ProfessorBainbridge.com

Ruffino Riserva Ducale Oro (Chianti Classico) 1999

An outstanding, moderately upscale Chianti. Not a pizza wine; we served it with Veal Marsala. Medium ruby. Good, clean nose of cherries and damp earth. On the palate, the wine is well-balanced with smooth tannins and plenty of acidity. Delicious cherry and earthy mineral flavors. Grade: B++

Duckhorn Cabernet Sauvignon (Napa Valley) 2000

Duckhorn?s 2000 Cabernet Sauvignon is a deep purple-black, with strong legs. It offers a rich nose of dark berries, chocolate, and mocha java. The palate follows with black cherries, blackberries, chocolate, soy sauce, and oriental spices. All in all, a delicious wine for consumption now and for the next few years. Lacks the tannic backbone it would need for truly long-term cellaring. Grade: A-

Hedge Funds; And Why Donaldson = Souter

Republican Presidents have often had cause to be disappointed with their choices for the Supreme Court, who end up being far more liberal than one would have hoped. We see the same thing these days at the SEC. where Bush-nominated and registered Republican Chairman William Donaldson increasingly sides with the Commission's two Democrats against the other two Republicans. The latest 3-2 vote came on the SEC's proposal to regulate hedge funds. Fortunately, good old Fed Chairman Alan Greenspan may have let some of the air out of that trial balloon:

Federal Reserve Chairman Alan Greenspan on Tuesday said a U.S. Securities and Exchange Commission proposal to crack down on hedge funds will not work as hoped and predicted a flood of new funds could lead to large losses. "My problem with the SEC's current initiative is that the initiative cannot accomplish what it seeks to accomplish," said Greenspan in testimony before the Senate Banking Committee. Making clear he disapproves of the proposal backed by SEC Chairman William Donaldson, Greenspan said forcing hedge funds to register with the SEC as proposed would likely do little to prevent fraud. As a result, he said, the SEC could come under pressure to tighten its regulatory grip even more on the $850 billion hedge fund industry, resulting in damage to an industry that he called a vital part of the U.S. financial system. "Hedge fund arbitrageurs are required to move flexibly and expeditiously if they are to succeed. If placed under increasing restrictions, many will leave the industry -- to the significant detriment of our economy," he said. ...

Reiterating earlier comments, Greenspan called hedge funds "major contributors to the flexibility of our financial system" that help the economy absorb shocks. He added that even if the SEC could detect hedge fund abuses through registration data, it would probably be too late. "By the time of detection, hedge funds would have long since moved on to different strategies," he told the committee.

We know Greenspan is right based on our experience with registration of corporate securities. The SEC almost never detects fraud through the registration process. Instead, the registration process creates a paper trail of disclosures against which subsequent events can be measured and upon which suit can be brought if fraud comes to light. As I explained in my treatise Corporation Law and Economics (makes a great gift!):

The large volume of registration statements filed with the SEC and its limited resources have meant that by the time the SEC gets around to prosecuting most violations, the offering is long since over. The SEC therefore usually relies on other civil and criminal sanctions to punish violators. Indeed, the SEC cannot even make a detailed examination of all of the registration statements that are filed with it. A two tier system of review has thus evolved. A full blown SEC review normally is undertaken only with respect to initial public offerings and with respect to filings by financially troubled companies. Other filings typically only receive cursory review.

If you're interested in pursuing this topic, I commend to you the dissenting statements by SEC Commissioners Glassman and Atkins.

SEC: No 9/11 Insider Trading

If you were a criminal mastermind about to devestate the American economy, wouldn't you do a little insider trading on the basis of that information? Short the entire stock market or something? According to the SEC, it didn't happen:

On Sept. 12, 2001, the Securities and Exchange Commission began an investigation to determine whether there was evidence that anyone who had advance knowledge of the terrorist attacks on September 11 sought to profit from that knowledge by trading in United States securities markets. In the course of that review, we did not develop any evidence suggesting that anyone who had advance knowledge of the September 11 attacks traded on the basis of that information.

Presumably Osama figured he'd be okay with just the CIA chasing him, but didn't want to mess with the SEC.

Those Divesting Presbyterians - Part II

Following up on my post on the PCUSA's decision to divest from Israel, over at Point of Law James Copeland writes (correctly, IMHO):

Professor Bainbridge cites to two studies, based on the South Africa boycotts, that show (a) that the divestment campaigns had no financial effect, and (b) that they on average hurt the "socially responsible" portfolios that divested.

Financial theory would suggest as much. Unlike a boycott in a traditional goods market, the sale of a stock or bond in a financial market in sufficient volume to affect its price makes it more attractive to a buyer who doesn't care about the divester's social cause. These buyers will bid the price back up to its equilibrium level, the risk-adjusted net present value of expected free cash flows from the instrument. So whereas a goods boycott can be effective under certain conditions, a stock divestiture never can unless there is insufficient liquidity on the other side, a highly dubious condition in our financial market. The Presbyterian Church may have $7 billion in financial assets, but that's hardly a sufficient sum to control financial market pricing. ...

Instead of playing Pontius Pilate, the Presbyterians would be better off holding their stock and offering those annoying shareholder resolutions that companies today must typically face. Or they could organize actual boycotts of the goods and services produced by Israeli companies. Or, better yet, they could just keep their mouths shut.

Why I am Not a Libertarian

Over at the Conspiracy, Randy Barnett w rites:

Even if, as many Libertarians believe, governments themselves inherently violate rights, it does not follow (as some Libertarians appear to assume) that everything such an unjust institution does is a rights violation. Consider mail delivery. The post office may be an unjust monopoly (and unconstitutional to boot), but the letter carrier who coincidentally is walking up my driveway as I type this) is not violating my rights by delivering my mail. Likewise, even if the government of the United States is an unjust institution, this does not make everything (or anything) done by the U.S. Army a rights violation. ... One of the biggest errors made by Libertarian anarchists is assuming that because an institution is an unjust monopoly (because it confiscates its income by force and puts its competitors out of business by force), this makes everything such institutions do also unjust. The latter proposition simply does not follow from the former.

Do people really believe this crap? The post office is an "unjust monopoly"? [Assuming a requirement of universal service, core postal services probably constitute a public good, at least for most of our history. (See post below.)] The government as a whole is "unjust"? Please. I doubt whether Barnett believes such nonsense, but his post implies that some people do. Unfathomable. Here then we find the essential difference between sensible conservatism and the lunacy of libertarian anarchy. I plan to do more on this over the weekend. Suffice it for now to direct you to an oldie but goodie:

Let me simply quote [Russell] Kirk on this one: "[I]n any tolerable society, order is the first need. Liberty and justice may be established only after order is reasonably secure. But the libertarians give primacy to an abstract Liberty. Conservatives, knowing the 'liberty inheres in some sensible object', are aware that freedom may be found only within the framework of a social order, such as the Constitutional order of these United States. In exalting an absolute and indefinable "liberty" at the expense of order the libertarians imperil the very freedom that they praise."

Their view of the state as the great oppressor, particularly their view of government as the state as the enemy. While conservatives often share the libertarian's concern over bloated and inefficient government, libertarians take this view too far. They often seem to join with Marx in seeking the withering away of the state. Conservatives realize that government is necessary for an ordered liberty. Again Kirk: "Society requires not only that the passions of individuals should be subjected, but that even in the mass and body, as well as in the individual, the inclinations of men should frequently be thwarted, their will controlled, and their passions brought into subjection."

More to follow. But I cannot resist closing with this cheap shot from the pen of Father Richard John Neuhaus: "libertarianism remains in the largest part a thought experiment for college sophomores of all ages."

The Post Office Monopoly

Is the post office really an "u njust monopoly," as some libertarian anarchists apparently believe?

For most of its history, the post office was a tool of an older sort of nation-building. It was never intended to be profitable; its first duty was as national infrastructure. Everyone knows that "universal service"--long a buzzword in postal circles--implies subsidies for rural mail and mail to far-flung places, subsidies that are footed by urbanites whose per-unit mailing costs are typically much lower. Indeed, even in the post-1970 era, the agency has run at a loss two out of every three years. Americans have allowed this and have mostly found it to be unobjectionable.

The Constitution, after all, explicitly authorized Congress to establish a postal system for national purposes--not necessarily commercial ones-- and like national highways, we expect the post office to provide universal service at reasonable cost. The post office lies well within the spirit of the Federalist Papers, which argued for a capable central government with taxation and regulatory powers (though, it should be noted, without explicitly advocating a national postal function). Railroads feature prominently in tales of how the West was won, but the less glamorous post office clearly mattered too. In war, the national mail has been indispensable for keeping up morale among Americans overseas without compromising security. Even free-market advocates who favor privatizing the Postal Service recognize the attraction Americans see in the national mail, and realize how dim are the prospects that United States might implement a private mail system like that of the Netherlands. Clearly, in America, despite our free-market instincts, arguments that a national mail is a public good serving worthy national interests remain popular and strong.

Board demographics

Predictably, the recent regulatory development in corporate law, such as Sarbanes-Oxley (see my article The Creeping Federalization of Corporate Law) and new stock exchange corporate governance listing standards (see my article A Critique of the NYSE's Director Independence Listing Standards) are affecting the demographics of corporate boards of directors. The Transformation of US Corporate Boards: 1997-2003 finds:

During that period boards become smaller and more independent, there are fewer cases of interlocking directorships and a decrease in multiple directorships. We also find changes in director background: an increase in the number of directors with financial background and a decrease in the number of directors with industrial background. ... We find little change in the financial stake of independent directors and in separating CEOs from the chairman position.

Don't assume these changes are an unalloyed good until you've read my articles cited above.

Those Divesting Presbyterians

So the Presbyterian bureaucracy is divesting the denomination's funds from Israel. This is precisely the sort of whacked-out PC lunacy that contributed to my conversion from Presbyterianism to Catholicism. On the other hand, it seems a bit over-the-top to play the anti-semitism card as a couple of bloggers (including the big guy) have done. It ought to be possible to criticize - even severely - Israeli policy without being labelled an anti-semite. Anyway, that's neither here nor there as far as I'm concerned. As a corporate law guy, what interests me is whether divestment campaigns work (in the sense of achieving their proponent's goals). The answer seems to be no.

The Effect Of Socially Activist Investment Policies On The Financial Markets: Evidence From The South African Boycott concludes:

We find that the announcement of legislative/shareholder pressure of voluntary divestment from South Africa had little discernible effect either on the valuation of banks and corporations with South African operations or on the South African financial markets. There is weak evidence that institutional shareholdings increased when corporations divested. In sum, despite the public significance of the boycott and the multitude of divesting companies, financial markets seem to have perceived the boycott to be merely a "sideshow."

The Stock Market Impact of Social Pressure: The South African Divestment Case in fact found:

Using the South African divestment case, this study tests the hypothesis that social pressure affects stock returns. Both short-run (3-, 11-, and 77-day periods) and long-run (13-month periods) tests of stock returns surrounding U.S. corporate announcements of decisions to stay or leave South Africa were performed. Tests of the impact of institutional portfolio managers to divest stocks of U.S. firms staying in South Africa were also performed. Results indicate there was a negative wealth impact of social pressure: stock prices of firms announcing plans to stay in South Africa fared better relative to stock prices of firms announcing plans to leave.

In sum, divestment may make activists feel all warm and fuzzy, but the evidence is that (1) it has no significant effect on the target of the divestment campaign but (2) likely does harm the activists' portfolios. My take? I don't want Presbyterians managing my portfolio.

Update: When the PC(USA)'s General Assembly voted to divest the denomination's funds from corporations doing business with Israel, many folks in the blogosphere jumped to condemn the action as anti-Semitic (including the big guy). At the time, it struck me that people were being too quick to play the anti-Semitism card. Playing that card whenever Israel comes into criticism is a problem for two reasons. First, it tends to silence legitimate criticism of Israel, which is no more perfect and no more immune from constructive criticism than any other polity. Second, over time, playing the anti-Semitism card every time somebody criticizes Israel tends devalue the moral authority of that card. (Remember the story of the boy who cried wolf?)

In an Opinion Journal column, however, Jay Lefkowitz suggests:

A more nuanced standard, and one that properly recognizes that legitimate criticism of Israel is perfectly appropriate, was articulated last year by Natan Sharansky. A member of the Israeli cabinet who for years had been a prisoner of conscience in the Soviet gulag, Mr. Sharansky defined one current expression of anti-Semitism by three features: the application of double standards to Israel, the demonization of Israel and the delegitimization of Israel.

Fair enough. A nuanced standard indeed. Applying it, Lefkowitz goes on to make a persuasive case that the Presbyterian divestment was anti-Semitic:

The recent action by the Presbyterian Church sadly satisfies Mr. Sharansky's test. The church has singled out Israel, alone among all the nations of the world, for divestment. It has demonized Israel's treatment of the Palestinians, and it has delegitimized Israel's right to self-defense.

The church is not calling for divestment of its $7 billion portfolio from China, despite China's denial of the most basic political and religious rights and its particularly harsh treatment of followers of Falun Gong. It is not condemning Russia, even though Russia's policies in Chechnya are by any human-rights standard atrocious. It is not even calling for economic sanctions against Syria or Iran, whose human-rights records for their own people are egregious and whose Jewish citizens are denied the basic civil rights and liberties afforded to all Israelis, including its Arab citizens, some of whom even serve in the Knesset.

Lefkowitz also notes:

In contrast to the action taken by the Presbyterian Church this month, the Roman Catholic Church has recognized that one-sided criticism of Israel can at times be so grotesque that there is no name to describe it other than anti-Semitism. And in a document ironically signed the same week as the Presbyterian General Assembly, the Catholic Church equated anti-Zionism with anti-Semitism.

As regular readers know, I left the Presbyterian Church several years ago and converted to Catholicism. These events are just one more reason I'm glad I changed teams.

Things About Which I Don't Give a Hoot

In no particular order, here is a list of recent news topics and/or people in the news about which I simply don't care one whit:

• What Sandy Berger put in his socks (or was it briefs).
• What Joe Wilson knew and when he knew it.
• How many babies Michael Jackson has in the pipeline.
• How many kids Britney Spears' fiance has had with other women.
• What Moveon.org, the ACLU, the Libertarian Party, Michael Moore, or Donald Trump (among others) think about the state of the world.
• The 16 words.
• The 9/11 Commission.
• "I, Robot" the movie.
• "I, Robot," the book.
• The Tour de France.
• France, in general.
• Doonesbury
• Anti- Bush celebrities.
• Celebrities, in general.
• Celebrities named Hilton, in particular.
• Scott Peterson.

Each and everyone of these topics is hereby banned from this blog for the indefinite future on grounds of being too painfully boring for further discussion.

Weak Form Efficiency in an Emerging Market

The fundamental thesis of the efficient capital markets hypothesis (ECMH) is that, in an efficient market, current prices always and fully reflect all relevant information about the commodities being traded. In other words, in an efficient market, commodities are never over- or under-priced. The current price is an accurate reflection of the market?s consensus as to the commodity?s value. Of course, there is no real world condition like this, but the U.S. securities markets are widely believed to be close to this ideal.

Studies of the ECMH, as applied to the securities markets, have explored three forms of the theory. Each tests a different level on which markets process information. The weak form posits that all information concerning historical prices is fully reflected in the current price. Put another way, the weak form predicts that price changes in securities are random. Randomness does not mean that the stock market is like throwing darts at a dart board. Stock prices go up on good news and down on bad news. If a company announces a major oil find, all other things being equal, the stock price will go up. Randomness simply means that stock price movements are serially independent: future changes in price are independent of past changes. In other words, investors can not profit by using past prices to predict future prices. (People trying to sell you technical analysis hate this, but it's true.)

An important question for investors is the extent to which the ECMH is a valid model for emerging markets. An interesting new paper, Testin g the Weak-Form Efficiency of the United Arab Emirates Stock Market, sheds light on that question:

This study examines the behavior of stock prices in United Arab Emirates (UAE) stock market. The data consist of the daily prices of the 43 stocks included in the Emirates market index covering the period commencing October 2, 2001 through September 1, 2003. The returns of all the 43 sample stocks do not follow the normal distribution, so the study utilizes only the nonparametric runs to test for randomness. The results reveal that the returns of 40 stocks out of the 43 are random at a 5% level of significance. Hence, the empirical study supports the weak-form EMH of UAE stock market.

These results are surprising and challenging to traditional views because the UAE stock market is newly developed and just recently became official with sound regulations. Furthermore, the market is very small and thin suffering from infrequent trading. However, the results of the paper may be attributed to the essential steps that have already been taken by the authorities to improve the operating and pricing efficiency of UAE stock market during the last two years.

I find this a particularly significant result, because it suggests that weak form efficiency may develop quite early in an emerging market's development. Hence, a whole host of trading strategies (such as charting), likely will be unprofitable - or even counter-productive - even in relatively underdeveloped capital markets. (On the other hand, as the paper notes, studies of other thin capital markets have reached the opposite result. Caveat emptor.)

Profiling the Securities Fraudster

From SLW:

A study earlier this year by KPMG (discussed in this post) found that the "profile" of the most typical corporate fraudster was a male director or senior manager between the ages of 36 and 45, who has worked in the finance department of a public company for more than 10 years. Apparently we can now add "workaholic" to that profile.

According to this article , a new anti-fraud guide due to be released today by Ernst & Young warns that "employees who work excessive hours, refuse to delegate and fail to take up their full holiday entitlement are more likely to commit fraud."

Fascinating. BTW, if you're thinking about hiring me, let me assure you that I do not fit the profile.

UCLA surging

Leiter opines:

In summary form, the schools most improved among the top 18 over the last five years are: Columbia University; University of California, Los Angeles [!]; University of Texas, Austin; Vanderbilt University; Yale University.

The schools who lost the most ground are: Cornell University; Northwestern University; University of Chicago; University of Michigan, Ann Arbor.

Cool. (My alma mater, UVa, "broke even," which sounds about right from what little I hear these days.) Larry Solum has an intersting post on trends (rather than quality) in hiring by the schools covered by Leiter.

Taittinger Brut Prestige Rose (Champagne) NV

A brilliant cherry red color presages a bright and delicious sparkling wine with a rich nose. Cherries, strawberries, and an interesting berry flavor reminiscent of Ocean Spray Cran-Apple. Grade: B+

Why Wasn't Ken Lay Indicted for Insider Trading?

The SEC's civil suit against former Enron CEO Ken Lay charges Lay with insider trading; alleging that:

Lay took advances on a non-collateralized $4 million line of credit with Enron in the total amount of $77,525,000. Thereafter, in twenty separate transactions, Lay repaid the credit line by selling $70,104,762 worth of Enron stock back to the company, at prices he knew did not accurately reflect Enron's true financial condition.

In contrast, the Justice Department's criminal indictment of Lay does not allege insider trading. Why not?

Lay has defended the transactions in question by arguing that he needed to raise cash to satisfy margin calls on stock:

Lay insisted that his sales of Enron stock were made to meet margin calls, which are demands to pay back loans made to buy the stock, that kicked in as Enron's stock price dropped in late 2001. Lay noted that he tried to do everything he could to hold onto his Enron shares, including using a $10 million company bonus, instead of stock, to pay down debt.

Lay's defense raises a technical, but highly important issue in the law of insider trading; namely, can one be held liable for insider trading where the government merely shows that one possessed material nonpublic information at the time of the trade in question or must the government show that one used that information (i.e., that one traded on the basis of that information)? [The following discussion is excerpted from my book Securities Law: Insider Trading.]

The SEC long has argued that trading while in knowing possession of material nonpublic information satisfies Rule 10b-5, the regulatory provision governing most insider trading (including that of Ken Lay). The difficulties with the SEC’s position, however, are readily apparent to any securities lawyer. Most importantly, a mere possession test is inconsistent with Rule 10b-5's scienter requirement, which requires a showing that the defendant had intent to defraud (or, at least, acted recklessly).

In SEC v. Adler, 137 F.3d 1325 (11th Cir.1998), the Eleventh Circuit rejected the SEC’s position in favor of a use standard. Under Adler, "when an insider trades while in possession of material nonpublic information, a strong inference arises that such information was used by the insider in trading. The insider can attempt to rebut the inference by adducing evidence that there was no causal connection between the information and the trade—i.e., that the information was not used." Although defendant Pegram apparently possessed material nonpublic information at the time he traded, he introduced strong evidence that he had a plan to sell company stock and that that plan predated his acquisition of the information in question. If proven at trial, evidence of such a pre existing plan would rebut the inference of use and justify an acquittal on grounds that he lacked the requisite scienter.

The Ninth Circuit subsequently agreed with Adler that proof of use, not mere possession, is required. The Ninth Circuit further held that in criminal cases no presumption of use should be drawn from the fact of possession—the government must affirmatively prove use of nonpublic information. United States v. Smith, 155 F.3d 1051 (9th Cir.1998).

In 2000, the SEC tried to resolve this issue by adopting Rule 10b5-1, which states that Rule 10b-5's prohibition of insider trading is violated whenever someone trades "on the basis of" material nonpublic information. Because one is deemed, subject to certain narrow exceptions, to have traded "on the basis of" material nonpublic information if one was aware of such information at the time of the trade, however, Rule 10b5-1 rejects the Adler/Smith position. In its effect, if not in its precise language, Rule 10b5-1 tries to resurrect the mere possession test.

Did the SEC have authority to adopt Rule 10b5-1 in the face of contrary judicial holdings? The SEC cannot adopt rules that go beyond the scope of the statutes authorizing them. Admittedly, there is some evidence that supports the SEC’s position. In adopting the Insider Trading Sanctions Act of 1984, for example, Congress imposed treble money civil fines on those who illegally trade "while in possession" of material nonpublic information.

The bulk of the evidence, however, raises serious doubts as to the validity of Rule 10b5-1. The Supreme Court has consistently held that Section 10(b) of the Securities Exchange Act, which provides the authority under which Rule 10b-5 was adopted, prohibits only fraud and manipulation. In turn, as we have seen, fraud requires proof that the defendant intended to deceive (i.e., scienter). Indeed, the Supreme Court explained in Dirks that "[i]t is not enough that an insider's conduct results in harm to investors; rather a violation [of Rule 10b-5] may be found only where there is 'intentional or willful conduct designed to deceive or defraud investors.' " Dirks v. SEC, 463 U.S. at 646, 663 n. 23, (1983). Yet, as the Ninth Circuit pointed out in Smith, “a knowing-possession standard would … go a long way toward making insider trading a strict liability crime.” Second, as the Ninth Circuit also noted, “the Supreme Court has consistently suggested, albeit in dictum, that Rule 10b-5 requires that the government prove causation in insider trading prosecutions.” In other words, the government must prove that the defendant used the inside information in making the relevant trading decisions.

Bottom line? I’m guessing that the Justice Department is loath to rely on Rule 10b5-1. Instead, the Justice Department seems to assume that Smith is the law of the land. If Ken Lay had a plausible argument that his trades were intended to satisfy margin calls, the government would have a very difficult time proving beyond a reasonable doubt that he used inside information in connection with the trades. Lay would be in the position of a forced seller, who would have traded anyway. In contrast, the SEC’s complaint makes clear that it is relying on Rule 10b5-1 and going forward on a mere possession basis. If Lay defends himself as vigorously as he claims, perhaps the Lay case will finally give us a definitive ruling as to the validity of the Rule.