Author: Lawrence Cunningham


Crisis Yields Turnabout by SEC Chair

SEC Seal.gifIn a speech Wednesday

at the Practising Law Institute’s program on securities regulation, the historically arch-conservative, deregulatory Chair of the Securities and Exchange Commission, Christopher Cox, offered very surprising recommendations for financial regulation reform based on lessons taught by the current economic meltdown. Highlights include:

1. Establishing a Congressional Select Committee on Financial Services Regulatory Reform.

2. Merging the SEC and the Commodity Futures Trading Commission “with a clear mandate to protect investors by regulating the markets in all financial investments, including securities, futures, and derivatives.” Many such calls have been made, dating to the 1987 market crash to the Treasury Department’s March 2008 blueprint for financial regulation reform. Most propose diluting the resulting agency by having the merged agency adopt the lax approach to regulation used by the CFTC rather than the relatively tight approach of the SEC. Mr. Cox’s statement emphatically prescribes sticking with traditional SEC approaches in the resulting merged agency. He says the crises “highlight the need for a strong SEC.”

3. Merging all existing bank regulators, of which there are six at the federal level and scores at state levels. Again, this proposal has been often made, including by Treasury, although Mr. Cox again signals an urgency and muscularity that differs from the looser supervisory approach Treasury contemplated. Mr. Cox says: “the lessons of the credit crisis all point to the need for strong and effective regulation.” He contrasts the traditionally “strong SEC” with the comparatively lax banking regulatory structure: the SEC is independent of those it regulates. In contrast: “banks regulated by the Federal Reserve Bank of New York elect six of the nine seats on the board of the New York Fed. Both the CEOs of J.P. Morgan Chase and Lehman Brothers served on the New York Fed board at the beginning of the credit crisis.”

4. Mr. Cox also takes the lessons from the crisis to reject proposals, made as recently as a year ago, to weaken US regulations on the grounds such regulation results in the US losing financial business to less-regulated markets. The “mortgage meltdown” and “credit crisis” show that what is needed is strong regulation backed by statute, not mere supervision, voluntary compliance, weaker regulation or limited enforcement, Mr. Cox said.

The speech overall is an impassioned defense of a strong SEC, and strong regulation. Numerous SEC observers over Mr. Cox’s tenure may recognize this as a bit of a turnabout for him.


Capitalism and Regulation

dollar sign.jpgThis weekend’s talk among world leaders will be accompanied by opposing diagnoses of economic failure and prescriptions for correction and prevention. The outgoing President of the United States sought to frame discussion in a speech yesterday extolling the virtues of unbridled free-market capitalism, warning that government regulation is a danger not a solution. In contrast, the continuing President of France and Prime Minister of Great Britain signal interest in devising an elaborate international, government-sponsored regulatory structure at global levels, to modulate capitalism’s most acute downsides.

Neither of these extremes is likely to hold. All modern capitalistic economies involve considerable government regulation and no advanced modern government is likely to cede sufficient national sovereignty to international regulatory authorities to forge a single global financial regulator. Reality suggests a combination of continued or enhanced national regulatory oversight with perhaps greater international coordination among senior national regulators.

Deeper policy talk may turn to the form regulations should assume within nations to enhance oversight and facilitate coordination. This may refashion discussion about whether rules or standards are superior. No slogan has been more popular in financial regulatory circles in the past few years than “principles-based systems” as contrasted to “rules-based systems.” Conservative reformers in the US, including current Treasury Department leadership, had been condemning the US system as “rules-based” and celebrating the “principles-based systems” they assert exist in the UK and Europe.

Regulation in general, and rules in particular, are a problem not a solution, in this view. If any regulation is politically necessary or economically justified, it would assume the form of broad general expressions of expected conduct, as standards or principles, not rules. This approach enables reposing maximal discretion in targeted actors, letting them exploit opportunities and take risks sans regulatory shackles. Opponents, skeptical of such discretion, contend that, at least for some purposes, strict rules are required to restrain excesses to which such actions can lead. When taking stances on the form of national and international financial regulation in coming discussions, participants may need to confront several fundamental questions.

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Michael Lewis on Causes of Financial Crisis

Michael Lewis, author of the long-selling book, Liar’s Poker, offers a magazine-style account of some of the factors provoking the current financial crisis. It is a delightfully literary contribution that will likely appeal to those captivated by best-selling narrative (complete with protagonists and famous characters plus expletives and references to football, sex and gambling).

Mr. Lewis’s 9000-word piece does not purport to provide a full picture, of course, because many factors conspired to generate the disaster. Extensive research and diagnosis must be undertaken to form a useful understanding. But the piece is enjoying attention and may be of some interest.

In general, Mr. Lewis blames the crisis on a “Wall Street machine” incubated by stupid investment bankers who lacked training to understand the risks they were creating. He ties the current crisis back 20 years to his period on Wall Street, as a 20-something, know-nothing paid a huge salary and bonuses. It was in that period that devices like mortgage-backed derivative securities were invented—the devices that proliferated geometrically in the past five years and form the catalyst of crisis.

In particular, the “Wall Street machine” consists of two parts: (1) real pools of subprime mortgage loans packaged into bonds presenting meaningful default risk and (2) a synthetic market of side bets that those bonds would indeed default packaged into bonds backed by bettors’ wagers. Mr. Lewis reports a story based on interviews with several people who participated in this casino. Its substantive elements can be summarized as follows.

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Saving Sallie Mae?

Salle Mae Logo.gifSallie Mae continues to weather the widening financial havoc that began by throttling the financial sector and now spreads to manufacturing, retail and even university sectors. SLM Corporation, its formal name, is a private corporation that in 2004 shed its government sponsored roots that dated to 1972. It provides student loans for education that are financed, in turn, by extensive use of asset-backed securitizations. In its quarterly report issued last week, Sallie Mae reported significant losses ($158 million) but far less than in the same quarter the previous year ($343 million). Institutional investors have been seen increasing their stake in Sallie Mae’s equity. Its stock closed in New York today at $8.26 per share (compared to a 52-week trading range of $4.19 to $42.00).

If Sallie Mae is a bright spot in an otherwise dismal economy, it may be vital to provide hope for a timely economic recovery from the brewing recession. Many universities, including Brown, Cornell and Harvard, faced with shrinking endowments, are reporting hiring freezes and budget cuts. Conventionally, these and other universities could count on economic recessions to increase demand measured by rising applications, especially for graduate programs in business and law. In general, applications to those programs rise as employment opportunities for college graduates shrink. When the economy expands, employment opportunities rise and applications flatten out.

Recently, unemployment rates are rising sharply and are expected to continue rising. Law school applications are predictably up. Past patterns, however, are likely to recur only if students are both able to secure requisite funding and ultimately land jobs that facilitate loan repayment. So far, Sallie Mae’s relatively respectable performance bodes well, as it has avoided the fate ensnaring its former cousins, Freddie Mac and Fannie Mae. And also so far, despite some contrary rumors, there does not appear to be any student loan crisis.

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Rating Agencies: Disease and Cure

Today Congress put credit rating agencies on the hot seat during intense hearings. Rating agencies, including Moody’s and Standard & Poor’s, gave top grades to debt the credit crisis is now showing everyone was junky. Scholars have long berated the rating agencies, especially Frank Partnoy. The fundamental problem is that securities issuers pay the rating agencies their fees. The proverbial result: whose bread I eat, his song I sing. Also, law requires very little of rating agencies and essentially insulates them from liability to investors harmed by irresponsible ratings.

As Congress turns hearings into policymaking, Members should consider new scholarship from Jeffrey Manns forthcoming in North Carolina Law Review. He proposes that investors, not issuers, pay rating agencies. The so-called user fee system is coordinated mainly by investors, those owning rated bonds, with a government agency coordinating the system in the pre-issuance stages of a rated debt offering. In addition, rating agencies would have to certify their ratings much as auditors certify their audits. Also like auditors, agencies would be required by law to disclose discovered fraud or illegal acts at issuers whose securities they rate.

The proposal is timely and sensible. Inevitably, it contains elements worthy of debate as well. In particular, the proposal contemplates applying a standard of gross negligence for investor recovery for rating agency violations. The standard for auditors generally is the tougher one of recklessness. In addition, the proposal caps rating agency damages measured in relation to earnings from the botched rating. Despite decades of campaigning by auditor lobbyists for such a cap on their damages, they have not been able to win this victory. Also, alas, auditors continue to be paid by the clients whose financial statements they audit (which I’ve proposed addressing by using financial statement insurance or capital market funding to prevent destroying the auditing industry).

Those interested in preliminary diagnosis of causes and cures for the current crisis should read Manns’ new article. My guess is that everyone who has written or thought about the rating agency’s role in our corporate finance system will consider the piece must reading.


Rescue Plan Relies on Accounting Finesse

Green Eyeshade.jpg Treasury’s latest plan to address the credit crisis by direct investment of $250 billion in US banks has politicians telling Americans one thing and firms telling investors another. Politicians tell Americans the investments are temporary, no threat to private market capitalism in a democracy; thanks to deals brokered by Treasury and the Securities and Exchange Commission this weekend, firms will tell investors the investments are permanent, necessary to account for them as increasing firms’ permanent capital and minimizing dilution of common stockholders.

The tension is finessed by imaginative design and classification of the two components of the government’s investment: preferred stock and warrants to buy common stock. As to the preferred stock, the solution is designing terms to exploit a gray area in accounting dividing debt from equity. Borrowed funds a firm must repay are debt (liability); permanent funds a firm need not repay are equity (capital). Preferred stock is a liability if the firm must repay it and equity otherwise.

Critical to the Treasury’s plan is boosting firms’ equity capital, which means making the securities look as permanent as possible. But if they look too permanent, that would impeach the political story. The result is a term sheet negotiated this weekend calling the preferred perpetual while incentivizing firms to repay it within five years, without an explicit obligation to do so. Examples include a spike in the dividend rate at year five from 5% to 9%, forbidding firms to pay dividends on common stock unless dividends are first paid on preferred and limiting firms’ right to repurchase common stock while the preferred is outstanding.

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“Interim Final Temporary Rule”?

What should regulated persons make of a federal agency describing a binding regulation as an “interim final temporary rule”? That’s the self-titling the Securities and Exchange Commission gives to two (here and here) of its latest in a series of controversial regulations concerning short selling of securities (selling securities one doesn’t own at a current price to be delivered in the future after buying them at an expected lower price).

The strange nomenclature may be due to difficulties the SEC has faced trying to create a sensible policy on short selling as it struggles with a role to play in addressing the credit crisis. It settled on restricting short selling in the name of trying to prop up prices of equity securities. It adopted emergency measures, and amended and expanded these then allowed them to lapse and is now reviving its effort to play a role. Everything it has done has been subject to criticism and second-guessing, with some evidence indicating that its efforts have exacerbated equity market performance rather than helped.

The SEC now adopts these two “interim final temporary rules,” trying to micro-regulate short selling with greater precision. Separately, it also adopted more traditional forms of regulation more in keeping with its longstanding regulatory philosophy, establishing anti-fraud principles.

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Federalized Deregulatory Corporate Law

NYSE Building.jpg Since the country’s founding, states have fashioned most of the regulatory landscape for the incorporation and supervision of corporations in the United States. Many laud the resulting competition among states as they pioneered innovation in laboratories of experimentation to determine the optimal structure of corporate law.

In recent years, that competition abated considerably, Delaware having won, with some newfound competition for it from Washington taking the place of erstwhile state competitors. To many, including Roberta Romano, that state system of corporate regulation appeals and a deep commitment to state production sought, yielding a race to the top; to others, say Lucian Bebchuk, that system fails miserably, being a race to the bottom, and can only be corrected by preempting state corporation law and vesting corporate authorization and supervision in federal law.

The logic of the Treasury Department’s blueprint for changes in US financial regulation offers up yet another alternative that may likely be unappealing to both sides of that debate. State corporate law could be preempted in pretty much the same way that the blueprint imagines preempting state insurance law.

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Caution on Financial Reform

The Council of Institutional Investors yesterday released a white paper it commissioned from me entitled Some Investor Perspectives on Financial Regulation Proposals. The paper critically evaluates Treasury Department proposals to reform US financial regulation, initially made in March 2008 and still the Department’s recommendations for the future.

The paper examines Treasury’s proposals to integrate securities and futures regulation, including merging the Securities and Exchange Commission and Commodity Futures Trading Commission, and to create a single-agency oversight of all financial markets. It also considers SEC proposals to pursue global mutual recognition in securities regulation.

My analysis urges authorities to take a cautious approach to these proposals. The blueprint’s thrust is to consolidate regulatory authority in a unitary way in the executive branch of the federal government, under presidential control, and then delegate much of this authority to self-regulatory organizations in the various financial industries being supervised. As matters of substance, procedure and philosophy, the proposals could considerably weaken critical investor protections in existing US law.

This is important. The Council, an association of pension funds controlling more than $3 trillion in assets for US workers, so suggests in the following from its press release announcing the paper:

The global credit crisis has unmasked weaknesses in U.S. regulation of the capital markets and has badly shaken trust in those markets. A careful analysis of the factors that fueled the crisis is required before regulators, lawmakers and market participants consider ways to strengthen financial oversight and restore confidence in our markets. As they evaluate potential reforms, certain principles should be paramount: Oversight must be independent and reliable; disclosures must be timely and meaningful. Above all, investor protection and enforcement of the rules must be vigorous.

Alternative to Treasury’s proposals appear in the Report, issued earlier this week, of the Group of Thirty. Other comprehensive alternatives likely will be forthcoming. But Treasury’s blueprint will continue to be an important starting point for coming debate on financial regulation.


The SEC’s Failed Cover Up

SEC Seal.gif

SEC officials redacted extensive portions of the agency’s internal watchdog’s report exposing its internally documented failures overseeing failed investment bank, Bear Stearns. But an unredacted version is published by Senator Charles Grassley, Senate Banking Committee Member who requested the study.

The failed cover up is ironic for an agency charged with promoting transparency in corporate America. It makes a mockery of todays’s SEC roundtable on how the SEC can help investors by promoting corporate transparency.

Many of the failed deletions refer to internal SEC documents showing that the SEC knew of problems that it left unaddressed. Also deleted are judgments the inspector makes about SEC performance, including one concerning the existence of ignored red flags.

It is not obvious why it is appropriate for SEC officials to delete these materials. Indeed, Senator Grassley obviously believes there is no basis for doing so. Below I highlight differences between the SEC’s redacted version (available in full here) and Senator Grassley’s published version of the original (available in full here).

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