bernard Madoff’s Ponzi scheme despite warnings, costing investors billions, with Mr. Cox later saying he was “deeply troubled” that he didn’t catch it;

• failed in its oversight of the investment banking industry, which led to its extinction, costing investors hundreds of billions more (with multiplied costs for the rest of the economy and probably permanently impairing the economy of New York City, the country’s center of investment capital), with Mr. Cox later describing the SEC’s oversight program as a total failure;

• reduced enforcement intensity for securities law violations (measured by year-to-year reductions in fines and restitution of about 2/3), with uncertain but probably significant future costs for investors from reduced deterrence; and

• reversed major parts of the 2002 Sarbanes-Oxley Act’s implementation concerning corporate internal controls, the costs and fallout from which will not be known for months or years when accounting scandals emerge as a result of the increased opportunities for fraud, although the costs may again run to billions of dollars.

In addition, as Chair of the SEC, Mr. Cox concentrated considerable personal and institutional resources on two subjects that subordinated investor interests to pursue projects that Mr. Cox believed in for some other reasons. In particular, Mr. Cox and the SEC Staff at his direction:

• spent thousands of hours and enormous other resources pushing an ill-advised campaign to eliminate US accounting standards in favor of global ones, although this was fortunately delayed in the final months of his term in response to investor and academic criticism; and

spent considerable resources promoting policies to let non-US enterprises access US capital markets, without any US regulatory oversight or legal enforcement, so long as they are overseen at home by authorities deemed comparable, also an idea that luckily has gained little traction and may die on the vine.

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Notes on Financial Reform

boardroom.jpgFinancial system reform debates are about to take place in earnest. For some, these may involve standard oppositions between those with more confidence in markets compared to those with more confidence in regulation. But superior policy may result from substantive analysis of issues that transcend such philosophical, political or ideological dispositions.

Two of the more important proposals may appear to be competitors reflecting polar dispositions. One, championed by outgoing Treasury Secretary, Henry Paulson, imagines a consolidated oversight structure with considerable latitude to promote US capital market competiveness. Another, championed by incoming Obama advisor, Paul Volcker, former Federal Reserve Chair, likewise outlines a consolidated structure, but with far more stringent controls intended to limit the size and risks of US financial institutions.

Despite the evident philosophical and perhaps political opposition that the Paulson and Volcker proposals may reflect, astute participants in policy debate will recognize both as essentially opening positions in the forthcoming public policy negotiations. For them, needed is balance between spontaneous market coordination and planned regulatory moderation. The exact balance may differ across different kinds of markets and constituents. In general, the following clusters of topics will be implicated.

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“Le laisser-faire, c’est fini”?

dollar sign.jpgThe title quote is attributed to French President Nicolas Sarkozy in Roger Altman’s insightfully sobering piece in the current issue of Foreign Affairs [volume 88, at pp. 2-14]. The topic sentence: “The financial and economic crash of 2008, the worst in over 75 years, is a major geopolitical setback for the United States . . . .” True, the final paragraph concludes, “The United States will remain the most powerful nation on earth for a while longer.” [at 14]. But its standing and influence are badly damaged and there is little that can be done to reverse or limit the effects.

On average, Americans lost 1/4 of their net worth from June 2007 to December 2008. [I am one of those average Americans.] Net worth reductions appear in all assets classes: home equity values down 33% [$4.2 trillion, mine down 20%], retirement savings values down 22% [$2.3 trillion, mine down 25%], other securities investment values down 25% [$2.5 trillion, mine down 20%]. Total value reduction: $8.8 trillion.

Broad stock market indexes fell by nearly half from highs in 2007 to the end of 2008. Altman says this means participants are “anticipating an even worse drop in corporate profits” ahead, although he also notes how the current environment reflects psychological as well as substantive effects, highlighting “deep fright”, “shock,” and a sense of “doom pervading Washington and the U.S. media.” Altman also notes that the recent period shows “a classic pattern of overshooting, [with] markets swinging from euphoria to despair.”

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Satyam Fraud’s Systemic Regulatory Implications

Green Eyeshade.jpg

From a systemic regulatory standpoint, the Madoff Ponzi scheme remains of limited significance, especially compared to the latest exposed fraud case, at the large Indian software company, Satyam Computers Services Ltd., whose shares trade on the New York Stock Exchange (in the form of American Depository Receipts, or ADRs). Its CEO released a letter yesterday disclosing an elaborate, and apparently simple, billion-dollar fraud that went undetected by the firm’s outside auditors, an India affiliate of PriceWaterhouseCoopers (PWC).

The Satyam fraud presents serious questions about systemic regulatory efficacy, particularly concerning auditing and audit firm oversight. True, it may seem outlandish that Madoff was able to use a rinky-dink auditing firm to review the books of a fund commanding billions of dollars in assets and it may be that even such small auditing firms of even private funds require as much regulatory supervision as larger auditing firms auditing public enterprises.

But the Satyam scandal presents a far more serious problem. Unlike Madoff, the company has shares listed in the United States. Also unlike Madoff, it was audited by a foreign affiliate of a large US auditing firm, PWC, whose operations apparently were outside the scope of review undertaken by the US auditing profession’s regulatory overseer, the Public Company Accounting Oversight Board (PCAOB).

Pending additional information from the newly-revealed fraud, of course, a couple of preliminary issues may prove to be lessons of the Satyam fraud. First, if foreign companies list securities in the United States, their financial statements need to be audited by a firm whose activities are subject to regulatory oversight in the United States.

Second, the fraud implicates the Securities and Exchange Commission’s recent enthusiasm for the concept of mutual recognition. This refers to a policy allowing foreign firms, especially brokers but potentially also companies and auditors, to access US securities markets without regulatory oversight here, so long as they are subject to comparable regulatory oversight at home. (I have questioned this policy before.)

Third, there is some possibility that audit failures by foreign affiliates of US auditing firms could expose the US firm to crushing legal liability. This could lead to the dissolution of one of the four remaining large US auditing firms (see my post here). Should that occur, with only three such firms standing, the country would face an additional blow to its system of corporate finance, with attendant adversity for the real economy and citizens.

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Humble Tribute to Chief Judge Judith Kaye

Chief Judge Judith Kaye.jpgOne of the country’s greatest contemporary judges, Judith Kaye, Chief Judge of the New York Court of Appeals, will retire at year-end under the state’s mandatory retirement law. Having served with distinction for some 25 years (15 as Chief Judge), she has earned a deserved reputation for integrity, influence, discernment, very high quality opinion writing—as well as administrative excellence. Notably, Judge Kaye was the first woman appointed to New York’s high court and its longest serving Chief Judge.

In an editorial tribute on December 14, the Sunday New York Times instanced “groundbreaking decisions,” including interpreting the New York Constitution to require the state to provide its citizens with “sound, basic education;” finding certain provisions of a New York death penalty statute unconstitutional; and finding that gay persons enjoy rights to adopt their partners’ children.

In fields closer to my heart and mind, Judge Kaye wrote several important and influential opinions on the common law of contracts, continuing a tradition on her court, whose earlier members include luminaries such as Benjamin Cardozo, Stanley Fuld, and Charles Brietel. Judge Kaye’s opinions have made their way into Contracts casebooks, becoming staples of the course.

Judge Kaye’s opinions are likely to increasingly be reprinted in Contracts casebooks. If so, she would join the only other woman, Ellen Ash Peters, former Chief Justice of Connecticut, on lists of judges whose opinions are frequently reprinted, which include the likes of Cardozo, Roger Traynor, Richard Posner and Learned Hand).

One illustration, from Judge Kaye’s early years on the bench, is the classroom favorite, Van Wagner Advertising Corp. v. S&M Enterprises, 492 N.E.2d 756 (N.Y. 1986), where Judge Kaye announced her holding in the opening lines: “specific performance of a contract to lease ‘unique’ billboard space is properly denied when damages are adequate to compensate the tenant . . . .”

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Inauguration Day—Plus One

drink2b.jpgBars in the District of Columbia can stay open 24 hours a day (and night) from January 17 through January 21 (and sell alcohol until 5:00 a.m. instead of the usual 2:00 a.m.), thanks to legislation its City Council passed for the occasion. WaPo story here.

With hotels booked up early, at high prices, and many home owners or renters letting their places out for two nights at a rate that can cover a months’ carrying costs, maybe some revelers will simply spend the night in a bar and head home at dawn the next day!

For those of us scheduled to teach classes in Washington at 9:00 a.m. on the Wednesday after Inauguration Day, one wonders what percentage of students likely will preparedly attend.

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Congrats to Mary Schapiro, SEC Chair Nominee

Mary Schapiro.jpgUS President-elect Barack Obama announced his intention to nominate Mary Schapiro as Chair of the Securities and Exchange Commission. We at GW Law School, from which Ms. Schaprio graduated in 1980, are delighted. We wish her well in what promises to be a very difficult period for the SEC. Already, questions arise about the orientation Ms. Schapiro will bring, raised sharply in Susan Antilla’s Bloomberg column today. From the Obama transition team web site is the following biography of Ms. Schapiro.

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W Presidential Library

The following letter is making rounds in philanthropic circles. Some hyperbole is evident. But, hey, times are tough.

Dear Fellow Constituent:

The George W. Bush Presidential Library is now in the planning stages and accepting donations. The Library will include:

1. The Hurricane Katrina Room, still under construction.

2. The Alberto Gonzales Room, where you forget everything.

3. The Texas Air National Guard Room, where you don’t even have to show up.

4. The Walter Reed Hospital Room, where they don’t let you in.

5. The Guantanamo Bay Room, where they don’t let you out.

6. The Weapons of Mass Destruction Room, though no one has been able to find it.

7. The National Debt Room, which is huge and has no ceiling.

8. The Tax Cut Room (only the super rich, if any are left, can enter this one).

9. The Economy Room, which is in the toilet.

10. The Iraq War Room. (After you complete your first visit, the stern librarians make you go back for a second, third, fourth, and sometimes fifth visit.)

11. The Dick Cheney Room, in an undisclosed location, but complete with shooting gallery.

12. The Environmental Conservation Room, still empty, though full of promise.

13. The Supreme Gift Shop, where elections may be on sale.

14. The Airport Men’s Room, where some Senators have been observed hanging about.

15. The Decider Room, complete with dart board, magic 8-ball, Ouija board, dice, coins and straws.

The library will include many famous Quotes by George W. Bush, including the following:

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Times Softens SEC Bashing

SEC Seal.gifOn Monday, I posted my opinion that people should be cautious in rushing to rebuke the Securities and Exchange Commission for any failures leading to the Madoff Ponzi scheme. Also on Monday, the New York Times engaged in such a rush. In today’s paper, the Times softens that stance. These views may have some bearing on whether the SEC survives, is dismantled or reconstituted in coming financial regulation reform.

My post said charges against the SEC for failure in the Madoff case should be looked into but that it was equally likely that the charges would prove incorrect. Above all, I opined that talk of SEC blame for the Ponzi scheme risks distracting from manifestly pressing matters of systemic significance arising in the general financial crisis.

In Monday’s Times Stephen Labaton painted a very unflattering piece on the SEC, emphasizing its alleged failures to interdict the Madoff scam, and quoting Chris Cox, current SEC Chair, as acknowleding some fault. The story, which ran on page B6 and spanned 876 words, called the Madoff episode the “latest black eye” for the SEC. It also mentioned the SEC’s failure to anticipate the problems at Bear Stearns, and cited SEC inspector general reports on “several major botched investigations” (although without noting that those reports have been contested by other SEC officials).

The Monday story also reported on other rumor-based and word of mouth complaints about morale among SEC staff, even assertions of a “hollowing out” of the agency under Bush administration directives.

In today’s paper, Mr. Labaton offers a different view.

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