A balanced analysis.
Jim Hamilton has a list of seven "pieces of legislation amending the Dodd-Frank Act passed the House in the 113th Congress by a bi-partisan vote, sometimes an overwhelming bi-partisan vote, but were never taken up the Senate."
I found this to be a very interesting paper:
This paper supports the objective of the proposed revision of the Shareholder Rights Directive (Directive 2007/36/EC), that is, to contribute to the long-term sustainability of EU companies. However, it expresses concern that the measures being considered will not achieve their intended purpose, and worse, that they may have unintended negative consequences. The fundamental issue is that shareholder empowerment will not, on its own, improve corporate governance or contribute to sustainable growth in the EU.
Short-termism was one of the root causes of the financial crisis. It has not been adequately addressed to promote sustainable European growth over the long-term. Despite the Commission’s well-intentioned efforts, the proposed revision falls far short of addressing the underlying causes of short-termism so as to prevent future crises.
The current proposal relies exclusively on shareholders to drive the shift to a longer-term perspective. Especially after the financial crisis, there is no clear reason for this exclusive reliance on shareholders. Although shareholders have and should have specific rights in corporate governance, shareholders do not own companies. Their relationship with the company is a contractual one, just like that of creditors and employees. Moreover, shareholders differ considerably in their time frames and approaches. Some shareholders are committed to holding for the long-term, whilst others only hold for the short-term. It is important that the former group become more engaged; however, there is a danger that the proposed revision will further empower shareholders with a short-term orientation. For this reason, there is a need for further measures to complement the proposed revision and achieve the goal of a longer-term approach to corporate governance. The paper suggests minor changes to the proposal and canvasses some more far-reaching changes.
Walter Olson has the details. Here's the key point:
According to [WaPo] reporter Sudarsan Raghavan, these provisions “set off a chain of events that has propelled millions of [African] miners and their families deeper into poverty.” As they have lost access to their regular incomes, some of these miners have even enlisted with the warlord militias that were the law’s targets.
But go read the whole thing.
As I explained in my book The Complete Guide to Sarbanes-Oxley:
SOX § 203 requires registered public accounting firms to rotate (1) the partner having primary responsibility for the audit and (2) the partner responsible for reviewing the audit every five years. The audit committee must ensure that the requisite rotation actually takes place.
There now appears to be evidence that rotating audit partners does contibute to improved disclosure:
The main purpose of audit partner rotation is to bring a "fresh look" to the audit engagement while maintaining firm continuity and overall audit quality. Despite mandatory audit partner rotation being required in the U.S. for over 35 years, to-date there has been limited empirical evidence speaking to the effectiveness of U.S. auditor partner rotations given that audit partner information is not disclosed in U.S. audit reports. Using SEC comment letter correspondences to identify U.S. audit partner rotations, we provide initial evidence among publicly-listed companies suggesting that audit partner rotation in the U.S. supports a "fresh look" at the audit engagement. Specifically, we find that audit partner rotation results in substantial increases in material restatements (129 to 135 percent) and write-downs of impaired assets (one percent of market value). Overall, these findings suggest that audit partner rotation supports auditor independence and is an important component of quality control for U.S. accounting firms.
Citation: Laurion, Henry and Lawrence, Alastair and Ryans, James, U.S. Audit Partner Rotations (October 27, 2014). Available at SSRN: http://ssrn.com/abstract=2515586
Note that this result does not support audit firm rotation. As I also noted in my book Complete Guide to Sarbanes-Oxley: Understanding How Sarbanes-Oxley Affects Your Business, as a matter of good practice, a company ought to consider rotating audit firms periodically so as to get the benefit of a fresh set of eyes. Some corporate governance experts recommend doing so at least every ten years. In addition, governance experts recommend rotating audit firms if a substantial number of former company employees have gone to work for the audit firm or vice-versa.
But should good practice be made mandatory?
My concern is that consolidation of the accounting profession has made auditor rotation extremely difficult. As I explained in my book Complete Guide to Sarbanes-Oxley: Understanding How Sarbanes-Oxley Affects Your Business, SOX prohibits a public corporation from obtaining a wide range of non-audit accounting and consulting services from the accounting firm that performs their audit. Many public corporations get a wide array of such non-audit services from all 3 of the other Big 4 accounting firms. Rotating the auditing firm thus will be pretty complicated, as firms have to reshuffle their non-audit services. It'll be even more complicated if the firms are subject to some sort of cooling off period between when they provide audit services and can begin providing non-audit services (and vice-versa).
One key reform of the accounting profession thus ought to be promoting smaller accounting firms as viable alternatives to the Big 4.
In my essay Corporate Governance and U.S. Capital Market Competitiveness (October 22, 2010), available at SSRN: http://ssrn.com/abstract=1696303, I explained that:
During the first half of the last decade, evidence accumulated that the U.S. capital markets were becoming less competitive relative to their major competitors. The evidence reviewed herein confirms that it was not corporate governance as such that was the problem, but rather corporate governance regulation. In particular, attention focused on such issues as the massive growth in corporate and securities litigation risk and the increasing complexity and cost of the U.S. regulatory scheme.
Tentative efforts towards deregulation largely fell by the wayside in the wake of the financial crisis of 2007-2008. Instead, massive new regulations came into being, especially in the Dodd Frank Act. The competitive position of U.S. capital markets, however, continues to decline.
This essay argues that litigation and regulatory reform remain essential if U.S. capital markets are to retain their leadership position. Unfortunately, the article concludes that federal corporate governance regulation follows a ratchet effect, in which the regulatory scheme becomes more complex with each financial crisis. If so, significant reform may be difficult to achieve.
If you believed the Obama administration and the Democrats' hyoe, the JOBS Act was going to solve the problem. They were wrong, according to a new study by some economists (which I'm more inclined to accept that ones done by law professors masquerading as quants):
We examine the effects of Title I of the Jumpstart Our Business Startups Act (JOBS) for a sample of 213 EGC IPOs issued between April 5, 2012 and April 30, 2014. We show no reduction in the direct costs of issuance, accounting, legal, or underwriting fees, for EGC IPOs. Further, the indirect cost of issuance, underpricing, is significantly higher for EGCs than other IPOs. More importantly, greater underpricing is present only for larger firms that were not previously eligible for scaled disclosure under Regulation S-K. EGCs that are more definitive about their intentions to use the provisions of the Act have lower underpricing than those that are ambiguous. Finally, we find no increase in IPO volume after the Act. Overall, we find little evidence that the Act has initially been effective in achieving its main objectives and conclude that there are significant consequences to extending scaled disclosure to larger issuers.
Interestingly, one of the authors - Kathleen Weiss Hanley - was until very recently an economist at the SEC,
I recommend a new paper:
Davidoff, Solomon and [Zarig] have put together a paper on the litigation between the government and the preferred shareholders of Fannie Mae and Freddie Mac. Do give it a look and let us know what you think. Here's the abstract:
The dramatic events of the financial crisis led the government to respond with a new form of regulation. Regulation by deal bent the rule of law to rescue financial institutions through transactions and forced investments; it may have helped to save the economy, but it failed to observe a laundry list of basic principles of corporate and administrative law. We examine the aftermath of this kind of regulation through the lens of the current litigation between shareholders and the government over the future of Fannie Mae and Freddie Mac. We conclude that while regulation by deal has a place in the government’s financial crisis toolkit, there must come a time when the law again takes firm hold. The shareholders of Fannie Mae and Freddie Mac, who have sought damages from the government because its decision to eliminate dividends paid by the institutions, should be entitled to review of their claims for entire fairness under the Administrative Procedure Act – a solution that blends corporate law and administrative law. Our approach will discipline the government’s use of regulation by deal in future economic crises, and provide some ground rules for its exercise at the end of this one – without providing activist investors, whom we contend are becoming increasingly important players in regulation, with an unwarranted windfall.
The Sarbanes-Oxley Act created a new obstruction of justice law that imposes stiff criminal penalties on anyone who “knowingly alters, destroys, mutilates, conceals, covers up, falsifies, or makes a false entry in any record, document, or tangible object with the intent to impede, obstruct, or influence the investigation or proper administration of any matter within the jurisdiction of any department or agency of the United States or any case filed under [the Bankruptcy Code].” Just how literally are we to take the term "tangible object, however? A new article discusses an upcoming Supreme Court case whose facts push that question to the outer limits:
Abstract: Occasionally the Supreme Court of the United States hears a case simply to correct an injustice. That happened in Yates v. United States. Yates, a fishing captain, threw back three undersized fish. He later was convicted of violating the Sarbanes-Oxley Act, a statute designed to prevent corporate fraud, on the ground that he destroyed a “record, document, or tangible object,” even though the fish could not remotely be deemed a financial record or an information storage device. The court of appeals upheld Yates’s conviction by relying entirely on a dictionary definition of the term “tangible object.” That literal-mindedness lead to an uncommonly silly result. The Supreme Court should not only reverse the judgment of conviction, but also underscore two canons of construction. First, courts should use common sense when interpreting criminal laws, rather than be slaves to the dictionary. Second, the Rule of Lenity is a “rule” of lenity, not just an “option” of lenity, and it is an especially important rule when a defendant faces a potentially severe sentence.
Marcia Narine is a rising star in corporate law academia and the blawgosphere who I've been following with interest for some time. In her latest post at Business Law Professor Blog she poses the following questions as Dodd-Frank turns 4. So I thought I'd try my hand at offering some answers:
1) When Dodd-Frank turns five next year, how far behind will we still be, and will we have suffered another financial blip/setback/recession/crisis that supporters say could have been prevented by Dodd-Frank?
I'm not a macro economist, so I have no idea whether the economy will tank in the next year (but if forced to guess with a gun to my head, I'd say no). As for being behind, she is referring to the fact that the regulatory agencies have only adopted about half of the rules Congress mandated in the Dodd Frank statute. My prediction: In July 2015, about 65% of the required Dodd Frank rulemaking proceedings will have resulted in a final rule but at least 15% will still not have even resulted in a proposed rule.
2) How will the results of the mid-term elections affect the funding of the agencies charged with implementing the law?
Obviously, the big question here is whether the GOP takes control of the Senate. My current guess is that we end up with a 50-50 Senate, with Biden throwing control to the Democracts (and thereby being so busy that he has no chance of beating Hillary for the 2016 Democrat nod). If so, we're looking at high odds of a budgetary train wreck.
3) What will the SEC do to address the Dodd-Frank rules that have already been invalidated or rendered otherwise less effective after litigation from business groups such as §1502, Conflict Minerals Rule (see here for SEC response) or §1504, the Resource Extraction Rule (see here for court decision)?
Both of those rules are pet favorites of the left, so I see the SEC's three Democrat members facing enormous political pressure to get them into law by 2016.
4) Given the SEC's failure to appeal after the proxy access litigation and the success of the lawsuits mentioned above, will other Dodd-Frank mandates be vulnerable to legal challenge?
I think the SEC has finally figured out that it has to throw a lot of resources into doing cost/benefit analysis of its rules and that it has to stick to the limits of its statutory authority. If I'm right, their new rules should be less vulnerable to challenge. In addition, given that Obama's finally been able to tilt the DC Circuit to the Democrat side (7-4), the odds are much better that any challenge will be decided by a pro-SEC panel.
5) Will the whistleblower provision that provides 10-30% of any recovery over $1 million to qualified persons prevent the next Bernie Madoff scandal? I met with the SEC, members of Congress and testified about some of my concerns about that provision before entering academia, and I hope to be proved wrong.
I have no idea. But I did read an interesting article on health care fraud whistleblowers in today's WSJ. Does that count for anything?
Peter Wallison commemorates the sad day:
Dodd-Frank has already overwhelmed the regulatory system, stifled the financial industry and impaired economic growth.
According to the law firm Davis, Polk & Wardell's progress report, Dodd-Frank is severely taxing the regulatory agencies that are supposed to implement it. As of July 18, only 208 of the 398 regulations required by the act have been finalized, and more than 45% of congressional deadlines have been missed.
The effect on the economy has been worse. A 2013 Federal Reserve Bank of Dallas study showed that the GDP recovery from the recession that ended in 2009 has been the slowest on record, 11% below the average for recoveries since 1960. ...
[Dodd Frank-caused regulatory] uncertainties, costs and restrictions have sapped the willingness or ability of the financial industry to take the prudent risks that economic growth requires. With many more regulations still to come, Dodd-Frank is likely to be an economic drag for many years.
I called Dodd Frank "quack corporate governance." It's a conclusion I stand by despite the naysaying of numerous nattering nabobs of negativity.
I liked this article a lot: Fisch, Jill E., The Broken Buck Stops Here: Embracing Sponsor Support in Money Market Fund Reform (June 16, 2014). U of Penn, Inst for Law & Econ Research Paper No. 14-24. Available at SSRN: http://ssrn.com/abstract=2456255:
Abstract: Since the 2008 financial crisis, in which the Reserve Primary Fund “broke the buck,” money market funds (MMFs) have been the subject of ongoing policy debate. Many commentators view MMFs as a key contributor to the crisis, in part because widespread redemption demands during the days following the Lehman bankruptcy led to a freeze in the credit markets. The response has been to deem MMFs a component of the nefarious shadow banking industry and to target them for regulatory reform.
Determining the appropriate approach to MMF reform has proven difficult. Banks regulators prefer a requirement that MMFs trade at a floating NAV rather than a stable $1 share price. By definition, a floating NAV would prevent future MMFs from breaking the buck, but it is unclear that it would eliminate the risk of large redemptions in a time of crisis. Other reform proposals have similar shortcomings. More fundamentally, pending reform proposals could substantially reduce the utility of MMFs for many investors, which could, in turn, dramatically reduce the availability of short term credit.
The complexity of regulating MMFs has been exacerbated by a turf war among regulators. The Securities and Exchange Commission has battled with bank regulators both about the need for additional reforms and about the structure and timing of any such reforms. Importantly, the involvement of bank regulators has shaped the terms of the debate. To justify their demands for greater regulation, bank regulators have framed the narrative of MMF fragility using banking rhetoric. This rhetoric masks critical differences between banks and MMFs, specifically the fact that, unlike banks, MMF sponsors have assets and operations that are separate from the assets of the MMF itself. Because of this structural difference, sponsor support is not a negative for MMFs but a stability-enhancing feature.
The difference between MMFs and banks provides the basis for a simple yet unprecedented regulatory solution: requiring sponsors of MMFs explicitly to guarantee a $1 share price. Taking sponsor support out of the shadows provides a mechanism for enhancing MMF stability that embraces rather than ignoring the advantage that MMFs offer over banks through asset partitioning.
Jonathan Adler weighs in:
In an opinion by Judge Raymond Randolph (joined by Judge David Sentelle), the court concluded that compelled disclosures of commercial information are subject to the same level of First Amendment scrutiny as are other regulations of commercial speech (under the Central Hudson test), unless the disclosures are limited to “purely factual and uncontroversial information” and the mandatory disclosure is “reasonably related to the State’s interest in preventing deception of consumers.”
Because, as the SEC conceded, the conflict mineral disclosure requirements have nothing to do with preventing consumer deception, the court concluded the rules should be evaluated under Central Hudson. Under this test, the requirements must serve a substantial government interest, directly advance that interest, and be narrowly tailored. Whether or not the SEC could demonstrate that its conflict mineral disclosure rule satisfies a substantial government interest, the court found the SEC offered no evidence that its rule was narrowly tailored. On this basis the court struck down the requirement that companies declare that products “have not been found to be ‘DRC conflict free.’” Insofar as Dodd-Frank requires other disclosures, including reports to the SEC, such requirements were upheld.
Go read the whole thing.
The DC Circuit's decision in NAM v. SEC, which partially struck down the SEC's conflict mineral disclosure rule is doubtless an important decision. But let's not get carried away. If anyone thinks that the conflict minerals case presages constitutional invalidation of the mandatory disclosure, they would be reading way too much into the opinion.
First, it seems clear that the court is not foreclosing all conflict mineral disclosure rules, just this one. See footnote 14 of the majority opinion:
The requirement that an issuer use the particular descriptor “not been found to be ‘DRC conflict free’” may arise as a result of the Commission’s discretionary choices, and not as a result of the statute itself. We only hold that the statute violates the First Amendment to the extent that it imposes that description requirement. If the description is purely a result of the Commission’s rule, then our First Amendment holding leaves the statute itself unaffected.
Second, note the majority's discussion of SEC v. Wall Street Publishing Institute at page 20-21 of the opinion. It rather clearly suggests that SEC securities regulation that plausibly can be linked to preventing consumer deception will be reviewed under the commercial speech standards.
Third, note the concurrence/dissent's discussion of the pending American Meat Institute v. United States Department of Agriculture case. As Judge Srinivasan notes, the en banc panel in that case "will receive supplemental briefing on the question whether review of 'mandatory disclosure' obligations can 'properly proceed under Zaudere' even if they serve interests 'other than preventing deception.'" The panel decision here assumes that the answer to that question is no. But what if it is yes?
Finally, beyond the scope of the present decision, there are lots of precedents suggesting that the constitutonality of the basic mandatory disclosure regime is beyond peradventure. See, e.g., Ohralik v. Ohio State Bar Ass'n 436 U.S. 447, 456 (1978) (stating in dicta that: Numerous examples could be cited of communications that are regulated without offending the First Amendment, such as the exchange of information about securities . . . .”); Paris Adult Theatre I v. Slaton, 413 U.S. 49, 61-62 (1973) (noting that “both Congress and state legislatures have ... strictly regulated public expression by issuers of and dealers in securities ... commanding what they must and must not publish and announce”); Full Value Advisors, LLC v. SEC, 633 F.3d 1101 (D.C. Cir. 2011) (“Securities regulation involves a different balance of concerns and calls for different applications of First Amendment principles.” ); United States v. Bell, 414 F.3d 474, 484-85 (3d Cir. 2005) (holding that the government may regulate speech so as to prevent consumer deception and, accordingly, that “mandatory disclosure of factual, commercial information does not offend the First Amendment”); Blount v. SEC, 61 F.3d 938, 944-47 (D.C. Cir. 1995) (holding that the SEC's anti-pay to play Rule G-37 survived strict First Amendment scrutiny); SEC v. Wall St. Publ'g Inst., Inc., 851 F.2d 365, 374-76 (D.C. Cir. 1988), cert. denied, 489 U.S. 1066 (1989) (holding that an investment newsletter could be required to disclose whether it was being paid to run an article touting a stock article).
In sum, don't bet the house on a constitutional challenge to mandatory disclosure.
As my Competitive Enterprise Institute colleague Hans Bader and I have written in blog posts, articles, and regulatory comments, the conflict disclosure mandate creates a compliance nightmare, hurts American miners and manufacturers, and does the greatest harm to those it was intended to help — the struggling worker in and nearby the Democratic Republic of Congo. ...
Fighting violence in the Congo is a laudable goal, but it defies common sense and basic civics to pursue foreign-policy objectives through a banking and investment bill. The government entity charged with enforcing this provision is neither the State Department nor the Defense Department, but rather the Securities and Exchange Commission — which no one would call an agency well-schooled in the nuances of foreign policy.
The Court looked at this leap of logic and decided that the provision could not survive the First Amendment’s prohibition against “compelled speech,” even under the lesser standard for “commercial speech.” As Judge A. Raymond Randolph wrote in the majority opinion, this compelled speech is not even “reasonably related” to the SEC’s mission of “preventing consumer deception.” The opinion concludes, “By compelling an issuer [publicly-traded company] to confess blood on its hands, the statute interferes with that exercise of the freedom of speech under the First Amendment.”
I agree with much of what Berlau says, although I would caution that I read the majority opinion as making a rather narrow ruling:
This brings us to the Association’s First Amendment claim. The Association challenges only the requirement that an issuer describe its products as not “DRC conflict free” in the report it files with the Commission and must post on its website. ... That requirement, according to the Association, unconstitutionally compels speech. ...
Specifically, the Commission argues that issuers can explain the meaning of “conflict free” in their own terms. But the right to explain compelled speech is present in almost every such case and is inadequate to cure a First Amendment violation. See Nat’l Ass’n of Mfrs., 717 F.3d at 958. Even if the option to explain minimizes the First Amendment harm, it does not eliminate it completely. Without any evidence that alternatives would be less effective, we still cannot say that the restriction here is narrowly tailored.
We therefore hold that 15 U.S.C. § 78m(p)(1)(A)(ii) & (E), and the Commission’s final rule, 56 Fed. Reg. at 56,362-65, violate the First Amendment to the extent the statute and rule require regulated entities to report to the Commission and to state on their website that any of their products have “not been found to be ‘DRC conflict free.’”14
14 The requirement that an issuer use the particular descriptor “not been found to be ‘DRC conflict free’” may arise as a result of the Commission’s discretionary choices, and not as a result of the statute itself. We only hold that the statute violates the First Amendment to the extent that it imposes that description requirement. If the description is purely a result of the Commission’s rule, then our First Amendment holding leaves the statute itself unaffected.
It seems to me that that court left the SEC (and Congress) a lot of room to go back and adopt new conflict mineral disclosure rules. Such rules would be a bad idea, but they could doubtless be crafted to pass constitutional muster. After all, the whole SEC disclosure apparatus regulates speech and nobody with any sense thinks federal courts are ever going to strike down that apparatus as a violation of the First Amendment.