Concurring Opinions » Securities Regulation

Call for Papers: Dodd-Frank

Lawrence Cunningham — Wed, 15 Jun 2011 11:54:01 +0000

Call for Papers:

Financial Institutions and Consumer Financial Services Section

AALS Annual Meeting – January 2012

Rubber Hits Road: Implementing Dodd-Frank amid Reform Fatigue

This program will take place one and a half years after the Dodd-Frank Act was signed into law. The law left many of the details of financial reform to be filled in by regulators, raising the risk of capture. Some of the most important rule makings have begun in earnest; others have stalled as reform fatigue sets in. Meanwhile, reform efforts in Europe and international regulatory initiatives remain works-in-progress.

What lessons can we draw from the implementation of Dodd-Frank so far? What have been the greatest achievements and the greatest disappointments as the legislative process has given way to the administrative? What devils have lain hidden in the details of the Federal Register? What aspects of reform have been largely forgotten? What does the path of financial reform say about legislative and regulatory process? What lessons can be drawn from the reform efforts in Europe and elsewhere? Does the focus on regulating institutions detract from a focus on regulating financial instruments, markets or economic functions and risks?

More ominously, is the crisis truly over? Are we at grave risk of fighting the last war? Has reform missed the mark altogether? This meeting is part of a project to engage the legal academy in sustained theoretical and policy contributions to financial regulation. It also presents an opportunity to look at specific rulemakings in detail, as well as to address larger questions about the course of reform after laws are made.

Call for papers:

Law teachers and other scholars are invited to submit manuscripts or abstracts dealing with any aspect of the foregoing topics. Junior faculty members are particularly encouraged to submit manuscripts or abstracts. A review committee consisting of Section officers will select one or more papers or proposals and will invite the author(s) of each selected submission to present their work at the program session in Washington, D.C. in January 2012.

Abstracts should be comprehensive enough to allow the review committee to meaningfully evaluate the aims and likely content of papers they propose. Please send manuscripts or abstracts to the Program Chair (Erik Gerding, University of Colorado) at profgerding@gmail.com no later than August 30, 2010. Please place the name and contact information of authors only on the cover page of submissions.

Please forward this Call for Papers to anyone who might be interested.

Targeting Odious Top Pay Contracts

Lawrence Cunningham — Wed, 13 Apr 2011 16:09:51 +0000

Cross-posted at Harvard Law School’s Corporate Governance blog, this summarizes in some detail my new paper on applying simple contract principles to police odioius executive pay contracts:

Executive pay has skyrocketed in recent decades, in absolute terms and compared to average wages. The area of largest growth has been in stock-based components, including stock options, often tending to focus on the short-term, with associated risks we’ve seen. A vigorous academic debate has run for more than a decade, becoming a popular political discussion amid the financial crisis exposing arcane debate to public scrutiny.

Growth could be laudable, explained as creating proper incentives to align manager interests with shareholder interests and to promote optimal risk taking. In this view, if there is a problem, it is narrow and limited. Critics are skeptical whether this story holds up. They worry that managerial power has strengthened to enable top executives to control setting their own compensation. In this view, the problem is pervasive and warrants a comprehensive response—and proposals abound.

I come down in the middle. There are problems in at least an important number of cases, and current proposals to redress them are unlikely to work. So I seek a new approach—contract unconscionability—to police extreme cases. The proposal must surmount some hurdles but isn’t as radical as it sounds.

A good way to summarize the debate highlights a three-pronged theory that promotes much of prevailing executive compensation, especially stock-based components, and contrasts it with limits on each prong.

First: in optimal contracting theory, boards design manager contracts to minimize agency costs. But when managers dominate the process, the managerial power thesis suggests this ideal may not be met.

Second: with efficient stock markets, stock price is a good proxy for the shareholder interest and a mirror of managerial performance. But stock price can differ from business value for sustained periods, fogging both.

Third: stock-based pay could align managerial incentives with shareholder interests if designed right and markets work well. But otherwise they create perverse effects.

From the viewpoint of critics, one problem with corporate pay is relatively little legal oversight. Even well-intended boards can fail, yet corporate law defers to them; federal securities and tax law encourage stock-based pay, without regard to perverse effects.

Reforms debate expanding shareholder power to motivate boards, led by Lucian Bebchuk and Jesse Fried. Others, like David Walker, prescribe tax changes or better disclosure. Still others, others, like Randall Thomas and Harwell Wells, look to enhanced corporate law oversight, invoking officer fiduciary duties, recently explicated in Gantler v. Stephens, to police renewals of employment contracts.

Throughout debate, and most of the reforms, there is much talk of redesigning pay contracts to focus managers on long term value, not short term price, by scholars as diverse as Bebchuk/Fried to Roberta Romano. Many of these are careful and useful. What’s still missing is a way to implement them, and I suggest using private litigation and contract law.

So I invent a new way to provide legal oversight to regulate associated risk: a contract law doctrine that has much in common with corporate waste, but is slightly more capacious. Pay has been evaluated under corporate law. But its business judgment rule and deference to independent committees and process means the only possible way to prevail is under corporate law’s waste doctrine. It bans only gifts, or dumping cash into the river, so massive salaries and stock-based pay with perverse incentives are outside it.

Unconscionability has some kinship to waste. It is used sparingly, reflecting freedom of contract. It looks at procedural aspects of a transaction. But unlike waste, which varies little with context, contract law’s propensity to use unconscionability intensifies according to a coherent logic. It becomes increasingly skeptical of lop-sided bargains as it goes beyond arm’s-length deals, into those plagued by procedural irregularities, heard by courts in equity, and involving fiduciaries.

So my basic theory is simple. These are contracts and when unconscionable should be rescinded—whether or not they amount to corporate waste, or are approved by boards or shareholders. Several hurdles appear, meaning few cases succeed, catching only the most odious.

First Hurdle: The first is the internal affairs doctrine that could make pay contracts governed by the corporate law of the state of incorporation, not the contract law of another. This doctrine protects corporate participants in relations with each other against inconsistent laws. Compared to the home state, others have weak interests in internal affairs, like shareholder voting, director elections, and mergers.

Employment agreements could be internal affairs. They are authorized by the board with officers as the counter-party. They regulate the corporation-officer relation. The internal affairs case is strengthened by seeing stock-based pay as a way to align manager-shareholder interests. But they are not inevitably internal affairs. That is clearest when formed with a newly-recruited manager—an outsider. Their primary function is to get labor in exchange for pay. They are increasingly justified as recruiting and retention tools, not alignment devices. From these viewpoints, they are merely contracts.

Second Hurdle. Another hurdle could arise if managers put favorable choice of law clauses in their contracts. That’s a nice gambit but faces three limits. First, choice-of-law clauses are not dispositive. Standard conflicts of law principles apply, asking what state has greatest interest. Second, an unconscionability claim can render the entire contract unenforceable, determined before applying any contract terms, including a choice of law. Third, even a Delaware choice of law clause would mean Delaware contract law not corporate law applies, which is a bit tougher.

Third Hurdle. The next hurdle involves whether a claim is direct or derivative. If derivative, shareholders face corporate law hurdles. Most seriously, shareholders must demand that boards act or show why that’s futile and special board committees can take control of the case and even decide to dismiss it. The line between the two can be blurry. The issue is whether a harm to be remedied is better conceived as individual to a shareholder or runs to the corporation as a whole.

The conceptual difficulty makes classification turn on factors, not bright line rules. These include the theory of liability and remedy. Cases tend to classify as derivative—claims for breach of duty and seeking money damages. Cases and statutes tend to classify as direct, claims asserting lack of corporate authority (called ultra vires), and/or seeking equitable relief. Shareholder challenges to pay contracts will more likely be seen as direct by asserting that their unconscionable character puts them beyond the corporation’s authority, and the primary remedy is rescission.

Fourth/Final Hurdle. Finally, judges may exercise comity and refuse to confront these hurdles or refrain because contracts may be so complex that judges hesitate to assume competency to evaluate them. Enforcement incentives are another practical issue. It is certainly beyond the SEC’s power and probably beyond that of many states or the interests of their attorney’s general. That leaves the private bar, whose incentives may be limited. A pure case of rescission would produce no payment and even a claim accompanied by a judgment in restitution may be comparatively small. But there may be sufficient incentives for the most high-profile case that could yield instrumental and reputational value.

Still, the hurdles are formidable, though incrementally lower than under corporate law. On balance, that is desirable. There is no risk of any floodgate effect. And a few egregious cases would be enough to deter excesses.

Turning to the merits, contract analysis is slightly broader than corporate law’s. Procedural aspects are not confined to corporate law’s focus on board independence or information. Courts consider the bargaining process, probing whether it was more consistent with optimal contracting or managerial power. Substantive unconscionability analysis is contextual, so stating broad principles difficult. But some tests can be suggested. One would compare the contract’s terms with academic models appearing in the literature (whether by Bebchuk/Fried or by Romano). Conforming contracts would be presumptively valid, but those wildly out of line suspect.

Another would compare dollar amounts, though that often will be difficult, and doubts resolved in favor of upholding the agreement. But when that ratio can be measured with reasonable certainty, and does shock the judicial conscience, the contract can be declared unconscionable and rescinded.

In short, while not a slam dunk, this approach would be considerably stronger under contract law than corporate law. And that offers a new legal theory to test executive pay. Not as radical as you thought, and not merely theoretical either, as readers who specialize in lawsuits targeting corporate abuses indicate that they are prepared to apply the proposal when the right factual case comes along.

Law & Econ’s Influence on Law & Accounting

Lawrence Cunningham — Fri, 04 Mar 2011 14:46:20 +0000

The hottest book of the century, on corporate law, is in production, thanks to editors Brett McDonnell and Claire Hill, both of Minnesota. As part of a series investigating the economics of particular legal subjects, overseen by Richard Posner and Francesco Perisi, this Research Handbook on the Economics of Corporate Law, promises a comprehensive canvass of the broadest definition of this field of law as it has been structured by economic theories over the past forty years.

My contribution addresses the influence of law and economics on the sub-field of law and accounting, which I suggest takes the form of “two steps forward one step back.” You can read a draft of my chapter (comments welcome!), available free here, accompanied by the following abstract:

Theory can have profound effects on practice, some intended and desirable, others unintended and undesirable. That’s the story of the influence the field of law and economics has had on the domain of law and accounting. That influence comes primarily from agency theory and modern finance theory, specifically through the efficient capital market hypothesis and capital asset pricing model. Those theories have forged considerable change in federal securities regulation, accounting standard setting, state corporation law, and financial auditing. Affected areas include the nature of disclosure, the measure of financial concepts, the limits of shareholder protection, and the scope of auditor duty.

Analysis reveals how agency theory and finance theory often but not always point to the same policy implications; it reveals how finance theory’s assumptions and limitations are often but not always respected in policy development. As a result, while these theories sometimes produced policy changes that were both intended and desirable, some policy changes were both unintended and undesirable while others were intended but undesirable. Examination stresses the power of ideas and how they are used and cautions creators and users of ideas to take care to appreciate the limits of theory when shaping practice. That’s vital since the effects of law and economics on law and accounting remain debated in many contexts.

Other contributions to the book similarly available in draft form are by Matt Bodie (St. Louis), David Walker (BU) and Charles Whitehead (Cornell). The following scholars are also contributing chapters: Bobby Ahdieh (Emory), Steve Bainbridge (UCLA), Margaret Blair (Vandy), Rob Daines (Stanford), Steve Davidoff (Ohio State), Jill Fisch (Penn), Tamar Frankel (BU), Ron Gilson (Stanford/Columbia), Jeff Gordon (Columbia), Sean Griffith (Fordham), Don Langevoort (GT), Ian Lee (Toronto), Richard Painter (Minnesota), Frank Partnoy (SD), Gordon Smith (BYU), Randall Thomas (Vandy), and Bob Thompson (GT).

GW’s Junior Scholars Finalists

Lawrence Cunningham — Tue, 01 Mar 2011 01:53:47 +0000

Thanks to my colleague, Lisa Fairfax, GW has finalized the program for this year’s Junior Faculty Business and Financial Law Workshop and Prize (detailed here). Of the more than 100 papers submitted, the following dozen presenters were chosen. [Commentators appear in brackets; I've shortened some paper titles.]

The workshop will take place at GW on April 1 and 2, 2011. We are delighted by the submissions, congratulate those chosen, and stress that making the selections was difficult because of the volume of amazing papers. We encourage everyone interested to attend and look forward to the weekend.

Adam Leviton (Georgetown), In Defense of Bailouts [George Geis (Virginia) & Art Wilmarth (GW)]

Jodie Kirshner (Cambridge), A Transatlantic Perspective on Regional Dynamics and Societa Eurpoea [Francesca Bignami (GW) & Theresa Gabaldon (GW)]

Alan White (Valparaiso), Welfare Economics and Regulation of Small-Loan Credit: Lessons from Microlending in Developing Nations [Michael Pagano (Villanova) & Lawrence Mitchell (GW)]

Nicola Sharpe (Illinois), Corporate Board Performance and Organizational Strategy [Deborah Demott (Duke) & Michael Abramowicz (GW)]

Julie Hill (Houston), The Rise of Ad Hoc Bank Capital Requirements [Anna Gelpern (American) & John Buchman (E*Trade Bank & GW Adjunct)]

Michael Simkovic (Seton Hall), The Effects of Ownership and Stock Liquidity on the Timing of Repurchase Transactions [Richard Booth (Villanova) & Henry Butler (Mason)]

Michelle Harner (Maryland), Activist Distressed Debtors [Donna Nagy (Indiana Bloomington) & Lisa Fairfax (GW)]

Saule Omarova (UNC), The Federal Reserve Board’s Use of Exemptive Power [Patricia McCoy (Connecticut) & Arthur Wilmarth (GW)]

Heather Hughes (American), Suburban Sprawl, Finance Law and Environmental Harm [Scott Kieff (GW) & Lawrence Cunningham (GW)]

Robert Jackson (Columbia), Private Equity and Executive Compensation [Norman Veasey (Weil Gotshal) & William Bratton (Penn)]

Brian Quinn (BC), Putting Your Money Where Your Mouth Is: Post Closing Price Adjustments in Merger Agreements? [Gordon Smith (BYU) & John Pollack (Schulte Roth)]

Mehrsa Baradaran (BYU), Reconsidering Wal-Mart’s Bank [Heidi Schooner (Catholic) & Renee Jones (BC)]

This is one of many events sponsored by GW’s Center for Law, Economics and Finance.

Some Sense on Top Pay

Lawrence Cunningham — Tue, 15 Feb 2011 17:51:09 +0000

Executive pay continues to spark heated debate: some want it curtailed across the board, the impetus of recent federal law, while others want no legal oversight whatsoever, the effect of Delaware corporate law. Contract law may provide an optimal solution, narrower than the overly broad federal regime yet targeting egregious cases ignored by Delaware.

Thanks to readers of this blog for comments, forthcoming in the Iowa Law Review is my paper, now available on SSRN, “A New Legal Theory to Test Executive Pay: Contractual Unconscionability.” The paper is available for free downloading here. The abstract follows below.

Lucrative pay to corporate managers remains controversial yet continues to evade judicial scrutiny for legitimacy. Although many arrangements likely would pass the most rigorous scrutiny, it seems equally clear that some would not. Some agreements are not the product of arm’s-length bargaining, can rivet managers on short-term stock prices at the destruction of long-term business value, and can misalign manager–shareholder interests.

Yet even such objectionable arrangements are immune from serious legal oversight. In theory, they are open to judicial review under corporate law, but shareholders challenging pay contracts face formidable procedural hurdles in derivative litigation and substantive obstacles from corporation law’s business judgment rule and the anemic doctrine of waste. A new legal theory would be useful to check board excesses in the population of clearly objectionable cases.

This Article explains why and how traditional contract law’s theory of unconscionability should be used to create a modicum of judicial scrutiny to strike obnoxious pay contracts and preserve legitimate ones. Under this proposal, pay contracts that are the product of managerial domination of the process and formed on terms massively favoring the executive will be stricken.

This will follow direct shareholder lawsuits in state courts where the contract is made or performed and applying that state’s contract law. This new legal theory circumvents today’s dead-end route, where pay contracts are always upheld in derivative shareholder lawsuits applying corporate law that sets no meaningful limits on executive pay. This proposal creates new but modest pressure from sister states on Delaware to take greater responsibility for the effects its production of corporate law has nationally.

For those outraged by lopsided corporate executive compensation, this Article offers an appealing new legal theory of contractual unconscionability to police them. Those who see no or few problems with contemporary pay arrangements, or who are outraged by federal regulatory schemes like the Dodd–Frank Act, will welcome how this proposal is narrowly tailored using common law to address the most obnoxious cases.

Surveillance of the War Games of Finance

Frank Pasquale — Fri, 31 Dec 2010 16:21:42 +0000

Some of America’s greatest economists spent World War II devising formulas for optimal bombing. Milton Friedman, for instance, had to determine whether an anti-aircraft shell should burst into 600 small pieces or 20 big pieces in order to best accomplish a mission. Many translated their work into finance’s portfolio selection theory, which was “all about balancing risk and return.”* As Friedman said, “The logical character of the problem was the same. . . . How much power do you want to sacrifice in order to have a greater probability of hitting? [Finance theory involves] exactly the same thing: How much return do you want to sacrifice in order to increase the probability that you will get what you planned for?”

Today’s finance theorists probably have not spent much time on the battlefield. But they can still have fun with ballistics trajectories, in touchscreen video games like Angry Birds. To play, you use a virtual slingshot to launch squawking birds at pigs holed up in encampments made of glass, wood, and stone. The virtual materials in the game don’t act much like real structures; that’s not the point (who really cares whether a real vaulted bluebird would displace a girder)? Rather, you gradually learn from the game itself the strategies that cause optimal destruction, blissfully unmoored from the messiness of actual materials science.

From Wars to Games to High Finance

Stock trading now appears to be similarly deracinated, concerned less with actual fundamentals than with windows of opportunity for sudden arbitrage. In “Algorithms Take Control of Wall Street,” the indispensable econoblogger Felix Salmon (and Jon Stokes) extend a line of recent articles on high frequency trading. (I collect some earlier contributions here; this piece on news-reading technology also gives the flavor of the innovations they’re describing.) They define prop trading, algorithmic trading, and predatory trading, and tell the story of a former head of American Century Ventures who built a “neural network” to optimize his picks. They also discuss the unanticipated consequences of runaway algorithmic interactions.

Salmon and Stokes develop the martial metaphor mentioned above, quoting the head of Advanced Execution Services at Credit Suisse comparing the work of algorithmic traders to submarine navigators avoiding mines. Graham Bowley also reports on the dynamic in the language of war:

Math-loving traders are using powerful computers to speed-read news reports, editorials, company Web sites, blog posts and even Twitter messages — and then letting the machines decide what it all means for the markets. . . . In some cases, the computers are actually parsing writers’ words, sentence structure, even the odd emoticon. A wink and a smile — — for instance, just might mean things are looking up for the markets. Then, often without human intervention, the programs are interpreting that news and trading on it. . . .

In a business where information is the most valuable commodity, traders with the smartest, fastest computers can outfox and outmaneuver rivals. “It is an arms race,” said Roger Ehrenberg, managing partner at IA Ventures, an investment firm specializing in young companies, speaking of some of the new technologies that help traders identify events first and interpret them.

Edward Tenner, author of “Why Things Bite Back,” throws some cold water on the boys-with-toys mindset driving these developments:

Economists and psychologists have for over a decade been analyzing information cascades, in which people’s observations of each other’s judgments may accelerate trends for worse as well as better. These systems might turn cascades into torrents. Think, too, of the ethical quandary of journalists working for the financial news agencies offering the services, knowing that any turn of phrase may nudge somebody’s machine into a decision. And to make things even livelier, speculators will be able to program banks of computers to generate and broadcast verbiage that will feed the analysis machines and move markets, as some operators have already taken advantage of the quirks of search engine algorithms.

Salmon and Stokes are also worried. They report that, at its worst, the battle of rival computerized trading strategies “is an inscrutable and uncontrollable feedback loop. Individually, these algorithms may be easy to control, but when they interact they can create unexpected behaviors—a conversation that can overwhelm the system it was built to navigate.” The flash crash of May 6 foreshadows future, more disruptive events along those lines.

Whose Conversation? Which Rationality?

But Salmon and Stokes also believe that, “At its best, this system represents an efficient and intelligent capital allocation machine, a market ruled by precision and mathematics rather than emotion and fallible judgment.” I resist the idea that we can declare the algorithms’ patter(n) of interactions “efficient and intelligent capital allocation” without much more evidence about the results of the investments it favors. After Justin Fox, Yves Smith, and John Quiggin have lain waste to various forms of the “efficient markets” hypothesis, it’s hard to see how commentators can use the term “efficient” without explaining the scope and duration of the alleged efficiency. I can certainly imagine moves that are quite helpful to certain traders during certain brief periods of time. It is harder to conjure an explanation of how the interactions Salmon and Stokes describe can generate more robust efficiencies than that.

I also take issue with their curious use of the term “conversation” to describe the interaction of computerized trading programs. There is a fundamental difference between communicative actions like conversations and strategic competition. Since conversation and other basic human interaction involves “performances where an explicit definition of the problem seems beyond our capacity . . . [and] deploys skilled performances which are themselves not explicitly thematized,” the strategic modes of artificial-intelligence “thinking” can never properly mirror the communicative nature of human interaction.

Humans are receptive to the world, altering their responses to it, and their rules for altering responses, as a result of encounters with others. The algorithms are not “conversing;” rather, they are analogous to programmed weapons sent out to strategically outwit one another. Samir Chopra and Laurence F. White’s work A Legal Theory for Autonomous Artificial Agents may eventually inform our regulatory determinations about the degree of responsibility programmers should have for the negative consequences of their creations, but we should be under no illusions that anything resembling a “conversation” is taking place here.

To return to the Angry Birds analogy: I believe the most important thing to realize here is how unmoored contemporary finance markets are from meeting real human needs. Part of that is an inevitable result of wealth inequality; a sliver of the population owns most stocks. But the technology of finance is also playing a role. As McKenzie Wark puts it in Gamer Theory,

The game is what grinds. It shapes its gamers, not in its own image, but according to its algorithms. The passage from topography to topology is the passage from storyline to gamespace, from analog control of the digital to digital control of the analog, from the diachronic sequence of events to the synchronic inter-communications of space, from voice to code. . . .[emphasis added]

The final question for a gamer theory might be to move beyond the phenomena of gaming as experienced by the gamer to conceive of gaming from the point of view of the game. . . . Surely we resemble a Beckettian assemblage of abstracted functions more than we do a holistic organism connected to a great chain of being. As games players, we are merely a set of directional impulses (up, down, left, right); as mobile phone users, we take instructions from recorded, far distant voices; as users of SMS or IM, we exchange a minimalized language often communicating little beyond the fact of communication itself (txts for nothing?).” Gamespace is an end in itself.

Computerized finance is becoming an end in itself, as well. We’re the tools of our tools. And in what is perhaps the most depressing aspect of the Angry Birds analogy, it’s hard to imagine Wall Street suffering any more from societally catastrophic capital allocations than the casual gamer who drops a bird instead of flinging it. Most of the traders are already rich; the bonuses have already been booked. It’s a pure M-M’ play, to use a theoretical framework this excess is, unfortunately, making ever more relevant.

A New Focus for the Surveillance State

So what do we do next? A recent iBrief by Michael J. McGowan surveys some of the options:

Current efforts to regulate flash orders do seem to be a step in the right direction. . . . Possible solutions may [also] lie in introducing rules that eliminate the effects of pinging, or introducing certain taxes on share transactions or rules that curb the more harmful types of algo-trading across the board.

As I noted in another context, monitoring also appears to be key to any good regulation of rapidly changing, tech-driven industries. As Daniel Altman explains, the key to preventing further disruptive events is to assure that regulators have some reliable map of all trading activity:

All the talk of regulation misses a key point: If we don’t know which institutions are doing what–if we don’t actually monitor what we’ve regulated–then that regulation won’t work. . . . The new tools that researchers now envision are meant to foresee crises in financial systems that have become impossibly complicated. “You want to see the build-up to a crash,” Markus Brunnermeier, a professor of economics at Princeton, told me in a recent interview. . . .

In February, Otmar Issing and Jan Krahnen, members of a commission advising the German government, wrote in the Financial Times that a global network map was “a vital element” for preventing future crises. And the main consultative document prepared for the European Union also recommended a map of global risks. But, without cooperation from the United States, any supposedly global map will be woefully incomplete.

I hope that the Office of Financial Research is taking that recommendation seriously. Tech luminaries like Jaron Lanier have proposed methods of representing a “wide range of innovative, nonstandard transactions” in order to give central banks and “other authorities” a “full comprehension” of the risks involved. As the OFR sets standards for Legal Entity Identification for Financial Contracts, and the SEC works on its Consolidated Audit Trail, they must develop methods for real-time monitoring of troubling developments caused by computerized high frequency trading. Though there are serious First Amendment issues raised by some government surveillance programs, these programs would not raise such concerns.

*I rely here on Justin Fox’s excellent book, The Myth of the Rational Market, pp. 47-48. Philip Mirowski has a much more extensive account of how “many of the major preoccupations and much of the theoretical machinery that now dominates economics can be traced to military research carried out in cold war think tanks, especially the RAND organization,” as Kieran Healy explains.

Photo Credits: Alex Drennan; TimmyGunz.

Hockett on the Financial Crisis

Frank Pasquale — Thu, 23 Dec 2010 16:22:47 +0000

There is a growing consensus that our mortgage markets are fundamentally broken. In a recent article in The American Prospect, Robert Kuttner surveys a number of leading legal academics’ prescriptions for the foreclosure crisis:

Katherine Porter, a law professor at the University of Iowa and an expert in mortgage servicing, recently testified to the Congressional Oversight Panel for the Troubled Asset Relief Program (TARP) that according to lawyers for both home-owners and banks, “a very large number (perhaps virtually all) securitized loans made in the boom period in the mid-2000s contain serious paperwork flaws, did not meet underwriting or other requirements of the trust, and have not been serviced properly as to default and foreclosure.” . . . .

One remedy, proposed by professor Adam Levitin of the Georgetown Law Center, would create a new chapter of the bankruptcy code and allow a home-owner to come before a bankruptcy judge and get the mortgage reduced to the present value of the home. The process would also clear the title. Another proposal, by professor Howell Jackson of Harvard Law School, would use government’s power of eminent domain to take securitized mortgages, compensate the holder at the securities’ (much reduced) fair market value, and use the savings to turn the paper back into whole mortgages with steep reductions in interest and principal. This would also allow millions of people to keep their home and help stem the broad decline in housing values.

I think each of these ideas is valuable. I’d also like to see them complement a broad set of proposals articulated by Robert Hockett in a recent piece in the Washington University Law Review. Hockett’s proposals are worth quoting at length, since he keenly grasps the historical dimensions of this crisis:

1. Regulation as Modulation: The Fed and Bubble Preemption
Easily the most important lesson to be drawn from the model of asset price bubbles and bursts schematized [earlier in the article], I think, is the critical role that the Fed must play in preventing bubbles from emerging and inflating in the first instance. . . . While, of course, it is not easy to separate out “fundamental” value and “merely speculative” value with scalpel-like precision or an entirely bright line, it is often quite easy to find reasonable proxies for fundamental value and then to compare prevailing market prices to them. When home prices depart as significantly from counterpart rental prices and from building costs . . . there simply cannot be serious doubt that a bubble is afoot. . . .

Second, and relatedly, any inadequacy in private rates of betting against bubbles could readily be supplemented by regulatory action. For one thing, of course, the Fed now would have means of better timing their boosting of the market rate of interest, the credit-dampening margin requirements imposed upon financial institutions, or both. For another thing—and here we would be speaking not simply of the Fed, but the IRS working in cooperation with the Fed—we could readily impose a form of “Tobin taxation” on the capital gains realized by those who “flip” assets like houses during times of speculative excess, as now would be newly determinable by the Fed.

2. Portfolio Regulation by Reference to Underlying Assets
Asset markets’ overvaluation of assets during times of speculative excess, and their undervaluation of such assets during times of symmetrical “depressive” excess, are problem enough in themselves. But their harmful effects are transmitted more widely when assets are valued by regulators–not just the Fed, but other financial regulators as well—and private institutions by reference to market value. So-called “market value” and “mark-to-market” accounting—employed by our financial regulators, our rating agencies, and many other institutions alike . . . played a critical role in enabling our stock and real estate bubbles to inflate. . . .I]t has never been obvious why such measures should altogether supplant, rather than simply complement, measures-by-proxy of more lasting, “fundamental” value. . . .

3. Derivative and Hedge Fund Disclosure
[T]he multitude of derivative financial arrangements pursuant to which asset price risk was transmitted worldwide have been occluded. . . . [which] is surely one of the most remarkable and surprising features of our current finance-regulatory environment. As any student of securities regulation knows, the leading strategy adopted by Congress in the 1930s for purposes of securities regulation was that of disclosure. . . . Up through the mid-1990s, there might arguably have been reason for this. Derivative transactions were, well, derivative—they were, at most, the tail on the dog of securities. . . . But that growth has long since occurred, and the once-tail now very much wags the dog.

4. A Glass-Steagall for Auditors, Rating Agencies, and Regulators
Banks now are able to affiliate with securities firms, as well as insurance companies, with abandon. A single financial holding company may hold multiple such firms. . . . [T]here are two conspicuous conflicts of interest that proliferate right now and are clearly germane to the integrity of our financial system. One is the case of auditors and rating agencies. These reputational intermediaries are retained and paid by the very financial firms that they audit and rate. And significant evidence already is emerging that some of these intermediaries have been lax in rating many of our recently worst-hit financial institutions. A related conflict is that raised by the practice of many financial regulators–not to say Members of Congress–who pursue careers with financial institutions after brief careers regulating them. . . .

[S]omething in the way of imposition of walls of separation here could be managed at little public cost. It would not be at all difficult, for example, simply to prohibit former regulators from taking positions with financial firms for some lengthy period–say five years or more–following their stints in office. By the same token, it would not be that difficult to impose upon financial firms, as a sort of licensing cost, fees of the sort that they pay auditors and raters, with a view then to publicly paying those intermediaries. . . .

5. Originator Liability
We do not, after all, permit manicurists and pizza delivery companies to underwrite or sell securities. Why, then, did we permit them to originate mortgages–a form of asset at least as critical to wealth and the health of the macroeconomy? The final reform that I take our present troubles to show critical, then, is just this: Recognize once and for all that real estate finance is as critical as is corporate finance, and regulate markets in these assets accordingly.

These are all excellent ideas, and illuminate a holistic response to the crisis. Hockett’s article is well worth reading in toto. He notes that “among the many accomplishments of the first Roosevelt Administration touted on campaign flyers during the 1936 reelection campaign now on display at [the Roosevelt Library in Hyde Park, New York], upwards of half are finance-regulatory in nature.” A party that took Wall Street reform seriously could expect similar electoral dividends.

Why Big Banks Fail to Act in Their Own Self Interest

Frank Pasquale — Thu, 23 Dec 2010 14:38:52 +0000

In an earlier post, I characterized some financial institutions as “shadowy and unstable ensembles of desks and divisions whose main goal is slipping by whatever bonus-maximizing scheme won’t set off alarms among risk managers and regulators.” Too harsh? Well, today ProPublica’s Jake Bernstein and Jesse Eisinger offer offer yet another confirmation of value-destroying skulduggery at the core of contemporary finance. They explain how payments of a few million in “bonuses” to employees running one division of Merrill Lynch helped those running another division “offload” billions of dollars in toxic assets to their own firm:

Two years before the financial crisis hit . . . [n]o one, not even the bank’s own traders, wanted to buy the supposedly safe portions of the mortgage-backed securities Merrill was creating. Bank executives came up with a fix . . . .They formed a new group within Merrill, which took on the bank’s money-losing securities. But how to get the group to accept deals that were otherwise unprofitable? They paid them. The division creating the securities passed portions of their bonuses to the new group, according to two former Merrill executives with detailed knowledge of the arrangement.

The executives said this group, which earned millions in bonuses, played a crucial role in keeping the money machine moving long after it should have ground to a halt. “It was uneconomic for the traders” — that is, buyers at Merrill — “to take these things,” says one former Merrill executive with knowledge of how it worked. Within Merrill Lynch, some traders called it a “million for a billion” — meaning a million dollars in bonus money for every billion taken on in Merrill mortgage securities. Others referred to it as “the subsidy.” One former executive called it bribery. The group was being compensated for how much it took, not whether it made money.

The three men at the top of the scheme made about $6 million each that year, and there were probably some handsomely paid lieutenants beneath them. Surely, there must have been someone who objected to such deals? There was: “a Merrill trader [who refused to go along] . . . was sidelined and eventually fired.” The power in the firm was held by those who could make quick money in big deals. Has anything changed about the structure of these firms since the crisis to alter that dynamic?

I think there is one key lesson that emerges out of a story like this, one of an excellent series ProPublica has been doing over the past year: we need a financial transactions tax. Dozens of critics of health care finance have observed that if you pay only for procedures and office visits, you get more procedures and office visits—not necessarily better outcomes. In finance, traders are getting fees for deals with no regard for the ultimate outcome. Some tax on the transactions is needed to pay to clean up the mess this excessive churn will inevitably create.

It’s become fashionable nowadays for thoughtful conservatives to acknowledge the damage that Wall Street wreaks, then immediately claim that very little can be done about it. Richard Posner’s A Failure of Capitalism was ahead of the curve in articulating this position; Tyler Cowen offers its latest incarnation:

For better or worse, we’re handing out free options on recovery, and that encourages banks to take more risk in the first place. In short, there is an unholy dynamic of short-term trading and investing, backed up by bailouts and risk reduction from the government and the Federal Reserve. . . . .And it’s not just the taxpayer cost of the bailout that stings. The financial disruption ends up throwing a lot of people out of work down the economic food chain, often for long periods. Furthermore, the Federal Reserve System has recapitalized major U.S. banks by paying interest on bank reserves and by keeping an unusually high interest rate spread, which allows banks to borrow short from Treasury at near-zero rates and invest in other higher-yielding assets and earn back lots of money rather quickly. In essence, we’re allowing banks to earn their way back by arbitraging interest rate spreads against the U.S. government. This is rarely called a bailout and it doesn’t count as a normal budget item, but it is a bailout nonetheless. . . .

[But we] probably don’t have any solution to the hazards created by our financial sector, not because plutocrats are preventing our political system from adopting appropriate remedies, but because we don’t know what those remedies are.

Cowen has opposed a transactions tax in other contexts, and I can’t see him getting too enthusiastic about this one as a risk-deterring method. But there must be some way of targeting these internal accounting tricks to make reckless risk-taking more expensive.

Cuomo Sues E&Y: Auditing Profession At Risk

Lawrence Cunningham — Tue, 21 Dec 2010 19:57:09 +0000

Ernst & Young, one of the Big-4 auditing firms left in the world, faces a grave lawsuit filed a couple of hours ago by New York’s Andrew Cuomo, the incoming governor’s last major act as state attorney general. The lawsuit is based on fraudulent accounting committed by Lehman Brothers, the failed investment bank, that E&Y either overlooked or condoned, as I explained last March.

The AG seeks unspecified damages the audit failure caused, certainly running to the hundreds of millions and easily reaching into the billions. Given that E&Y does not have external insurance to cover such losses, but self-insures, the lawsuit could put the firm’s survival at risk. Even so, settlement talks, going off-and-on since March, failed, suggesting that the firm is banking on being exonerated. That is quite a gamble.

As I told the New York Times and readers of this blog in March, if the case impairs E&Y’s viability as a going concern, a corporate financial reporting crisis should be expected. It would be acute compared to the modest scramble that corporate America faced after government prosecutors a decade ago drove from the profession the Big-5 firm, Arthur Andersen, auditor of Enron Corp. Then, 1/5 of companies needed to find a new auditor and most were able to count on one of the remaining four with little trouble.

Today, 1/4 of public companies would be obliged to find a replacement auditor; thanks to rules stated in the federal response to Enron, the Sarbanes-Oxley Act of 2002, about 1/3 of those would be unable to engage any of the 3 remaining firms because of conflicts of interest (those other firms provide internal control or tax advisory services making them ineligible to render financial audits). Amid such a crisis, and with only 3 available firms, the existing structure of the auditing profession would be unsustainable.

It would be reassuring if the Securities and Exchange Commission could tell the nation that is has foreseen this contingency and developed plans for addressing it, as urged last March and in 2006. Alas, I am not sure that it is prepared to do either.

Finance Sector as Ultimate Risk Manager?

Frank Pasquale — Thu, 16 Dec 2010 16:03:55 +0000

David A. Moss’s When All Else Fails: Government as the Ultimate Risk Manager should be a vital guide to our future. Moss describes programs ranging from social security to bankruptcy as backstops of support for all classes. As volatility in prices, employment levels, and wages climbs, we should be exploring new “automatic stabilizers” to guarantee every family a “social minimum.” Instead, we appear to be privatizing and financializing risk via opaque institutions whose only mandate is to increase their own profits.

Consider, for instance, this vignette from Louise Story’s excellent reporting on derivatives trading:

[B]anks in an elite group, which is affiliated with a new derivatives clearinghouse, have fought to block other banks from entering the market. . . Banks’ influence over this market, and over clearinghouses like the one this select group advises, has costly implications for businesses large and small, like Dan Singer’s home heating-oil company in Westchester County, north of New York City.

This fall, many of Mr. Singer’s customers purchased fixed-rate plans to lock in winter heating oil at around $3 a gallon. While that price was above the prevailing $2.80 a gallon then, the contracts will protect homeowners if bitterly cold weather pushes the price higher.

But Mr. Singer wonders if his company, Robison Oil, should be getting a better deal. He uses derivatives like swaps and options to create his fixed plans. But he has no idea how much lower his prices — and his customers’ prices — could be, he says, because banks don’t disclose fees associated with the derivatives. “At the end of the day, I don’t know if I got a fair price, or what they’re charging me,” Mr. Singer said.

As Story explains, if this arrangement prevailed in the housing market, “It would be like a real estate agent selling a house, but the buyer knowing only what he paid and the seller knowing only what he received. The agent would pocket the difference as his fee, rather than disclose it.” Whatever Wall Street’s apologists say, the secrecy is indefensible. But perhaps the reliance of people like Mr. Singer on derivatives themselves is more troubling still.

Let’s step back a bit and think about what a derivative is. There is a dazzling world of financial transactions that come under that heading, but when we think of deals like Robson Oil’s, the following reflections from Brian Holmes are clarifying:

[A derivative] is a fungible contract, created by applying a mathematical formula to an underlying asset or commodity whose price is susceptible to fluctuation . . . . By assembling constellations of values that statistically tend to fluctuate in opposite directions, derivatives were supposed to mitigate the risks of globalization with the highest degree of efficiency. The idea was that that all risks, including collective ones, should be made into salable products, formatted for the market by private actors in search of a profit. . . .

Derivatives . . . have nothing directly to do with production; instead they are conceived to manage the environmental risks that weigh on the future of speculative activity. In this sense they are meta-commodities that govern the unfolding of the contemporary economic model. Their fascinating appearance acts to conceal the private deliberations that effectively shape the environment in which any productive or consumptive activity can take place.

Derivatives thus offer a tempting alternative to the messiness of politics. Rather than investing in sustainable energy, the US can allow everyone to hedge their own bets. Worry about peak oil? Buy some derivative that pays off big when it hits $200 a barrel. Think it’s all a big hoax? Then you can short the same instrument, or come up with some exotic variation on the short. Everyone gets to vote with dollars on some future. Worried about your home price? Robert Shiller seems to think that a “thick housing futures market” would help you diversify away that risk.

There are a few problems with such a future. Let’s forget, for now, the unfortunate fact that so many Americans are broke. Let’s not trouble with the divide between the median household (which has has net worth of under $100,000) and the top 1 percent of households’ mean wealth of over $15 million.* Let’s heroically assume that individuals can make all kinds of bets, er, investments, based on what they think the future holds. Could derivatives still serve as our ultimate risk manager?

Not really. Consider Mike Konczal’s fanciful take on the problem:

[W]hat do we call a product that pays out in times of high volatility, in times when an event out of the ordinary happens? One thing to call it is “insurance.” . . . There’s good reason we regulate insurance – it needs to pay out exactly at the moment when it is the least likely to get paid.

[There are limits to what insurers can promise. What] would you price a contract that paid $100 if the world turned into The Walking Dead, where cities were overrun with armies of zombies? The short answer is that you wouldn’t pay anything, since when you need to collect it the person on the other end is probably a zombie. This “who can credibly commit to backstopping bad events” goes towards a notion of the role the government can play in financial markets.

Of course, we did see a version of that disaster in 2008. Zombie banks walk among us to this day, propped up by lenient regulators, low interest rates, and dead ideas. Their employees will get about $143 billion in bonuses this year–more than the “$130 billion total budget gap for all 50 states,” according to SEIU. Perhaps in gratitude for the state’s generous subvention, Josef Ackermann (head of Deutsche Bank) said “I no longer believe in the market’s self-healing power” in 2008, admitting a role for government.

Yet this is the same Josef Ackermann who “pledged to seek 25 percent returns on capital before tax” after the crisis. As Simon Johnson argues, “In a world where safe assets barely earn a few percent, he can only achieve such returns through significant risk-taking.” Competitors will do the same, dancing while the music is playing. It’s hard to credibly promise protection to all the Robson Oils of the world, and to support seven to nine figure incomes. Risks have to be taken.

So we are in a curious situation: the very instruments designed to diversify away risk in one field end up exacerbating it in others. Back in November, 2007, one of the world’s best economic sociologists (Donald Mackenzie) was thinking about what he called the “end-of-the-world trade:”

The trade is the purchase of insurance against what would in effect be the failure of the modern capitalist system. It would take a cataclysm – around a third of the leading investment-grade corporations in Europe or half those in North America going bankrupt and defaulting on their debt – for the insurance to be paid out.

I asked one investment banker what might cause half of North America’s top corporations to default. No ordinary economic recession or natural disaster short of an asteroid strike could do it: no hurricane, for example, and not even “the big one,” a catastrophic earthquake devastating California. All he could think of was “a revolutionary Marxist government in Washington.”

The exchange both reveals a mindset common in New York and London, and confirms Mackenzie’s larger thesis about “performative theories” in finance. MacKenzie’s book An Engine, Not A Camera: How Financial Models Shape Markets describes how both finance theorists and traders’ views on “how the world works” end up promoting the very conditions they claim to merely reflect. The trader here locates the source of risk in the only institution that could credibly get the economy out of a severe rut, or (more importantly) avoid the rut in the first place.

MacKenzie’s trader’s nightmare scenario of a Marxist government is not nearly as plausible as the doomsday on the horizon of leading novelists, historians, environmentalists, and geologists. To take but the latest example of a flourishing genre, consider these ideas from Alfred McCoy:

Other developed nations are meeting [the threat of declining oil supply] aggressively by plunging into experimental programs to develop alternative energy sources. The United States has taken a different path, doing far too little to develop alternative sources while, in the last three decades, doubling its dependence on foreign oil imports. Between 1973 and 2007, oil imports have risen from 36 percent of energy consumed in the U.S. to 66 percent. . . .

[Given current trends in the dollar's value, one can imagine] OPEC oil ministers, meeting in Riyadh, demand[ing] future energy payments in a “basket” of Yen, Yuan, and Euros. That only hikes the cost of U.S. oil imports further. At the same moment, while signing a new series of long-term delivery contracts with China, the Saudis stabilize their own foreign exchange reserves by switching to the Yuan. . . .

The oil shock that follows hits the country like a hurricane, sending prices to startling heights, making travel a staggeringly expensive proposition, putting real wages (which had long been declining) into freefall, and rendering non-competitive whatever American exports remained.

Rather than engineering alternative sources of energy, we have focused on “financial engineering” of distributed risk management. But who really thinks we can arrange an “end of the oil era” trade to hedge against the situation McCoy is describing?

The ultimate irony is that ostensibly distributed risk management really isn’t that diversified at all. As Amar Bhide has demonstrated, the modern financial system is Hayek’s nightmare:

The financial system has been giving up . . . on the decentralization of judgment and responsibility. Case-by-case judgments by many, widely dispersed financiers with the necessary ‘local knowledge’ have been banished to the edges. . . . The core is now dominated by a small number of very large firms that have little direct contact with the ultimate real users or providers of finance. . . . [E]mployees of the organizations that produce research and ratings–and the traders whose aggregated opinions constitute the wisdom of crowds–usually don’t have much case-by-case local knowledge. They, too, often rely on [standard] statistical models, or just take cues from each other. (A Call for Judgment, 12)

Conservative thinkers like Russ Roberts and Nicole Gelinas have also observed just how far modern finance is from anything resembling a decentralized, “free market.” Louise Story’s “secetive banking elite” is not merely affecting derivatives trading, but core operations across the sector.

The finance industry’s long term efforts to take over government’s role in major risk management fail even on their own, free market terms. It’s time for radical rethink of the role of finance in the economy. The right is already well on its way toward “tight money” or even a gold standard as an answer to our current economic crisis. Progressives must realize how much is at stake if they fail to deliver an alternative narrative. Matt Stoller gets this, and offers the following insights:

Liberals should stop their love affair with conservative technocratic myths of monetary independence[,] move beyond [a] consumer-driven approach[,] and think about reform of the credit system, of the monetary order, as Elizabeth Warren [and Jane D'Arista have]. The link between the Federal Reserve and the ‘real economy’ is broken. When banks were the main conduit between the financial world and economic activity, translating savings into investment, the Fed could manipulate the economy by manipulating the banking sector. But now that shadow banks dominate our credit markets, and the Fed has allowed hot money to take over monetary policy, the Fed’s tools just don’t work. That’s why quantitative easing is foolish. We must dispatch with the ridiculous notion that pushing hundreds of billions of dollars into a broken banking system will have useful consequences.

Instead, let’s recognize that the Fed doesn’t fulfill either part of its mandate, and work towards a better and more plausible system of monetary stability. That’s not a longterm process, it’s a constant process. D’Arista argues that the Fed must connect itself to the shadow banking system and force credit to flow. This necessarily implies important changes in how the Fed interacts with financial services firms and entities. To give some idea of what this might look like, at least conceptually, Timothy Canova paints the portrait of a more democratic Federal Reserve financing the government debt during World War II. Cooperating with a phalanx of institutions, such as the Reconstruction Finance Corporation, and government boards that directed wartime rationing, the Fed was able to . . . dramatically equalize economic opportunity and wealth-building for the middle class.

Whatever one thinks of Stoller’s, Canova’s, and D’Arista’s views, we should be able to agree that high finance’s theories of risk management have led it to usurp roles that only government can play. We continue to bet on the privatization of risk at our peril.

*I derive that figure from Wolff’s update on trends in household wealth and Domhoff’s observation that “there has been an ‘astounding’ 36.1% drop in the wealth (marketable assets) of the median household since the peak of the housing bubble in 2007. By contrast, the wealth of the top 1% of households dropped by far less: just 11.1%.”

Rule of Law in Russia

Frank Pasquale — Thu, 28 Oct 2010 14:16:22 +0000

This presentation by Bill Browder at the Stanford Graduate School of Business is a pretty astonishing account of the Russian economy over the past two decades. I am familiar with the usual story of oligarch profiteering, but Browder’s experience shows how even the ostensibly sound legal arrangements of today can quickly unfold into a nightmare for investors. As the Stanford GSB news puts it,

Browder soared to fame and fortune investing in Russian equities amid the chaos and corruption of the post-Soviet economy. His hallmark: finding hidden values in Russian companies and driving up their share prices by exposing corporate malfeasance and mismanagement. His widely publicized campaigns for shareholder rights and corporate governance helped propel the Hermitage Fund from $25 million in 1996 to $4 billion a decade later. But eventually the U.S.-born financier ran afoul of the Russian government, which banned him from the country in 2005 as a threat to national security.

According to Browder, “Anyone who would make a long-term investment in Russia right now, almost at any valuation, is completely out of their mind. . . .My situation is not unusual. For every me, there are 100 others suffering in silence.” And for a “bigger picture” presentation about the “disembedded markets” and the types of forces Browder was a victim of, Nancy Fraser’s Storrs Lecture podcast on “Predatory Protections, Tragic Tradeoffs, and Dangerous Liaisons: Dilemmas of Justice in the Context of Capitalist Crisis” is also well worth listening to.

Where Have You Gone, Hernando de Soto?

Frank Pasquale — Sun, 03 Oct 2010 21:56:52 +0000

Remember Randy “Duke” Cunningham’s “bribe list” pricing—”$50,000 for every $1 million in appropriated funds he would obtain?” There are now allegations that certain firms offered to “fabricat[e] documents out of whole cloth” to lubricate the foreclosure machine. For a mere $95, one could “recreate entire collateral file,” which is all “the documents the trustee (or the custodian as an agent of the trustee) needs to have pursuant to its obligations under the pooling and servicing agreement on behalf of the mortgage backed security holder [including] the original of the note (the borrower IOU), copies of the mortgage (the lien on the property), the securitization agreement, and title insurance.” Yves Smith draws some interesting implications:

Amar Bhide, in a 1994 Harvard Business Review article, said the US capital markets were the deepest and most liquid in major part because they were recognized around the world as being the fairest and best policed. As remarkable as it may seem now, his statement was seem as an obvious truth back then. In a mere decade, we managed to allow a “free markets” ideology on steroids to gut investor and borrower protection. The result is a train wreck in US residential mortgage securities, the biggest asset class in the world. The problems are too widespread for the authorities to pretend they don’t exist, and there is no obvious way to put this Humpty Dumpty back together.

Smith’s global perspective reminds me of two items. I once heard that, in the wake of Bush v. Gore, a representative of the OAS began a meeting by saying something along the lines of: “We are now to hear from a fragile democracy, one that has suffered severe strains but which looks capable of attaining legitimate procedures for governance. Would the United States representative please come to the dais?” And policymakers who prescribe the titling work of Hernando de Soto for Latin America might want to apply it a bit more carefully at home.

On the Colloquy: The Credit Crisis, Refusal-to-Deal, Procreation & the Constitution, and Open Records vs. Death-Related Privacy Rights

Northwestern University Law Review — Sun, 05 Sep 2010 17:15:08 +0000

This summer started off with a three part series from Professor Olufunmilayo B. Arewa looking at the credit crisis and possible changes that would focus on averting future market failures, rather than continuing to create regulations that only address past ones. Part I of Prof. Arewa’s looks at the failure of risk management within the financial industry. Part II analyzes the regulatory failures that contributed to the credit crisis as well as potential reforms. Part III concludes by addressing recent legislation and whether it will actually help solve these very real problems.

Next, Professors Alan Devlin and Michael Jacobs take on an issue at the “heart of a highly divisive, international debate over the proper application of antitrust laws” – what should be done when a dominant firm refuses to share its intellectual property, even at monopoly prices.

Professor Carter Dillard then discussed the circumstances in which it may be morally permissible, and possibly even legally permissible, for a state to intervene and prohibit procreation.

Rounding out the summer was Professor Clay Calvert’s article looking at journalists’ use of open record laws and death-related privacy rights. Calvert questions whether journalists have a responsibility beyond simply reporting dying words and graphic images. He concludes that, at the very least, journalists should listen to the impact their reporting has on surviving family members.

Dodd-Frank on Pay: Neutrality, Signaling, and Exposé

Lawrence Cunningham — Thu, 29 Jul 2010 00:26:59 +0000

Neutrality, signaling and exposé are the tonics served up on executive compensation in the new law nominally aimed against Wall Street and for consumers. The 848-page statute also named for its sponsors, Senator Dodd and Representative Frank, makes public companies put neutral committees at the pay-setting helm, lets shareholders cast precatory votes on the results, and shines a potentially embarrassing spotlight on prevailing pay realities and ratios. It puts a heavy hand on big bank pay setting.

Those incrementally averse to regulation will be appalled while those fearing serious flaws in pay practices enthralled. But neither group seems right, as these efforts reflect real problems, yet they are not likely to achieve their objectives. Even so, here’s a run-down of our new federal executive compensation laws, and predicted effects.

Neutrality. Courtesy of mandates on our stock exchanges the SEC will impose, companies won’t be able to list securities unless their boards use pay committees staffed by independent directors. This new neutrality on pay committees looks different from other uses of the independence concept, riveting heavily on how those members are paid. The neutral group gets exclusive power to hire and pay consultants, whose neutrality in turn is to be mandated by regulation. This move mirrors the one in 2002’s Sarbanes-Oxley Act, dictating the power of audit committees who preside over financial reporting. Predicted effect: limited, as have been nearly all other investments in director independence since that reform impulse became fashionable two generations ago.

Exposé. Following the standard approach in securities law generally and executive compensation in place for decades, you’ll see more charts and images displaying pay. Disclosure will include what the neutral directors and their consultants did along with images relating pay packages to enterprise financial performance. Stunningly, companies will show in a crisp ratio what the median worker makes compared to what the CEO makes. Impressively, you’ll find out whether managers owning stock can hedge against declines in the stock price. That’s important because even stock pay designed to induce optimal incentives can be circumvented with hedges. Predicted effect: intensification of existing polarity in the populace dividing those outraged by great income disparities between workers and managers from those who assume big pay rewards hard work.

Signaling. At least every three years, companies must ask shareholders what they think of company pay in this newly neutralized and exposed world—and ask them every six years whether to make those votes more or less frequent. Shareholders also have to be told of any special pay managers get when voting on organic business changes like mergers and asset sales. These are all merely precatory votes, though, the statute making it clear they’re not binding and have no legal effects whatsoever, including on director duties and power. That makes this properly classified as a signal on pay (not, as the popular but misleading slogan has it, say on pay). Predicted effect: a new way to stick it to managers unwanted for other reasons.

Big Banks. Federal regulators must adopt rules to prohibit big banks—those commanding assets exceeding $1 billion—from using any contingent pay packages that yield either “excessive compensation” or risks of “material financial loss” to the bank. By fall, regulators must find out from banks whether any existing pay arrangements pose those problems. None of that must be disclosed to the public, though, and individual deals don’t have to be shared with the regulators either. Predicted effect: Byzantine regulations delineating the meaning of excessive and material plus incremental retrenchment against pay explosion.

Upshot: I still like my proposal to let the common law of contracts police particularly obnoxious pay contracts on a case by case basis under its doctrine of unconscionability. Contract law has a majesty and beauty unmatched by federal regulation or state corporation law. (My proposal is now in a paper I’ll submit to the law reviews in mid-August. The Dodd-Frank Act strengthens its appeal.)

Goldman’s $550 Million SEC Settlement

Lawrence Cunningham — Thu, 15 Jul 2010 21:59:42 +0000

The SEC announced this afternoon that Goldman Sachs agreed to settle, for $550 million, the civil lawsuit against it alleging materially misleading disclosures in circulars for some mortgage-backed securities it hawked. As I wrote on this blog, in a post of April 19 called SEC v. Goldman as a Simple Case, the case was simple.

In a bruising Consent to a Final Judgment in the federal case against it, Goldman acknowledges the point I made that makes the case simple. Its marketing circular said the reference portfolio was “selected by” the independent firm, ACA Management LLC, when in fact Paulson & Co. Inc., an interested party, played a role in that selection.

Within 30 days, Goldman must pay investors it misled by the marketing materials: $150 million to Deutsche Bank and $100 million to the Royal Bank of Scotland (known as ABN AMRO Bank when it bought Goldman’s securities). It must pay another $300 million to the SEC.

The SEC’s press release headlined that this amount set a ”record” for the agency and is non-trivial even for a firm of Goldman’s size. Its enforcement chief, Bob Khuzami, boasted that “half a billion dollars is the largest penalty ever assessed against a financial services firm in the history of the SEC.”

In addition to the cash outflow, Goldman agrees to extensive business practice and internal governance reforms. These include specific requirements for expanded oversight of internal product review; legal oversight of marketing materials, by internal and outside counsel; internal auditing; and education and training. It must file with the SEC special certifications of compliance with these requirements, which Goldman must maintain for three years.

Goldman also agrees to cooperate fully with the SEC in other ongoing investigations and litigation, including putting Goldman employees at the SEC’s disposal. That’s important because, though this settles the case for the firm, the SEC’s litigation against the Goldman man behind the misleading securities sale, wisecracking Fabrice Tourre, continues.

It was a simple case and this is a simple way to end it, especially with Goldman’s express acknowledgement of its misleading materials. As the Wall Street saying goes, though, there’s rarely only one cockroach in the kitchen. The SEC enforcement team is on the beat under Chair Mary Schapiro, a big improvement over her predecessor Chris Cox, whom I criticized repeatedly on this blog for regulatory laxity. Hats off to the diligent SEC team.

Here Comes FinReg

Frank Pasquale — Thu, 15 Jul 2010 13:42:17 +0000

Via Ezra Klein’s Wonkbook (definitely one of my favorite morning emails), a variety of takes on what’s in the financial reform bill:

1. From Deloitte’s 12-page summary:

Because the new U.S. law is complex, it can be helpful to remind ourselves that its underlying purpose is relatively simple and has two powerful strands: 1. ‘De-risk’ the financial system by constraining individual organizations’ risk-taking activities and capturing a broader set of organizations’, including the so-called “shadow” banking system, in the regulatory net 2. Enhance consumer protections. . . .For example, the need for “arm’s-length” swap desk affiliates combined with the move from over- the-counter to exchange trading for derivatives, tighter constraints on leverage and risk-taking, and higher liquidity requirements imply lower profit margins in future from those activities.

Some estimates I’ve seen have estimated the profit margins might be around 15% lower.

2. Simon Johnson on the Kanjorski Amendment as a “new kind of antitrust:”

Effective size caps on banks were imposed by the banking reforms of the 1930’s, and there was an effort to maintain such restrictions in the Riegle-Neal Act of 1994. But all of these limitations fell by the wayside during the wholesale deregulation of the past 15 years. Now, however, a new form of antitrust arrives – in the form of the Kanjorski Amendment, whose language was embedded in the Dodd-Frank bill. Once the bill becomes law, federal regulators will have the right and the responsibility to limit the scope of big banks and, as necessary, break them up when they pose a “grave risk” to financial stability.

I wish I could say I was as optimistic as Johnson about the prospects for effective enforcement here, but he certainly knows the lay of the land far better than I do. As Barry Lynn shows, in a variety of industries, we need a new form of antitrust, or at least better competition advocacy.

3. The Roosevelt Institute publishes a variety of takes; William K. Black is the most pessimistic:

The fundamental problem with the financial reform bill is that it would not have prevented the current crisis and it will not prevent future crises because it does not address the reason the world is suffering recurrent, intensifying crises. A witches’ brew of deregulation, desupervision, regulatory black holes and perverse executive and professional compensation has created an intensely criminogenic environment that produces epidemics of accounting control fraud that hyper-inflate financial bubbles and cause economic crises. . . .

The financial industry, with Bernanke’s support, already got Congress to extort FASB to gimmick the accounting rules so that insolvent banks could hide their losses and continue to pay the executives (already made rich by destroying “their” firms — that’s the meaning of Akerlof & Romer’s classic article: “Looting: Bankruptcy for Profit”) massive bonuses. All of this is made possible by huge, off budget subsidies to [systemically dangerous institutions] via the Fed and Fannie and Freddie.

4. Daniel Indiviglio on the uncertainty at the heart of the legislation (does it end or encourage TBTF?):

The prevailing debate between Republicans and Democrats on financial reform is whether the new bill institutionalizes the too big to fail problem. Democrats swear it doesn’t, since the legislation also includes a new non-bank resolution authority which will make quite certain that all firms can, and will, fail if they run into trouble. Republicans haven’t developed a very sensible criticism to this, but they could. While the resolution authority ensures that big firms fail, it would also almost certainly provide them some advantage.

A lot will depend on regulators’ interpretation and enforcement here.

5. James K. Galbraith provides some background:

The financial crisis in America isn’t over. It’s ongoing, it remains unresolved, and it stands in the way of full economic recovery. The cause, at the deepest level, was a breakdown in the rule of law. And it follows that the first step toward prosperity is to restore the rule of law in the financial sector.

[What went wrong?] First, there was a stand-down of the financial police. The legal framework for this was laid with the repeal of Glass-Steagall in 1999 and the Commodities Futures Modernization Act of 2000. Meanwhile the Basel II process relaxed international bank supervision, especially permitting the use of proprietary models to value complex assets—an open invitation to biased valuations and accounting frauds.

Key acts of de-supervision came under Bush. After 9/11 500 FBI agents assigned to financial fraud were reassigned to counter–terrorism and (what is not understandable) they were never replaced. The Director of the Office of Thrift Supervision appeared at a press conference with a stack of copies of the Code of Federal Regulations and a chainsaw—the message was not subtle. The SEC relaxed limits on leverage for investment banks and abolished the uptick rule limiting short sales to moments following a rise in price. The new order was clear: anything goes.

Second, the response to desupervision was a criminal takeover of the home mortgage industry. Millions of subprime mortgages were made to borrowers with undocumented incomes and bad or non-existent credit records. Appraisers were selected who were willing to inflate the value of the home being sold. This last element was not incidental: surveys showed that practically all appraisers came under pressure to inflate valuations in order to make deals happen. There is no honest reason why a lender would deliberately seek to make an inflated loan. . . . Third, the counterfeit mortgages were laundered so they would look to investors like the real thing. . . .Fourth, the laundered goods were taken to market. . . . Upon taking office, President Obama had a chance to change course and didn’t take it.

The question now is whether FinReg will provide a “second chance” for an Administration that so far has not distinguished itself on the financial reform front.

Image Credit: 1901 image of J.P. Morgan.

Are We There Yet? Driving The Financial Reform Bill Home

Kristin Johnson — Fri, 25 Jun 2010 21:24:26 +0000

This morning, at 5:39am, a conference committee comprised of 43 lawmakers from the House and the Senate agreed upon a final version of the financial reform bill. The bill is expected to pass in both chambers of Congress and to be signed into law on July 4th by President Obama. As anticipated, the final version reflects critical compromises that may alter the bill’s ability to mitigate the systemic risk in the financial system that inspired the bill’s creation.

Earlier versions of the bill included provisions proposed by former Federal Reserve Chairman Paul Volcker and Senator Blanche Lincoln. These provisions aimed to prohibit federally insured banks from engaging in riskier investment activities, such as investments in hedge funds or private equity funds, and required banks to limit and isolate their proprietary trading activities and to discontinue their origination and trading of nontraditional or exotic investment products, such as derivatives contracts. In the face of strong and well-financed opposition, the conference committee has adopted a less restrictive version of the proposed regulation.

In the version of the bill adopted by the conference committee, in lieu of a ban on alternative investments, banks retain the right to engage in hedge fund and private equity fund investments subject to a cap limiting those investments to 3% of the funds’ capital and no more than 3% of the banks’ tangible capital. The shift from a ban to a limitation on alternative investments curtails the bill’s impact in two significant ways: the cap continues to allow federally insured banks to have exposure to assets that perform with less predictability and greater volatility and the language establishing the cap creates ambiguity. Alternative investments involve inherently riskier strategies and permission for deposit institutions to engage in these investments keeps alive the notion that commercial banks are hybrid institutions – part deposit institution, part strategic investing or underwriting institution. In addition, the absence of precise definitions for the classes of capital that will be used to measure and limit banks’ alternative investments leaves these questions to regulators’ interpretations. Moreover, determining how banks measure capital and capital requirements is often debated, seldom universally agreed upon and subject to international application because of the integrated nature of international financial markets. As a result, we may have taken a much smaller step towards market reform than touted by the bill’s proponents.

Proposed language in the Volcker rule regarding banks’ proprietary trading activities also appears to be watered down and similarly ambiguous. Earlier versions of the bill would have altogether eliminated proprietary trading, or purchases and sales by banks of securities and other investment products for their own accounts. The language in the version of the bill adopted by the conference committee allows banks to engage in “market making activities,” or “trading that facilitates customer relationships.” Again, the regulators’ interpretation of the definition of “market making” will be the test of whether this provision has sufficient teeth to mitigate the concerns that motivated the inclusion of this provision. Distinguishing between market making and proprietary trading activities is not always easy. A bank may engage in a trade today on behalf of a customer looking to sell a security or an asset (market making activity) and that transaction is easily transformed into a proprietary trade tomorrow when the bank makes a strategic decision to hold or dispose of that same security or asset. Drafters will therefore need to spend some time improving the language to avoid the types of loopholes that would permit abuse of this exception.

Similar issues have arisen in connection with Senator Lincoln’s proposal to the limit federally insured banks from engaging in derivatives trading activities. Lincoln’s controversial amendment, which would have imposed a complete ban on such activities, has lost some of its sizzle. The version of the bill adopted by the conference committee would allow banks to trade currency, commodity, interest rate and certain credit derivative swaps. Why does the bill allow banks to continue to use of these types of derivative instruments? Without the ability to share the risks related to lending activities, banks argued that they would be less willing to lend and credit markets would contract. In contracted credit markets, banks explained, it would be harder for all parties that rely on credit to borrow, including businesses that borrow for payroll expenses, individuals borrowing to buy cars or automobile manufacturers borrowing to stay afloat. The most disconcerting aspect of the committee’s version of the bill lies in its thin definition of the parameters around banks’ use of these derivatives investments. In the version of the bill adopted by the conference committee, banks may only use these derivatives instruments to “hedge” or protect themselves from exposure to genuine risks of loss. Banks may not, according to the bill, use the derivatives instruments to engage in speculation. There is no attempt to sort out which activities constitute hedging or speculation in the legislation. This punt to regulators may prove especially challenging because they have struggled with distinguishing between activities that hedge against risks and mere bets.

By including these exceptions and failing to create more substantive definitions for some of the more critical terms, the drafters of the proposed financial reform bill may have created loopholes that are just big enough to lasso and diminish the effectiveness of each of the noted rules.

GW’s Junior Scholar Workshop and Prizes

Lawrence Cunningham — Tue, 08 Jun 2010 17:00:29 +0000

As anticipated, the Center for Law, Economics and Finance at George Washington University Law School (C-LEAF) has formally announced its first annual Junior Faculty Business and Financial Law Workshop and Junior Faculty Scholarship Prizes. The Inaugural Workshop will be held and Prizes awarded on April 1-2, 2011, at GW Law School in Washington, DC.

Up to ten papers will be chosen from those submitted for presentation at the Workshop. At the Workshop, one or more senior scholars will comment on each paper, followed by general discussion of each paper among all participants. The Workshop audience will include invited junior scholars, faculty from GW’s Law School and Business School, faculty from other institutions, and invited guests.

At the conclusion of the Workshop, up to three papers will be awarded Junior Faculty Scholarship Prizes, of $3,000, $2,000, and $1,000, respectively. Chosen papers will be featured on C-LEAF’s website as part of its Working Paper Series. In addition to participating in the Workshop, all scholars selected to present at the Workshop will be invited to become Fellows of C-LEAF.

Scholars who have held a full-time academic appointment for less than seven years as of the submission date are eligible. Subject matters encompass accounting, banking, bankruptcy, corporations, economics, finance, and securities.

Interested scholars should submit a summary or draft, preferably by e-mail, before October 15, 2010. Submissions, along with any inquiries related to the Workshop, should be directed to: Professor Lisa M. Fairfax, Leroy Sorenson Merrifield Research Professor of Law, George Washington University Law School, Washington, DC 20052. Email: lfairfax@law.gwu.edu

Papers and Junior Faculty Scholarship Prizes will be selected after a blind review by a committee of C-LEAF’s Executive Board. Authors of accepted papers will be notified by November 19, 2010.

The Workshops and Prizes are made possible by generous sponsorship of Schulte Roth & Zabel LLP, one of the leading law firms serving the financial services industry and known for its premier practice in the area of private investment funds and private equity M&A.

Nonlinear Theory Explains May 6 Market Break

Lawrence Cunningham — Thu, 13 May 2010 18:30:41 +0000

One week after stock markets dropped 10% in half an hour, regulators still confess bewilderment yet equally resolve never to let it happen again. No one at the SEC or CFTC or any of the exchanges has been able to identify a particular cause of the flash crash. They do say the precipitous decline was magnified by how some trading platforms, like the old-fashioned New York Stock Exchange, halted trading when the downward spiral began while electronic trading platforms did not.

A consensus appears to believe that this worsened the spiral because trades could still be made elsewhere but with fewer participants, in a thinner market. Adherents think the cure is obvious: such trading breaks should be adopted across all trading platforms so if there is ever any significant decline in price, all trading would halt. I respectfully dissent.

This is a replay of the 1987 stock market crash: no one could figure out why it happened so everyone decided such circuit breakers were the thing to do about it. The consensus is likely to be just as wrong today as it was wrong then, based on an alternative view, which I laid out in my 1994 GW Law Review article, From Random Walks to Chaotic Crashes: The Linear Genealogy of the Efficient Capital Market Hypothesis. Those seeking an explanation for the 1987 crash and last week’s flash crash presuppose things about stock markets and pricing that may simply be false.

They suppose prices accurately reflect collectively-rational behavior among informed traders whose spontaneously-coordinated actions invariably result in stock prices, and stock price changes, that linearly give up-to-the-minute best estimates of underlying business value. That is a delineated version of the popular efficient market hypothesis. Things like the 1987 crash and last week’s flash crash are inconsistent with that, so stand out as anomalies needing an explanation outside the popular hypothesis.

But that isn’t how prices actually work and episodes like the 1987 crash and last week’s flash crash merely put the recurring reality in sharp relief. Stock price adjustments are not always elegantly fluid, linear, and endlessly up-to-date. They are nonlinear and often chaotic. Price changes do not move in increments of pennies and dollars but alter abruptly, non-linearly, skipping from $10 to $14 to $8, not moving between those figures from $10.01, $10.02, $10.03 . . . $14. . . .

The same is true of the aggregate Dow index: when it drops from 10,600 to 9,870 — whether in 20 minutes or 20 days — that doesn’t mean anyone could have traded at incremental levels in between during that time. Stock prices are driven by the volume of buy-sell orders and the relative imbalance. Stock prices rise rapidly when buyers outbid sellers and vice versa.

Sometimes that means a massive rally in prices and sometimes it means a sharp plunge. Why is a combination of fundamental analysis and behavioral dispositions unrelated to that. So what, therefore, if stock prices rise 1000 points or fall 1000 points in a few minutes or a day or a month? Let the market rise; let the market fall!

If you still believe, as regulators insist, that we simply cannot have 1000 point drops in half an hour, one prescription seems obvious to them: if markets start to fall like that, shut them down—don’t let them fall. That is the logic behind the consensus that last week’s fall was magnified by trading halts (called circuit breakers) only applying at some, but not all, trading platforms. But at least two issues arise from this digagnosis of circuit breakers that were too limited and cure that circuit breakers should be universal.

One: if you are going to interfere and shut down a market because price levels are rapidly falling, why are you not going to interfere and shut down a market because price levels are rapidly rising? Proponents of circuit breakers think they know it is a potentially bad thing when prices plummet, bad enough to shut down the market. But sometimes prices get so high that they should plummet. (The reason circuit breaker proponents do not propose to shut markets down when prices are rising is not about policy logic but because that is party time and no one wants to take away the punch bowl!)

Two: if you think you are good at knowing that a market should shut down when prices have fallen by a certain amount within a certain time, how do you know ahead of time that your solution of automatically shutting them down will not exacerbate the problem you seek to correct? It is at least equally likely that, as a price change trigger is approached, the mere proximity to it induces panic selling by those fearful that the market soon will shut down and prevent them from getting out.

So far, officials officially are saying they don’t really know what happened last Thursday but they think whatever happened is a problem to which they need to find a solution. But it is possible that it was simply normal market behavior, in its chaotic non-linear beauty, merely magnified in its visibility, yet still quotidian. There is good news in this mix of professed regulatory ignorance about cause coupled with regulatory confidence about the cure: the SEC-CFTC are setting up a special committee to have a closer look. I hope they consider nonlinear market realities.

Corporate Pay Conference June 3

Lawrence Cunningham — Wed, 12 May 2010 21:02:37 +0000

Those interested in executive compensation are cordially invited to attend a half-day conference on the subject in New York June 3, sponsored by GWU Law’s Center for Law, Economics and Finance (C-LEAF).

To be held at the Century Club (7 W. 43rd St.), featured speakers are Treasury’s pay expert, Ken Feinberg (pictured at right), and institutional investor advocate, AFL-CIO Special Counsel, Damon Silvers, along with a pair of likewise distinguished panels.

Highlights follow. More information is here and registration can be made here. Attendance is limited but we’d like to have as many interested persons join us as possible.

C-LEAF in New York Conference: Executive Compensation

June 3, 2010

Century Club (7 W. 43rd Street)

Program Begins, 8:30 am, with welcoming remarks from GWU Law professor and C-LEAF head, Lawrence Mitchell.

Keynote One, 8:45, Kenneth Feinberg, Special Master for Executive Compensation, United States Department of the Treasury, designated as GWU Law’s Annual Manuuel F. Cohen Memorial Lecture.

Panel One, 9:45, on Pay as a Risk Factor, moderated by Michael Farber (Davis Polk & Wardwell), with contributions from Lisa Fairfax, Theresa Gabaldon and Lawrence Cunningham (all of GWU Law) and Ed Labaton (Labaton & Sucharow).

Panel Two, 11:00, on Reforms, moderated by Margarita Brose (Barclays Capital Markets), with contributions from John Buchman (E*Trade’s General Counsel), Anna Gelpern (American U. Law), Heidi Schooner (Catholic U. Law), and Art Wilmarth (GW Law).

Keynote Two, 12:45, Damon Silvers, Director of Policy and Special Counsel, AFL-CIO

This program is part of GWU Law’s Center for Law, Economics and Finance (C-LEAF), a think tank within GWU Law School, designed as a focal point for the study and debate of major issues in economic and financial law confronting the United States and the globe. It intends to operate primarily in Washington with a regular presence in New York and other major financial centers around the world.