Ideoblog

Manne on Paredes

Geoff Manne has some welcome praise over at TOTM for SEC Commissioner Troy Paredes, who has quietly been doing a great job speaking up against a looming tide of financial regulation.

It occurs to me that Troy is an important part of a generation of influential corporate scholars, regulators, judges and practitioners who learned important lessons from Geoff's father, among others. Maybe it's my imagination, but I see more pushback against the once inevitable regulatory backlash in the wake of a market collapse than in past generations. I'm even getting hopeful we won't have another SOX.

Maybe this is progress. Or maybe we just have health care to thank for this particular green shoot.

Capitalism: An unrequited love story

Michael Moore's new film is out this week. If the film sells a ticket for each breathless MSM story about it, Moore should do very well.

This film has some richly ironic implications for my theory of filmmakers' view of capitalism. To briefly recap: I argue that filmmakers have a negative view of capitalists because they resent the control that capitalists can exercise over their art. I focus on popular American dramatic films where this conflict between art and money is most intense. (This is obviously a tiny nutshell; if you want the whole story, read the whole thing.)

Filmmakers like Michael Moore present an interesting contrast to the films discussed in my article. Documentary makers get to say what they want because their films are cheaper to make. All they have to do is find unwitting talking heads and splice them together. Any anti-capitalism in these films was part of the original idea rather than a byproduct of thwarted expression.

The irony is that many of these films could not reach a wide audience if not for their backing by – yes, capitalists. This irony reaches a crescendo in Moore's film, as is brought home by Future of Capitalism (HT Overlawyered):

[T]he movie is presented by "Paramount Vantage" in association with the Weinstein Company. Bob and Harvey Weinstein are listed as executive producers. * * * Paramount Vantage. . . is controlled by Viacom, on whose board sit none other than Sumner Redstone and former Bear Stearns executive Ace Greenberg * * *. The Weinstein Company announced it was funded with a $490 million private placement in which Goldman Sachs advised.

Knowing that background puts the rest of the movie in a different context. Mr. Moore shows Rep. Dennis Kucinich asking rhetorically on the floor of the House of Representatives, "Is this the United States Congress or the board of directors of Goldman Sachs?" Later, Mr. Moore shows up at Goldman Sachs headquarters in Manhattan driving an armored Brinks trunk and announcing, "We're here to get the money back for the American people." Maybe Mr. Moore should look in his own pockets. * * *

One gets the sense that Mr. Moore still loves that part of America that allows him to make a living by running around publicly criticizing big companies and politicians, the America that funds the camera crews and movie theaters that allow him to display and distribute his ideas. * * * So maybe it's a love story after all, if not in quite the way that Mr. Moore intended.

Capitalism is easy to knock because it produces losers that artists can juxtapose with winners. It gets bad press compared to alternatives like socialism that produces less social wealth but also less envy and resentment. The irony is that some of the biggest winners are also the biggest whiners. Only capitalism enables the dissemination of any ideas that anybody wants to hear. Capitalism gives Michael Moore his megaphone.

It's almost enough to make me an anti-capitalist.

Who’s best in law and economics?

Leiter's having a poll. How to choose? Since law and econ is arguably the dominant paradigm in legal education, a lot of law profs are at least dabbling in it. Which schools are more than dabbling? One might look at who has the most econ PhD's.

Illinois has four (Dharmapala, Garoupa, Morriss and Ulen).

The government’s AIG casino

When last I discussed AIG I summarized the bailout this way:

The government is bailing out AIG because AIG undermined a system that the government was supposed to be, but wasn't, protecting. And now who's in charge?  The government, of course.

See also my earlier post along the same lines.

So it's interesting to catch up with AIG today. Per today's WSJ, the 20% common, an excrescence atop the government's 80% non-trading preferred interest, is now a day-trading casino, enhanced by a stock split and naked options. This is exactly the sort of thing the government was supposed to do something about, but it's a government creation. As the WSJ notes:

A year after the government sought to avert a market meltdown by rescuing some of the country's biggest financial firms, speculative traders are feasting on these companies' remains. Shares of two government wards, mortgage giants Fannie Mae and Freddie Mac, bounced between about 60 cents and $2 in August. Shares of Lehman Brothers, left to fail by the government and currently in bankruptcy proceedings, rose from five cents to 20 cents in recent weeks.

AIG, arguably, has been the biggest casino of all. In the past seven weeks, its common shares have careened between $13 and $55, surging past $54 on Tuesday before closing at $45.80.

The extraordinary price action is a dramatic display of an unintended consequence of the U.S. bailout of AIG.

The latest "news" feeding this market is Jim Cramer's suggestion that the government-financed company could undercut its stock by doing a secondary offering at the inflated price and using the cash to repay the loan. I wonder if the 80% owners of the company would have any fiduciary or disclosure duties in this situation. Oh wait, that's the government, isn't it?

Was the South Sea Bubble a bubble?

Maybe not, depending on how you define a "bubble." See the new article by Frehen, Goetzmann and Rouwenhorst, New Evidence on the First Financial Bubble. Here's the abstract:

The first global financial bubble in stock prices occurred 1720 in Paris, London and the Netherlands. Explanations for these linked bubbles primarily focus on the irrationality of investor speculation and the corresponding stock price behavior of two large firms: the South Sea Company in Great Britain and the Mississippi Company in France. In this paper we examine a broad cross-section of security price data to evaluate the causes of the bubbles. Using newly collected stock prices for British and Dutch firms in 1720, we find evidence against indiscriminate irrational exuberance and evidence in favor of speculation about two factors: the Atlantic trade and the incorporation of insurance companies. The fundamentals of both sectors may have led to high expectations of future growth. Our findings are consistent with the hypothesis that financial bubbles require a plausible story to justify investor optimism

And of course if you can't recognize a bubble, or if bubbles are necessarily at least somewhat rational, how can you sensibly impose regulation to stop them? Or more precisely, any such regulation is likely to prevent productive investment.

Here's a post from five years ago on more evidence of the rationality of "bubbles." And see my article, Bubble Laws, 40 Houston L. Rev. 77 (2003), about the dubious nature of bubble-borne financial regulation.

The rising Specter of secondary securities liability

Newly minted Democrat Arlen Specter, desperately latching onto an issue that he hopes will keep him in the Senate well into his 80s, is pushing his bill (first discussed here) to resurrect aiding and abetting liability for "substantial assistance" of securities law violations. Kevin LaCroix has a very valuable post, with a lot of links, on a Senate Judiciary hearing on the bill (HT PoL).

I'm with Adam Pritchard, who testified concerning the bill's potential harm to the U.S. securities markets. The act could wreak havoc, as LaCroix shows. Affected parties could include not only lawyers and accountants, but companies that deal with public companies – like Scientific Atlanta and Motorola that allegedly aided and abetted the fraud involved in Stoneridge. LaCroix notes that firms will have to revise their D & O policies to cover securities claims not only involving transactions in the company's own securities, but any alleged violation.

Even scarier is the threat to closely held companies that are not themselves engaged in any securities transactions. As LaCroix points out, these firms' D&O policies usually exclude securities claims. He notes that "in light of the possibility of aiding and abetting claims even against private companies, these private company D&O insurance policy exclusions should be carefully scrutinized to determine how they might affect coverage under the policy in the event of an aiding and abetting claim against the insured private company." One wonders if this will raise the costs of all transactions for publicly held firms.

Are these costs worth the benefits? As I have pointed out, this requires a global evaluation of alternative mechanisms for dealing with securities fraud. These considerations were apparent at the hearing on the Specter bill. For example, John Coffee wondered why someone should be criminally but not civilly liable for aiding and abetting. Also, LaCroix notes that the Specter bill gets impetus from the SEC's Madoff failure. Coffee's testimony reinforced this by asking, "does anyone really believe today, in this post-Madoff world, that the SEC, by itself, can adequately deter most secondary participants in securities frauds?" Yet one also wonders how useful private litigation alone will be given that it often piggybacks on a public investigation.

In any event, these complex issues demonstrate the folly of letting courts decide the scope of liability. Congress may well make the wrong decision for the wrong reasons, but this is still better than a court throwing darts.

Plato’s cave in Dallas

The WSJ describes watching football at the new Dallas stadium:

"You don't even know there's a field you stare at the board so much," said Marco Ramirez, who was tending the grill Sunday, and who also attended preseason games at the stadium. * * *

Unlike most NFL scoreboards, which show mostly replays, the Cowboys' screen will show the game live, with a dedicated camera crew feeding images to the screen. (The team had to hire its own crew because television networks only shoot the game from one side, meaning the action on the screen would have moved in reverse for fans on one side of the stadium.)

Mr. [Jerry] Jones says he got the idea at a Celine Dion concert in Las Vegas, where images of the singer were projected on a two-story screen. Mr. Jones said he didn't know what he had seen on the screen and what he had seen on the stage. "All I knew is I had a wonderful experience," he said.

I think I've seen the future. Next step: ditch the stadium.

The folly of regulating pay to reduce risk

The WSJ reports that the Fed is proposing to pay at Fed-regulated banks, focusing on the country's largest 25 or so banks. The Fed would "reject any compensation policies it believes encourage bank employees * * * to take too much risk." It would "review and, if necessary, amend each bank's salary and bonus policies to make sure they don't create harmful incentives"; push the use of clawbacks to punish employees who take too much risk, as well as "restricted stock or other forms of long-term compensation designed not to reward short-term performance."

This is in line with a European proposal to restrict bonuses and a House bill that would empower bank regulators to ban "imprudently risky compensation practices" at the approximately 700 banks that have more than $1 billion of assets.

The idea that these rules will address problems of excessive risk-taking takes the misguided government response to the financial crisis to a new low.

To begin with, as John Carney points out, it's far from clear that there is even a real problem of pay practices causing excessive risk:

[M]any banks already had policies that are very close to the ones the government wants to require. Bankers at Lehman Brothers were heavily invested in shares of Lehman Brothers, owning 25% of the shares. Most had stock options to purchase more, giving them the equivalent of a bonus deferral. When Lehman Brothers went bankrupt, many lost sizable chunks of their wealth, which had the effect of a clawback. 

More importantly, if bankers were blindly pursuing risk, they would have loaded up their balance sheets and trading books with the highest yielding, lowest rated securities. In fact, they did just the opposite. Just 19% of rated securities held by banks were AA or lower. By contrast, 81% of bankers chose to acquire AAA rated securities, the safest stuff around. This preference for safety indicates that bonus incentives were not making bankers heedless of risk.

What's more, banks often bought insurance on the securities they purchased, seeking to water down whatever risk remained. This was a thriving business for the bond insurers and for companies like AIG that sold credit default swaps. If bankers were reckless gamblers, bond insurance would have been unpopular. The bankers mistakenly believed they were being prudent and careful despite a bonus system that seemed to incentivize them to be imprudent and reckless. * * *

Alan Schwartz at Bear Stearns and Dick Fuld at Lehman Brothers both argued that their investment banks were healthy just before they collapsed. Since misleading shareholders has serious legal consequences, it seems far more likely that they were simply mistaken rather than intentionally lying. Fuld reportedly turned down an offer of billions in new capital from a Korean financial institution just days before Lehman went bankrupt. Why would he do this unless he was mistaken about the health of Lehman? * * *

Even if pay did cause excessive risk-taking, the proposals probably will create more problems than they solve. As Professor Bainbridge observes, government regulators are ill-suited to determining how to set compensation policy to encourage just the right amount of risk. They are most likely to err on the side of being over-conservative, which will encourage capital and labor to flow to other industries. Also, like most government proposals to regulate governance, this one does not allow for market responses. After all, the rise in the use of stock options followed a 1993 tax law that penalized high salaries.

Although I agree with all of the above, here I want to emphasize another, deeper, problem. Compensation is embedded in the overall governance contract. You can't possibly accomplish anything positive by tinkering with just one element of the contract.

In general, the governance policies of banks and other publicly traded firms must deal with the inevitable conflicts of interest between managers and owners. One of these conflicts arises from the fact that managers' economic fortunes are linked to a single firm while shareholders diversify away that single-firm risk by owning broad portfolios of shares. In other words, managers are generally inclined to take less risk than the owners would prefer. The Fed's proposal would exacerbate this conflict by reducing managers' reward and increasing the penalty for risk-taking.

Even more important, managers of large firms often lack both the incentive and the ability to penetrate into the core of their organization to determine the real risks that threaten the firm. That's why, as Carney says, bank managers weren't knowingly taking excessive risk to jack up their pay – they simply didn't know what they were doing.

As I've argued repeatedly in articles and on this blog, these problems might be addressed through a fundamental alternative to the corporate structure – that is, what I call the uncorporation. Thus, as I discussed back in August 2008, hedge funds did not generally have Lehman-type problems in the current meltdown. One reason is that hedge funds can adopt pay practices that really force managers to attend to the risks embedded in their firms by not only rewarding them for good performance, but penalizing them for bad performance to a greater extent than even the Fed is proposing.

As I discuss in my forthcoming book, Rise of the Uncorporation (208-09) (footnotes omitted):

[T]hese firms carry on the partnership approach of forcing managers to bear losses as well as gains. For example, the general partner of a hedge fund limited partnership usually makes nothing unless the firm's earnings cross a specified hurdle, and the firm has to make up any losses before fees to the partners resume. Many hedge funds liquidated in the financial collapse of 2008 as their losses mounted to the point that general partners saw only a dim prospect of fees. By contrast, corporate executive' compensation insulates them from declines in their firms' fortunes even as they get full credit for good years. Investors have to make up for the bad times, but the executives may not.

The problem of excessive risk aversion discussed above is addressed in the uncorporate structure by "forcing managers to make distributions or providing for liquidation or buyout of the firm after a preset amount of time." In other words, excessively risk-averse uncorporate managers will find themselves without any capital to manage.

The uncorporation is a market approach to deal with the fundamental problems that became evident over the last year or so. That approach involves a different overall governance structure, not just haphazardly shooting at a politically vulnerable target. Nevertheless, plans for new financial regulation suggest the government wants to hobble the uncorporation with costly and unnecessary disclosure rules.

If regulators and legislators really wanted to solve problems in financial markets they would try to figure out what went wrong and take account of potential market solutions. But isn't it much better from their perspective to regulate in ways that will mess up markets and thereby create more regulatory opportunities later on? Financial regulation as perpetual motion machine.

The corporate entity and speech rights

Jess Bravin, writing in the WSJ, highlights Justice Sotomayor's remark during the oral argument of Citizens United that "[t]here could be an argument made that that was the court's error to start with...[imbuing] a creature of state law with human characteristics."

Douglass Kendall of the Constitutional Accountability Center was quoted as saying that progressives "have to feel reassured that this was one of [her] first questions." On the other hand, Todd Gaziano of Heritage says the remark "doesn't give me a lot of confidence that she respects the corporate form and the type of rights that it should be afforded." Washington & Lee's David Millon says the corporate entity protects it from taxes and regulation.

In fact, while it's true that corporations get some mileage out being regarded as artificial entities, the entity is a double-edged sword. As I commented at the time of Sotomayor's remark, "I would argue that once you start looking at this as a case of individual speech rights, the case for First Amendment protection gets more obvious."

For more, see my article, Corporate Political Speech, 49 Wash. & Lee L. Rev. 109 (1992), discussed here.

In a nutshell, viewing the corporation as an entity for First Amendment purposes actually serves to push the speech rights of owners and managers under a rug. Abandoning entity reasoning would focus on what matters for the First Amendment analysis. My article and blog post just linked show that once you do that, and put the arguments for limiting speech rights under an analytical spotlight, they look pretty weak.

The SEC from Madoff to Rakoff

First Madoff saw through the SEC and gamed it for years of free passes. Now Judge Rakoff has called the SEC's usual bluff and thrown out a settlement featuring cosmetic relief.

So what's the SEC going to do now? Go after Ken Lewis and the Wachtell lawyers? These folks can and will fight even harder than Mark Cuban.

Of course the U.S. did get Ken Lay and Jeff Skilling, but the government had to use every trick in the prosecutorial book (summarized here). The SEC's reticence in the Bank of America case only demonstrates the wrongness of the Enron prosecutions. And even if one agrees with those prosecutions, that was the Justice Department, not the SEC.

Judge Rakoff's ruling, whether one applauds it or sees it as judicial interference, underscores the question I posed last week: is the SEC really necessary?