Trickle Down Retribution

In the end, the financial services bill is again a disaster organized by a committee.  This lays it out in some detail. – It will never stop the endemic fraud that now permeates the securities industry and which bubbled up through the highest ranks in 2008.

And no it is not about the brokers and the sale people who are trying to make a living and perhaps help clients.  It is about capital trying to rig the system so that they can not lose.

The most disturbing aspect is the broadening of the lawyer’s ability to prey on a corporation without much recourse to a client.

An investor in a stock must now consider that a predatory cabal of lawyers can set upon a company and extort massive capital from the company with slim pretext provided by an anonymous disgruntled employee.  This is actually outrageous and will likely get struck down when tested.

However, this may succeed in causing millions of Americans to abandon the securities markets of the USA. It is certainly a good start.

In the meantime, it is no big trick to merely move your corporate domicile over the border into Canada and to vigorously dispute legal venues.  It will not be perfect, but it certainly would be a good start toward thwarting the worst aspects of this bundle of nonsence.

Trickle-Down Retribution

Friday, July 9, 2010

Congress is close to passing a 2,300-page financial services bill. Despite media spin, this legislative muddle is bad news for the American public. The only victory can be claimed by the special-interest groups--in particular, plaintiffs' lawyers--that inserted provisions to advance ulterior motives but have little to do with the stated goals of the legislation.

This poorly drafted hodgepodge--most provisions have nothing to do with the true causes of the financial crisis--will drastically expand the power of the federal government, create new bureaucracies staffed with thousands, and do little to help the struggling American citizen. Ambiguous language will result in frivolous and unnecessary litigation, further stifling economic growth. The additional costs will weigh on consumers, raise barriers to entry for entrepreneurs and destroy jobs. What a great way to get an economy up and running.

Aside from a few provisions, most of the bill has not been fully debated in Congressional hearings, but is the product of a series of marathon, late-night, closed-door negotiations. As Sen. Christopher Dodd, D-Conn., remarked at the end of an all-night session leading to the final draft, "No one will know until this is actually in place how it works."

By upping the ante on liability and leaving unresolved bureaucratic turf issues between regulatory agencies, the bill guarantees that these instruments will become more expensive and hedging risk will become less certain.

Largely unnoticed and undebated are the ways in which the bill could further expand the ambit of the plaintiffs' bar. Chief among these are the whistle-blower provisions. The bill provides that the Commodity Futures Trading Commission and Securities and Exchange Commission may award whistle-blowers from 10% to 30% of monetary sanctions collected in enforcement actions. Two special funds of $300 million and $100 million are set up for the SEC and CFTC, respectively, to ensure payment of whistle-blowers. The bill provides that whistle-blowing employees can hire attorneys and that they must hire an attorney if they wish to remain anonymous. One can imagine what percentage of the 10%- 30% take the lawyers will demand from the whistle-blower.

The drafters of the bill clearly are aiming to encourage whistle-blowers and ease their fears of retaliation, ostracism and reputational damage for future employment--all authentic concerns for legitimate protesters. But the unintended consequences of unfounded charges from employees with ulterior motives will be devastating for shareholders.

Already, a company must hire attorneys and accountants to investigate almost any purported complaint, with strict policies and procedures to ensure due process. The injection of plaintiffs' attorneys into the mix increases the potential for specious claims to get traction and win a settlement, especially if the complainant is anonymous. Congress has skewed the delicate balance between good policy and over-indulgence of accusations.

In another example, the bill imports class-action lawyers' favorite tool, section 10(b) of the Securities Exchange Act, explicitly into the law governing securities-related derivatives and swaps. Section 10(b) is the hunting license for trial lawyers to bring class-action lawsuits for sometimes frivolous reasons. While itself not necessarily earth-shaking considering the current state of the law, the change's real-world effect could be troubling when combined with the bill's new regime regarding transparency and clearing of derivatives, which will make pricing information public for the first time. Because private plaintiffs must show causation under section 10(b), plaintiffs' lawyers simply point to drops in stocks as evidence of causation.

With stocks, frivolous lawsuits may be dismissed on causation grounds by the judge. However, derivatives often fluctuate for a variety of complicated reasons, so judges simply may avoid the difficult decision of dismissing a frivolous complaint on the merits and leave matters to a jury to sort out. Since the bill's exceptions from liability are very narrow, plaintiffs' lawyers will find the $1.5 trillion over-the-counter U.S. securities derivatives market a tantalizing prospect for lawsuits.

These securities-related derivatives are important tools in basic corporate finance, mergers and acquisitions, and hedging transactions. By upping the ante on liability and leaving unresolved bureaucratic turf issues between regulatory agencies, the bill guarantees that these instruments will become more expensive and hedging risk will become less certain. It does not take a financial genius to predict that the writing and trading of these instruments will migrate to London, Singapore and perhaps Toronto.

Other special-interest groups are celebrating. The bill gives the newly politicized SEC authority to let certain large shareholders, acting in coordination in a non-transparent manner, nominate directors directly--mainly unions, state pension funds and activist shareholders pushing special agendas. The interests of these groups often differ from the interests of individual shareholders. By tipping the scale further in the favor of them, the net effect will be to politicize the proxy process, overrule well-established state law, undermine company management and confer on opaque proxy advisory firms, "activist shareholders," unions and other often-allied interest groups additional back-room clout to influence corporate affairs for their own benefit. Who loses? The average shareholder.

What started out as a bill to "get" Wall Street has morphed into a bill that sticks it to everyone--Wall Street, Main Street, consumers, entrepreneurs, shareholders and taxpayers alike. The financial markets are critically important to America. They raise capital for businesses producing goods and services. They create jobs, fund ideas and increase wealth for all Americans. When Americans save and invest, they are putting their capital to work, building their nest egg and that of others too. We need a more thoughtful, balanced plan to make sure that that nest egg is as safe as it can be, but also to ensure that we are not killing the proverbial, golden egg-laying goose. Senators should reject this unhealthy bill.

Paul Atkins is a visiting scholar at AEI.

Great Moments in Financial Regulation

Wednesday, April 28, 2010

As Congress works to create a bipartisan agreement on financial regulation, lawmakers need to look closely at the effects of their proposals. While the administration believes another government institution will prevent future crises, history shows that this is not always true. Congress should instead focus on increasing transparency and giving regulators, creditors, and investors better and more timely information to perceive risk and make better informed investment decisions.

Congress is moving towards bipartisan agreement on changes to financial regulation, claiming to address the root causes of the market crash of 2008. The centerpiece of this legislation includes creating a group of officials to regulate "systemic risk." Unfortunately, instead of advancing transparency and empowering investors, it will do very little to address systemic risk, while adversely affecting many of America's most successful non-financial businesses. In fact, combined with other provisions of the bill, government officials will be in a position to substitute their judgment for that of investors.

Almost everyone can agree that the causes of the recent financial crisis included mistakes on all sides. Financial institutions offered loans to borrowers who could not repay them. Government-sponsored enterprises and government policy encouraged these sub-prime loans, which were then repackaged as securities and sold with high investment ratings (thanks to government backing) to buyers who did not fully assess the risks. All proceeded on the theory that asset prices would keep rising. Buyers, sellers, and government agencies mistakenly placed too much reliance on the supposed insight and expertise of credit rating agencies. When the music stopped, it became clear that nobody knew what the instruments, including their underlying assets, were worth. Tumbling investor confidence wreaked its special brand of havoc as liquidity evaporated and investors fled for the hills. In the case of the largest banks, the end result was hundreds of billions of dollars of U.S. taxpayer assistance.

The fundamentally wrong conclusion from these facts, now seized upon by the Administration and politicians on both sides of the aisle, is that another, cleverly designed government institution is the prescription for our present ills. Given that most of the "bailed out" institutions were the most tightly regulated, even in terms of capital standards specifically designed to prevent the kind of bank run we witnessed, the "safety and soundness" approach to bank regulation itself needs to be reexamined. The end result of this traditional regulatory approach is that government bureaucrats tightly control the information that investors can learn about a financial institution, limiting proper analysis. Even underwriters of a bank's securities offering have to do their due diligence inquiry without access to the candid assessments by bank examiners of the bank's condition. How can "systemically significant" financial institutions in the information age not be fully transparent?

The bill proposed by Senator Christopher Dodd, along with the Treasury and House versions, simply doubles down on this same approach. The proposals seek to extend bank-style regulation to any American company that is deemed to be systemically significant--a "threat" to the financial system. The powers extend to companies and, ultimately, financial products. The new regulatory body is to be both omniscient and omnipotent--supposedly able to predict future market excesses and use sweeping powers to stop them. If the bill becomes law, two outcomes are likely: the systemic risk regulator will prove as incapable of predicting the future as everyone else in history, and the regulator will prove so overly cautious that it prevents financial market innovation and stifles economic growth. Even if the regulator could accurately predict a problem, overwhelming political pressures prevent mere mortals from taking effective action, precisely because one person's asset bubble is another person's livelihood. Thus, the effect of the systemic regulator will be to substitute government judgments for investor judgments, deciding for investors whether a product merits investment. The effect will be compounded with the addition of the new consumer financial products bureau in the Dodd bill.

We should be skeptical about expecting a regulator to make accurate, one-size-fits-all judgments about the merit of specific financial products. For example, before 1996, certain initial public offerings of stocks were subject to merit review in certain states, where the state decided if a security is a "bad" investment and thus not appropriate to be offered to its citizens. In fact, this is exactly what happened to Apple Computer when it first went public in 1980. Massachusetts prohibited the offering of Apple shares because they were "too risky," and Apple did not even bother to offer its shares in Illinois due to strict state laws on new issues. What if federal bureaucrats had had the power to impose their judgment on a "risky" financial product (such as an IPO) on a nationwide scale, or every state followed Massachusetts' lead? Would Apple have become the successful company that it is today? While the Dodd bill probably will not affect IPOs, merit regulation (despite regulators' best intentions) can harm investors and other market participants.

Instead of creating a new super regulator incapable of meeting superhuman expectations, Congress should focus on increasing transparency and giving regulators, creditors, and investors better and more timely information to perceive risks and make better informed investment decisions. Markets froze in the fall of 2008 because no one could be sure of the financial condition of financial institutions and their counterparties. For all the government's extraordinary intervention, the markets showed their greatest improvement after the Fed's imperfect stress tests were made public in early 2009. This level of transparency did not exist during the market crisis and most likely would have seriously limited its impact. By empowering investors and market participants with full and open information, we limit systemic risk while also encouraging growth--and save billions of dollars in avoiding new government bureaucracies and the costs they impose.

Paul S. Atkins is a visiting scholar at AEI.

No comments:

Post a Comment