Ideoblog

Obama proposes SOX II

Here's a nifty summary, and Bainbridge's early critique.

I haven't evaluated the proposal closely, and won't be able to for awhile because I'm about to get out of range for a couple of weeks. But I do have a few quick thoughts on particular elements of interest. 

First, we have to keep in mind that this isn't really a legislative package, but a kind of starting gun to let the intense lobbying begin.  It will be interesting to compare the proposal to the sausage that emerges at the other end of the grinder.

Second, since we're about to embark on SOX II, wouldn't it be useful to look again at what happened with SOX I?  Here's Butler and my analysis.  At the end of our book we have some suggestions for regulatory humility, such as optional provisions and sunsetting.  I fear that in the end we will find that we learned very little from the SOX debacle.

Third, the Obama proposal suggests (p. 13) requiring hedge fund registration under the Investment Advisers Act overseen by the SEC.  It also proposes that hedge funds be required to make reports on funds under management sufficient to indicate whether they pose a threat to financial stability. 

This is particularly misguided.  The best commentator on that is Houman Shadab.  See here and here.  The bottom line is that hedge funds are more a solution to problems of the financial system than a cause. 

The "systemic risk" argument is totally misguided.  As Jon Macey has noted, hedge funds actually combat systemic risk by, essentially, betting against the "system."  One way to make them part of the problem is to force enough disclosure that other financial institutions can follow them off any cliffs they seek to explore.  See Macey, PROMISES KEPT, PROMISES BROKEN 265-72(2008).

And what's with this regulation by the SEC?  Are we satisfied with the great job that agency did supervising Madoff?  See here (detailing the SEC's massive regulatory incompetence in Madoff) and here (suggesting that the SEC was actually Madoff's unwitting accomplice). 

Fourth, the proposal calls for (p. 40) "increased national uniformity through either a federal charter or effective action by the states." Butler and I show that this objective in insurance regulation is misguided and offer a better alternative.

Finally, let's keep in mind that the US is no longer alone in the world.  Regulatory overkill here could be a boon for places like Singapore and Hong Kong.

Some thoughts on the Shareholder Bill of Rights

Martin Lipton, with Jay Lorsch and Theodore Mirvis, opine in the WSJ about the havoc that could be wrought by Schumer’s proposed Shareholder Bill of Rights Act of 2009. That Act would require shareholder say on executive pay, direct shareholder nomination of directors, majority vote for directors, and no staggered boards.

Schumer's proposal provides an opportunity for everybody to work out their favorite theories. Lipton, et al, true to their usual managerial perspective, are concerned about the potential for governance that is overly focused on the “short-term.” They would go in the opposite direction, with directors’ elected to 5 year terms.

Steve Bainbridge doubts there’s a problem with executive compensation and, true to his director primacy approach, questions the proposed solution.

I'm no fan of say on pay. But if we really want to get serious about shareholder power, why cram a federal law down their throats.  Indeed, why not go the other direction, to say on SOX? 

Or, how about even more shareholder say, by letting the shareholders choose their corporation's state legal regime? As Professor B discusses, leaving corporate governance issues to state law allows for some experimentation, and attaches market prices to the various alternatives. See my and Erin O’Hara’s Corporations and the Market for Law and The Law Market, ch. 6.

Finally, why corporate law? Why not choice of form as well as choice of law? Even if shareholder democracy is not the answer, that doesn’t mean we should lock control in directors make managers or directors trustworthy stewards. Of course what I’m thinking about is the uncorporation. My theory is that managers can be disciplined by giving them stronger incentives and lightening their grip on the firm's cash. 

The answer, at any rate, is choice.  I'm not ready to let Sen. Schumer and his friends decide how all firms should be governed.

More on Say on SOX

Last November I suggested letting shareholders opt out of SOX – a proposal that was also in my book on SOX with Henry Butler.

Last December, Henry Butler and I had an article in Forbes on this, discussed here, connecting it with “say on pay.”

Now Butler and I have a Washington Legal Foundation Legal Backgrounder developing the “say on SOX” idea.

I understand that this proposal bucks the groundswell for more regulation. But the WLF article shows not only why this idea is good policy, but also why it may not be as politically improbable as it might sound on the surface.

Shareholder power vs. mandatory securities laws

About a month ago I suggested making SOX optional.  Now Henry Butler and I have an article on this subject forthcoming in the December 22 Forbes.

Butler and I argue that the recent financial “crisis shows that SOX did not have the advertised payoff of flushing Enronesque risk out of the market.” So it’s not clear what shareholders got for all that money their firms spent on SOX. We suggest that it’s time to try an alternative: “SOX would remain, but firms could have their shareholders vote to opt out of some or all of its provisions. Or firms going public could opt out of SOX and let potential investors decide whether to buy their shares.”

We also make the connection with “say on pay:”

If shareholders should vote on pay, then why not on something that can have even more effect on profits. How about "Say on SOX"? 

Our proposal meshes with another one that’s getting some recent play: Adam Pritchard’s idea to let shareholders vote to amend the charter to modify the application of the fraud on the market theory, an important underpinning of federal securities class actions. Pritchard’s idea has now turned into a shareholder proposal at Alaska Air (here's an article, discussed in PoL).

Shareholder proposals could be the mechanism for adopting SOX opt-outs, too.  Of course SOX would have to be amended before such proposals would have an effect. 

So there you have it: shareholder choice vs mandatory federal protection. Using the corporate governance provisions of the securities laws (14a-8)  to opt out of the anti-fraud provisions of the securities laws.  As Henry and I concluded, “[i]t's time for the corporate governance reformers to decide what they really believe.”

How about optional SOX?

With all the calls for new regulation, it’s bracing to hear somebody calling for a rollback. Not surprisingly that would be Newt Gingrich, who with a co-author suggests repealing SOX.

Needless to say, after all I’ve written against SOX (e.g.here and here), I’m sympathetic. And although one might think that this is the wrong time to press these arguments, in fact, as Gingrich points out, repeal now makes more sense than ever.  SOX is best seen as a tax on entrepreneurs (the difference between regulatory costs and benefits) in difficult times when they most need a break. Moreover, we now can see clearly how little SOX accomplished in dealing with the unwise risk-taking it was intended to prevent.

But given the difficult politics of calling for a rollback now, and even on policy grounds, it’s worth exploring an alternative: make it optional. That would let the small firms avoid the “tax” while letting large firms, and particularly financial firms, post a SOX “bond” to assuage wary investors. Indeed, Bobby Bartlett, in Going Private but Staying Public, has found that some firms that could avoid SOX apparently have been doing just that. For the small firms, the economic effect of optional SOX would be equivalent to a significant tax break or subsidy, but without burdening the taxpayers (though the hit to accountants would be substantial).

A possible variation on my proposal is to disaggregate SOX's grab bag of provisions and let firms opt for some separately rather than having to choose the whole bundle.

Clearly investors have every incentive in this risk-averse environment to pay close attention to who is and is not subject to SOX’s risk-disclosure provisions.  This reduces the potential for a lemons market in a post-mandatory environment. So what’s the counterargument?

The main one I can see is investor complacency. Particularly given the recent meltdown of SOX-compliant firms like Bear, Lehman and AIG, SOX seems not to be delivering the promised risk protection. So investors in SOX firms might think they're more protected than they actually are. However, as just suggested, investors have every incentive to be wary.

More importantly, I do believe in contracts and markets don’t I? Then why not let the market decide whether the SOX bond is worth it? Presumably firms’ cost of capital will accurately adjust.

So, ironically, the choice between keeping SOX around as an option and getting rid of it altogether switches the sides in the SOX debate. The argument for optional SOX is based on free markets; the argument for total abolition is based on paternalism.

Enron redux: Where was SOX?

As we face SOX II let’s reflect on the effect of SOX I.

Remember Enron? That happened because nobody knew what was going on inside the company, including its independent audit committee, which was well up to the then-current regulation of the board of directors.

Instead of taking the time to really figure out the underlying governance failures, we had criminal trials centered on proving the guilt of scapegoated individuals and the hastily slapped together SOX. I have been warning since that act was passed not just about its cost, but that it would be completely ineffective to accomplish what it was supposed to do. As I said a couple of weeks ago in the post linked above:

SOX was sold as the way to prevent future market bubbles and crashes. Obviously, in addition to imposing huge costs, it utterly failed to deal, not only with some indefinite future, but with problems that were already brewing at the time SOX was enacted. Indeed, SOX may well have hurt by helping to make investors complacent.

Now here’s the WSJ on yesterday’s AIG hearing:

The committee . . . released minutes of a meeting of AIG board members that said AIG's outside auditor had warned Mr. Sullivan on Nov. 29 that the giant insurer "could have a material weakness" in its risk management. That was less than a week before Mr. Sullivan told investors in December that AIG was "confident in our marks and the reasonableness of our valuation methods."

Two months later, AIG disclosed that its auditors had found a material weakness in its accounting controls, and said it would lower the valuation on complex derivatives by billions of dollars. Mr. Sullivan said that when communicating with investors, he said what he truly believed to be accurate at the time Those derivatives, sold by the financial-products unit Mr. Cassano headed, were largely responsible for three consecutive multibillion-dollar quarterly losses AIG reported in the months before the government agreed to loan the company as much as $85 billion * * *

Rep. Henry Waxman, the committee chairman, asked both Mr. Sullivan, who was CEO from March 2005 until this June, and Mr. Willumstad, who had been AIG's chairman since 2006 and served as CEO from June to September, about concerns raised by a former auditor in the financial-products unit. "It looks like you both brushed it aside," Rep. Waxman said.

Mr. Willumstad said he didn't recall the matter being discussed by the firm's audit committee, and Mr. Sullivan said the company had been putting additional controls in place.

So where was SOX in all this, with all of its vaunted high-cost internal controls disclosures?  And what’s the fix going to be this time? Throwing more executives in jail? Slapping together some more complicated rules without any real consideration given to whether they’ll work?

Some thoughts about SOX II

The government is going to throw a lot of money (up to $700,000,000 “outstanding at one time,” which could be repeated purchases up to that amount followed by sales at lower amounts). Comforting to know there’s a “possibility that taxpayers could profit from the effort.” (CR notes the humor.)

But unfortunately that trillion bucks or so is only the beginning of the problem.  It's going to be surrounded and followed by lots of regulation. See my Bubble Laws, 40 Houston L. Rev. 77 (2003). In other words, get ready for SOX II.

There’s a general view that recent events show a failure of the capital markets to deal with their problems, necessitating government interference. At the risk of shouting into a noisy wind, let me suggest that it’s not so simple. Yes, the capital markets have floundered. But that doesn't mean we want or need another SOX. 

The big problem we face now is finding out how much assets are worth. Only markets can do that.  Surely the government hasn't a clue.

Some say that it’s evil over-complex derivatives that got us into this fix. Well, if the problem is over-complexity, we might ask why the market would produce more complexity than it needs. Tyler Cowen links an old Jane Galt post that provides part of the reason: 

Pundits continue to link the Enron debacle to a need for increased regulation, especially of derivatives. What most of these people . . . don't appreciate is that regulation and/or accounting rules are the most fertile breeding ground for derivatives and synthetic or packaged securities. Regulations and accounting rule-inspired transactions describe the bulk of the well known derivative-related blow-ups of the last two decades. Proscriptive regulation and the derivative trade have a symbiotic relationship. * * *

I strongly suspect that substantive regulation of the derivatives markets will lead to still more complexity by inducing the markets to work around the additional regulation.

The above post goes on to suggest we need more disclosure.  I wonder. The market is already buried under a mountain of disclosure. Clearly ordinary investors can’t sort through this, and the sophisticates probably don’t need it. For example, while “mark to market” may not have caused all of our problems, I seriously doubt that it helped.

Is this really a disclosure problem? As I have discussed, the problem was really fairly simple -- the mortgages on which the derivatives were based were valued based on patently unrealistic assumptions about real estate prices. This wasn't as much a disclosure problem as a governance problem with the managers who were buying all this junk.  The response is better incentives.

As I noted in my post, a possible answer to governance problems is partnerships like hedge funds, which have actually had fewer problems than financial corporations in this whole mess. For much more on this, and must reading, see Houman, Shadab, The Law and Economics of Hedge Funds. Houman will be making an exceptionally timely presentation of his paper in my Illinois Business Law and Policy Colloquium tomorrow.

Despite these considerations, expect hedge funds -- a perennial scapegoat -- to be a potential target of regulation in the aftermath of this crisis.

We do need more information.  Efficient securities markets could provide that information even without more disclosure laws.  This makes it all the more surprising that regulators should seek to clamp down on short selling.  Always seeing the glass as half full may be a nice comforting philosophy, but it's not going to illuminate the way out of the current crisis.

So we need is better managerial incentives and more information. Yet by regulating short-selling and hedge funds, we might get less of both. In other words, unless we really try to understand what went wrong, throwing more regulation – more disclosure, more regulation of hedge funds, more government ownership of overpriced assets -- at the problem not only won’t help, but is likely to hurt.

At the end of our book, The Sarbanes-Oxley Debacle, Henry Butler and I suggested some guidelines for better future regulation: Periodic review and sunset Provisions, optional rather than mandatory rules, nuanced regulation focusing on the specific problems that cannot be dealt with by optional rules, investor education and deregulation.  We might consider these recommendations now.

SOX was sold as the way to prevent future market bubbles and crashes. Obviously, in addition to imposing huge costs, it utterly failed to deal, not only with some indefinite future, but with problems that were already brewing at the time SOX was enacted. Indeed, SOX may well have hurt by helping to make investors complacent. Enough is enough. Let’s try to think before we leap again off the regulatory cliff.

The market meltdown and the regulators

Remember when SOX was supposed to, at enormous cost, expose the weaknesses and risks lurking in companies so they could be addressed to avoid another Enron? As Tom Kirkendall and I have been observing for awhile:  fat lot of good SOX did.  Could we please think about that when we try to regulate in the wake of this catastrophe?

And while we’re at it, let’s think about yesterday afternoon’s market plummet. That happened (and it's likely to continue this morning) because AIG, facing catastrophic downgrades of its securities, needs 70 billion by tomorrow to avoid bankruptcy.

Should we worry about that? Here’s what the WSJ has to say:

The company, whose stock fell 61% yesterday, is such a big player in insuring risk for institutions around the world that its failure could shake the global financial system. much of its exposure is related to credit default swaps, insurancelike contracts tied to corporate defaults. * * * The market for credit default swaps is immense, trading against about $62 trillion of debt. Some participants in the largely unregulated market worry that the default of a major player such as AIG could trigger chaos. * * *

[T]he firm is used by many companies world-wide to manage a range of risks, including exposure to investments in subprime mortgages. Its demise would potentially make it harder or more expensive for businesses to control their risks.

How did this happen? Well it’s worth speculating that it had something to do with AIG being left without its long-time leader, Hank Greenberg, for which we can thank Eliot Spitzer. As I’ve noted, per the WSJ (last May):

A careful and lengthy look at the evidence available so far . . . suggests that the AIG case, like so many others that Mr. Spitzer brought, was an example of prosecutorial excess. Instead of uncovering some great fraud by a titan of industry, its main result has been to damage the company, and harm innocent managers and shareholders. * * *Trading above $72 in February 2005 before it was Spitzerized, AIG shares closed yesterday at $39.57. The company's directors defend themselves by saying Mr. Spitzer gave them little choice but to dismiss Mr. Greenberg. Whether that was true at the time, they – and Mr. Spitzer – owe an apology to AIG shareholders.

And, of course, now we know it only got worse.  Thanks Eliot.

More lawyers in the boardroom

Here's another innovation for which we can thank SOX and securities litigation: more lawyers in the boardroom.  To add to the company's inside and outside counsel, now independent directors are bringing in their own lawyers.  Here's a Law.com article, HT PoL.

Let's hope they keep a little space and time for the business people.

Carney on the PCAOB

Dealbreaker's John Carney has a great post explaining why the DC Circuit’s recent case upholding SOX actually involves no mere technicality but a serious issue of delegation of power to administrative agencies, and why the Supreme Court may reverse if it gets the opportunity.

My only addition is to wonder if the DC Circuit figured that by upholding SOX with a strong dissent, it might be sending a message to Congress to amend to eliminate the problem. The court thereby avoids the chaos that would have ensued under the alternative holding of declaring the PCAOB unconstitutional. Because SOX lacks a severability clause, the effect of that would be to invalidate all of SOX and throw the whole thing back to Congress.

Of course, if that was the strategy, it doesn’t eliminate the problem, because once this part of SOX goes to Congress, the log-rolling on the whole act will begin, which could throw a lot of issues up for grabs – e.g., breaks for small and foreign firms.