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Category: Securities Regulation

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

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.

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Goldman’s $550 Million SEC Settlement

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.”

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Here Comes FinReg

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.

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Are We There Yet? Driving The Financial Reform Bill Home

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.

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GW’s Junior Scholar Workshop and Prizes

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. Read More

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Nonlinear Theory Explains May 6 Market Break

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. Read More

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Corporate Pay Conference June 3

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. Read More

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Analogies in SEC v. Goldman Case

Goldman Sachs told customers the terms of a bet would be set by an independent agent but the SEC alleges a competing customer actually played a significant role setting the terms, which may have been more favorable to it. Consensus emerges that the legal issue is whether it is important to the original customers that terms were set by an independent agent or the competing customer, given that they could inspect the terms for themselves.

It can be useful but difficult to find suitable analogies to help think about this. Yesterday on this blog Deric Ortiz asked whether this is akin to any buyer and seller of securities who simply have different views of the bet, whoever set its terms, which are available for all to see; today in The New York Times Binyamin Appelbaum sees a rough equivalence to alleging that an antiques dealer “lied about the provenance, but not the quality, of an old table.”

I’m not sure either of those analogies work.  I’ve come up with other candidates posted below, most of which also seem off for various reasons.  I’d like to invite interested creative readers to take a few minutes to contribute additional nominees.   Read More

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SEC v. Goldman as a Simple Case

Despite a complex context and heated rhetoric on all sides, the core of the SEC’s complaint against Goldman Sachs is simple: Goldman sold to investors a bet based on a list of securities it said would be hand-picked by an independent expert when the list was allegedly picked in part by a Goldman client with interests diametrically opposed to the investors. The only successful defense to this allegation is that the independent expert did in fact hand-pick the list and neither Goldman nor its other clients played a role in it.

Picking the list is vital and related disclosures or non-disclosures material within the meaning of federal securities laws. If investors are told a list is chosen by an independent party, they are told that the bet will be a fair game—knowing, of course, that other investors will have different views and either refuse to buy the same device or even take short positions against it. But if investors are told that a list will be chosen by someone who will make money only if its value declines, rational investors will eschew such a game as rigged, not fair.

Since the incubation of the asset-backed securities markets decades ago, when I helped to design them, selection of the pool or reference securities has always been seen as vital. In original deals consisting of a bank’s mortgage loans, for example, the selection is to be made using a haphazard selection protocol from across the bank’s entire mortgage loan portfolio. Banks cannot cherry pick their overall portfolio and dump only the worst-performing loans into a pool. Investors would not buy it if they knew that were happening. Read More

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SCOTUS Chides Posner/Easterbrook in Jones v. Harris

In a gentle rebuke to two famous academic judges, Richard Posner and Frank Easterbrook, today the US Supreme Court told them a debate they were airing in a recent case was not for federal judges but for Congress.

The Court, in Jones v. Harris, unanimously vacated as erroneous Easterbrook’s opinion that went out of its way to disagree with well-settled judicial interpretations of a relatively simple federal statute. Posner’s contending opinion engaged directly with the economic and market theories on which Easterbrook drew, both judges wrongly making debate out of the wisdom rather than the meaning of the statute.

The statute says an adviser to mutual funds is “deemed to be a fiduciary with respect to the receipt of compensation for services.”   For thirty years, virtually all federal courts take that to mean adviser fees cannot be so disproportionate to services rendered as to indicate lack of an arms-length sort of bargain.    Testing that requires considering all relevant factors.

The Court affirmed that interpretation and test as correct, in an opinion written by Justice Samuel Alito. Easterbrook erred when instead saying the fiduciary duty language required only that advisers disclose fees and that no other factor is relevant. The Court indicates that his dissertation on competition in the mutual fund industry and theories of market behavior is irrelevant to federal court business in the case.

Posner’s opinion, in the form of a dissent from the Circuit’s refusal to rehear the case en banc, engaged Easterbrook directly on economic theories and views of market efficacy, including debating empirical academic studies reaching opposite conclusions. The Supreme Court rebuked both, saying their job was to apply the statute not debate its wisdom. Read More