Ideoblog

Will Congress abolish corporations?

Christine writes that it will be fun watching the unintended consequences of raising the corporate dividend tax from 15% to 40%.

I doubt anybody will have more fun than me. She notes the effect on corporate decision-making. What corporations? Almost tripling the double tax will be a field day for uncorporations (unless Congress decides to delete Subchapter K while it's at it).

So get ready to buy my books, starting with Rise of the Uncorporation, and then moving onto Ribstein & Keatinge and Bromberg & Ribstein. Buy now before the price goes up 166%. And please recycle those corporate materials responsibly.

Mind-mapping and The Rise of the Uncorporation

Professor B shows how it's done. Get your own book and try it yourself.

Brokers’ fiduciary duties

Erik Gerding is right when he notes the importance of yesterday's hints by Senator Collins about imposing fiduciary duties on brokers. As Erik notes, "applying investment adviser-style fiduciary duties to broker dealers would be a sea change." Barbara Black discusses and criticizes recent Congressional moves in this direction.

Not only a sea change but, in my view, a misuse of the concept of fiduciary duties. As I've written, fiduciary duties properly apply only to situations involving the open-ended delegation of discretion and control over property. In this situation it is appropriate to depart from standards for arm's length dealings and impose a duty of unselfishness, as Justice Cardozo colorfully described it in Meinhard v. Salmon. In other contexts attempts to apply fiduciary duties result in mischief and confusion. Some broker-dealer relationships may be fiduciary in nature, but clearly not all of them, and even more clearly not the relationship between Goldman, IKB and ACA in the SEC's recent case.

We have recently seen this mischief and confusion at work in Jones v. Harris (watch this space for more about my forthcoming article on that case). Jones involved the "fiduciary duty" imposed on mutual fund investment advisers under Section 36(b) of the Investment Company Act. The duty is inappropriate there because the redemption right means investors do not lock in their money under investment advisers' control, anymore than they do when placing an order with a broker.

Forty years after the adoption of 36(b), hundreds of cases have been brought imposing billions in costs without a single plaintiff victory at trial. The Supreme Court struck down Judge Easterbrook's attempt to end this debacle, noting that was Congress's job. I doubt Congress will do anything about mutual funds. Now it seems Congress is considering extending the mistake to broker-dealer duties.

A new federal broker-dealer fiduciary duty would unleash havoc that would dwarf that in the 36(b) litigation. The Jones situation involved a fairly narrow situation in which the courts were able to come up with at least some kind of standard, the Gartenberg test, which the Court reaffirmed in Jones. Even so, the costs have been large and the benefits few. A broker-dealer duty will have the courts all over the lot for decades, no one will know who owes what duties to whom, efficient transactions will be foregone, entire markets will be stunted. And Jones stands as a lesson of how much help we can expect from the Supreme Court.

And remember, this is just one little thing Congress is thinking about doing as part of financial regulation.

Update: Erik Gerding responds, noting that some clients might want fiduciary duties, and asking whether "some sort of opt-in/opt-out system [would] be better?" Yes, in some cases. But what should it be – Opt-in? Opt-out? When should each type of duty apply? These types of questions indicate why this is better left to contracts and state law, particularly in an industry as dynamic as financial services.

The Dodd Debacle

Eight summers ago Congress decided to respond to a financial panic with a political panic. It was called the Sarbanes-Oxley Act, and it consisted of a sort of regulatory Christmas tree ornamented with half-baked ideas waiting for a so-called crisis to get enacted. Henry Butler and I wrote a book, The Sarbanes-Oxley Debacle, detailing the act's large direct compliance costs, as well as its even larger indirect costs in deterring legitimate business activity and subverting the vibrant state market for business law. We hoped that the book would at least stand as a warning for the next time.

Well, the next time is here, and financial "reform" is again before Congress. Unlike the last time, when Congress could at least point to a plummeting stock market, this time Congress and the SEC had to manufacture a crisis out of Goldman to move the legislation. It's another debacle in the making, as Professor B has already warned.

The concerns, of course, start with the financial provisions, whose effects go far beyond the large banks that were in the middle of the crisis. As the NYT discusses this morning (via Dealbook), the Act could, among other things, affect the price of candy, motorcycles and student loans and throw a monkey wrench on PayPal's ability to move Internet commerce.

Like Professor B, I'm concerned mainly with the corporate governance provisions. As with SOX, the Dodd bill plays host to a lot of tired ideas about corporate governance, including:

• Mandatory majority voting.
• Forcing firms to justify their decision not to separate the CEO and board chair jobs.
• Mandating ill-defined risk committees (which did little good for Citigroup and other firms in the financial meltdown).
• Forcing pay-performance disclosures, thereby increasing benchmarking and decreasing firms' ability to design incentives to fit their diverse needs.
• Require shareholders to vote on executive pay.

These reforms have much more to do with shoring up flagging union clout than with financial reform.

Scholars are just beginning to study the effect of these ideas. Consider the very recent Gox, Imhof and Kunz, 'Say on Pay' and its Repercussion on CEO Investment Incentives, Compensation, and Firm Profit, which tests the effects of various shareholder say-on-pay rights and finds, among other things, that "unconditionally binding voting rights reduce both firm profit and executive compensation significantly," and that even merely advisory shareholder voting rights can increase executive compensation, and "have only limited impact on firm profit and executive compensation." In general, the authors'

results suggest that regulators should carefully evaluate dysfunctional economic consequences of shareholder voting rights before they are introduced or before existing rules are tightened.

Apart from the costs and risks of say on pay and other governance proposals, their policy foundations are murky. Under the approach that has been in place in this country since the beginning of securities regulation, substantive corporate governance regulation has basically been the province of enabling state law, with the federal law limited to disclosure regulation. As financial markets have become far deeper and more competitive since the 30s, it makes little sense for regulators to actually trust them less. Moreover, if there is a basis for questioning shareholder choice of governance rules, then it would seem to make little sense to give shareholders more power over so complex a matter as corporate pay. If we're going to give shareholders say over pay, why not also say over SOX?

Although these provisions are woefully misguided, at least they relate to the big corporations that were caught up in the crisis. Other provisions of the law reach the firms that were more solutions than causes of the crisis – hedge funds who saw it coming and bet accordingly will now have to register with the SEC, undoubtedly a precursor to collaring them with more regulation; fewer investors will be able to participate in unregistered offerings; and small offerings will be burdened with the uncertainty and delay of SEC review. The ridiculousness of burdening growth of small firms in a still-struggling economy because some big firms messed up is too obvious to deserve discussion.

I suspect the Dodd bill will pass. It would be fitting if it did so the same day the Supreme Court strikes down Sarbanes-Oxley.

The mutating Goldman case

The Goldman case was initially reported as a fairly straightforward-seeming fraud in which Goldman sold securities to an unsuspecting customer without disclosing a famous hedge funder's position on the other side. It's quickly turning into something very different.

The WSJ reports:

Paolo Pellegrini, a former Paulson executive, told Securities and Exchange Commission investigators he had informed an outside firm helping to create a now-controversial mortgage deal that Paulson intended to bet against, according to a person familiar with Mr. Pellegrini's statements.

Meanwhile, John Carney, writing for The Daily Beast, reveals that IKB, the supposedly unsuspecting customer, "was playing the same game that Goldman was" – basically, buying junk and pawning it off (through an offshore company it controlled called Rhineland Funding) to those who, for whatever reason, were willing to take it, while profiting on the deal through management fees. As Carney says:

It was a piece of regulatory arbitrage: In essence, IKB was investing in complex mortgage bonds without having to set aside regulatory capital or report the increase in risky assets to its regulators or auditors. * * *

While it's not clear that in 2007 anyone would have been worried about a little-known hedge fund being short a deal if they weren't already worried about Goldman being short, Rhineland certainly should have asked how the portfolio was constructed. So why didn't Rhineland—or the managers who controlled it from Dusseldorf—make these inquiries? Most likely, because IKB was playing the game even more aggressively

Nevertheless, Charlie Gasparino, also writing in the Daily Beast (HT Dealbook) reports that despite the Paulson revelation the SEC will "get what it wants" from a settlement:

a precedent * * * that will help the SEC create new laws about how much Wall Street has to disclose to investors, even if they are large sophisticated players.

And what exactly is this new obligation that the SEC has taken on itself to develop through litigation? It seems that the case has boiled down to Paulson's alleged role in selecting the portfolio that the parties bet on. Indeed, that's what I said in my initial discussion of the complaint:

the real problem here, and the key to the whole case, is that neither ACA nor IKB and ABN knew that Paulson selected the securities knowing he was going to bet against them, and so presumably so as to enhance the possibility of failure.

Gasparino quotes John Coffee on this point:

"Even if ACA knew Paulson was short, Goldman couldn't have sold the investment to IKB without the notion that a neutral third party evaluated the investment," Coffee told The Daily Beast, adding that "enough of the portfolio was influenced by Paulson & Co.," that its omission from the sales documents and pitches by Goldman "could be material"—meaning a court could rule on the side of Goldman.

So what lesson should Wall Street take away from this case? What, exactly, does a bank in Goldman's position have to disclose to a customer? The identity of another customer on the other side, as the complaint suggests? Only when that customer is somebody like Paulson. What does that mean? Only if the customer has selected the portfolio? What does that mean? Many deals are put together with buyers in mind. Suppose ACA (the collateral manager) assembles the portfolio here with Paulson in mind, and then Paulson says, "that's for me. Now I'll invest." Is this more "material" than having Paulson take the initiative? Suppose they collaborate in putting the portfolio together?

Bigger questions here: should the SEC go so far beyond its role of protecting ordinary investors that it's now protecting parties like IKB who are not only sophisticated but are playing the same game as the defendant? To what extent should the SEC be redefining its role through litigation?

The Goldman case and the war on the shorts

Holman Jenkins in today's WSJ:

Make no mistake: The gestalt behind the SEC case is that short selling is bad. Constructing deals to enable short sellers to bet against certain markets (as Goldman did) is bad. When longs lose money because of freely chosen participation in such trades, it's bad. When shorts make money, it's bad.

Yep. His column is entitled "war on the shorts, cont'd." I've been reporting on that war for awhile, e.g., here.

The Goldman case as air freshener

From the WSJ:

Last Friday, the same day that the government unexpectedly announced its Goldman lawsuit, the SEC's inspector general released his exhaustive, 151-page report on the agency's failure to investigate alleged fraudster R. Allen Stanford. * * * Guess which of these two stories was pushed to the back pages? The SEC did its part by publishing the Stanford report so deep in its Web site that more than a few of our readers had trouble finding it. * * *

The commission has made young Fabrice Tourre of Goldman Sachs a household name for his debatable disclosures to institutional investors. But many individual investors will be more interested in learning the story of Spencer Barasch. He's the SEC enforcement official who sat on various referrals to investigate Allen Stanford and then, after leaving the SEC, performed legal work for . . . Allen Stanford. * * *

The examination staff at the SEC's district office in Fort Worth, Texas reviewed the Stanford Group's operations in 1997, concluded that its sale of certificates of deposit likely constituted a Ponzi scheme, and referred the matter to SEC enforcement staff. Mr. Stanford kept on selling his seemingly too-good-to-be-true CDs, so SEC examiners investigated again in 1998, 2002 and 2004. Each time, they concluded that the Stanford operation was a probable Ponzi scheme and urged SEC action. Each time, the enforcement staff failed to act.Along the way, SEC enforcers also ignored warnings from the daughter of an elderly investor in the Stanford scheme, the Texas State Securities Board, an anonymous insider in the Stanford operation, and U.S. Customs, which suspected that the Stanford organization was laundering money. * * *Particularly tragic is that almost all of the $8 billion that Mr. Stanford collected from investors was gathered after the SEC's first round of inquiries * * *

In other words, the SEC is a dreadful failure in fulfilling its core mission of protecting individual investors, as the Stanford and Madoff cases show. But the SEC is very good at nailing politically correct targets like Goldman years after the fact on charges that have little or nothing to do with the investing public. * * *

In the cases of Stanford and Madoff, thousands of small investors lost their life savings. In the case of Goldman, some masters of the financial universe lost money on what they knew was a calculated gamble. Which did more societal harm?

Conglomerate workshop on the future of legal education

Usha kicks it off, and my first post is up.

The financial origins of the eruption

A year and a half ago Iceland suffered another misfortune. I discussed it here, recasting the narrative in a story by the WSJ's Charles Forelle:

Plucky Iceland bucks the European Cartel Community, and is punished for its temerity. Then it gets brought down by a global financial calamity beyond its control.  Scrambling to fix the problem it's squished by its powerful neighbor. 

And what about Great Britain's role – a rival not only in banking, but for the raw material of its lifeblood – fish and chips (it fought several "Cod Wars" with Iceland). In the banking crisis, Britain claims it needed to protect its depositors. But how exactly did shutting down Kaupthing, precipitating defaults and exacerbating a run in the midst of its salvage efforts accomplish that?

There are rumors, not mentioned in the story, that Britain held up an IMF rescue loan to Iceland. And Forelle alludes to Britain's "using an anti-terror law to seize other Icelandic assets" * * *

And now the volcano. The connection seems obvious.

The Goldman case and the SEC’s irrelevance

As I've said, the fraud at the heart of the SEC's case against Goldman has a materiality problem. A story in today's Journal has more on this:

Some outside observers are not persuaded by the government's argument ACA was duped by Paulson's input in the process. "If ACA performed an independent analysis and concluded that the [Abacus] portfolio met ACA's criteria, I'm not sure what the issue is," says Leslie Rahl, president of Capital Markets Risk Advisors, a derivatives and structured finance consultancy in New York. In essence, "one sophisticated market participant thought that the portfolio was a good 'buy' and another a good 'sell' -- that happens all the time in financial markets and is what makes markets," she adds.

I also pointed out that the case is more about the SEC struggling to be relevant to the financial crisis than about securities fraud. A WSJ editorial has more on that:

After 18 months of investigation, the best the government can come up with is an allegation that Goldman misled some of the world's most sophisticated investors about a single 2007 "synthetic" collateralized debt obligation (CDO)? Far from being the smoking gun of the financial crisis, this case looks more like a water pistol.

The editorial wonders: "Is that all there is?" The SEC has been looking for a long time into what crashed the markets. It had every incentive to lead with its strongest case. And this is what it came up with?

But the SEC was under pressure to come up with something. The timing of this complaint continues to be suspicious. The editorial continues:

The SEC charges conveniently arrive on the brink of the Senate debate over financial reform, and its supporters are already using the case to grease the bill's passage. "I'm pleased that the Obama Administration is using all of the tools in its arsenal to bring accountability to Wall Street and standing up for homeowners and small businesses across America," said Senate Majority Leader Harry Reid on Friday about the SEC case. "This is also why we need to pass strong Wall Street reform this year."

A story in today's WSJ supports this political timing:

Goldman Sachs Group Inc. officials said they knew as far back as August 2008 that regulators were examining controversial mortgage securities created by the firm but were stunned by the bombshell civil fraud suit lodged against it Friday, with most having learned about it from news reports.

Firms typically get a chance to settle such suits, but not in this case, Goldman said. The Wall Street giant said it was alerted to the probe in the summer of 2008 and was warned that it might face a suit in July 2009. * * *

The way the SEC launched the suit "certainly doesn't follow the spirit" or practice of the agency, said Paul Atkins, who served as a Republican SEC commissioner last decade. * * *

In July 2009, Goldman and Mr. Tourre received so-called Wells notices from the SEC. Such notices are a formal warning that regulators intend to file civil charges, and serve as a point of negotiation about a settlement. By September 2009, both Goldman and Mr. Tourre had responded to the charges in a 41-page document, according to people familiar with the matter. * * *

"If this matter is litigated, Goldman Sachs is confident that a fuller record...will underscore that no one in fact considered Paulson's role important and that no one was misled," Goldman told the SEC in September 2009, in a document reviewed by The Wall Street Journal.

That was the last contact Goldman had with the SEC about the matter until late March, when Goldman placed a phone call inquiring about the case. The call wasn't returned, Goldman said. On Friday, the SEC moved ahead with charges, stunning Goldman officials.

In other words, the SEC, under pressure to come up with something on the eve of Congress's final push toward financial regulation comes with a case that the complaint makes clear is much more about the creation of systemic risk than about securities fraud.

This reflects, in part, the new Wall Street, more than three quarters of a century after the securities laws were enacted. Financial regulation is now much more about sophisticated market intermediaries than about individual investors who need somebody to ensure they have the truth about securities.

This is not to say that securities fraud is irrelevant. However, the SEC has struggled on that front – the Bank of America settlement, Madoff, Stanford.

And so now we are left with . . . Goldman.