Reuters reports that what S&P is aruing in court:
Former U.S. Treasury Secretary Timothy Geithner angrily warned the chairman of Standard & Poor's parent that the rating agency would be held accountable for its 2011 decision to strip the United States of its coveted "triple-A" rating, a new court filing shows.
Harold McGraw, the chairman of McGraw-Hill Financial Inc , made the statement in a declaration filed by S&P on Monday, as it defends against the government's $5 billion fraud lawsuit over its rating practices prior to the 2008 financial crisis. ...
S&P has claimed that the lawsuit was filed in retaliation for the downgrade, and should be dismissed. Its main rating agency rivals, Moody's Investors Service and Fitch Ratings, were not sued.
A new paper suggests that the internal controls disclosure may not properly incentivize corporate executives:
This study investigates the impact of internal controls over financial reporting requirements (ICFR) enacted as part of the Sarbanes-Oxley Act of 2002 on the judgment and decision making of corporate tax executives. Prior research indicates that companies with disclosed material weaknesses in internal controls face significant capital-markets based consequences (Ashbaugh-Skaife et al. 2009; Hammersley et al. 2008; Cheng et al. 2006). However, prior research has not examined whether these consequences impact the decision making of corporate executives. The current study examines the decisions of corporate tax executives to amend or not amend a prior year tax return when the cause of a discovered error will be classified as either a significant deficiency or a material weakness. Although the overall likelihood to amend the tax return is high, we find that tax executives are less likely to amend a prior year tax return when the cause of the discovered error will be classified as a material weakness than when the cause will be classified as a significant deficiency. In addition, when facing a material weakness classification, 16.7% of tax executives would not disclose the error (not amend the prior year tax return). These results indicate that the required ICFR disclosure rules have unintended consequences; impacting the decision making of company executives. In addition, if executives are willing to hide or not disclose an internal control deficiency, the overall reliability of the reporting on ICFR may be limited.
At a time when there is open talk in the media about the possibility of a repeal of ObamaCare, Peter Wallison's case for repeal of Dodd-Frank seems somewhat less fanciful than it did a year ago.
Today's WSJ reports that:
Investors are stampeding into initial public offerings at the fastest clip since the financial crisis, fueling a frenzy in the shares of newly listed companies that echoes the technology-stock craze of the late 1990s.
October was the busiest month for U.S.-listed IPOs since 2007, with 33 companies raising more than $12 billion. The coming week is slated to bring a dozen more initial offerings, including Thursday's expected $1.6 billion stock sale by Twitter Inc., the biggest Internet IPO since Facebook Inc.FB -2.10% 's $16 billion sale in May 2012.
As I document in my article How American Corporate and Securities Law Drives Business Offshore, in The American Illness:
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.
In the article, I explained that how the risk of anti-fraud liability adversely affects the competitiveness of U.S. capital markets and how the federalization of key aspects of corporate governance during the last decade generated significant net regulatory costs adversely affecting those markets. None of these structural problems have been solved. Instead, the current book in IPO volume is happening despite them.
The reasons behind the IPO boom in fact make it look like an IPO bubble:
The rush to buy shares of newly public companies is the latest sign of investors' thirst for assets with potential upside, at a time when relatively safe investments are generating scant income due to tepid economic growth and Federal Reserve policies that have kept a lid on U.S. interest rates. ...
To others, however, the demand is an indication that a rally fueled primarily by abundant liquidity from the Fed, and not by earnings growth and economic expansion, is entering dangerous territory.
"When I hear intelligent investors asking me not which companies are good to invest in, but which IPOs can I get into, it scares the heck of me," said Mark Lamkin, a wealth-management adviser based in Louisville, Ky.
As well it should. Once the Fed starts to curb liquidity, the structural legal problems that beset US capital markets will quickly pop the present IPO bubble.
Section 953(b) of the Dodd-Frank Act required the SEC to develop disclosure rules requiring issuers to disclose the ratio of the “median” total annual income for “all employees” to the annual income of the CEO. BNA is reporting that new SEC Division of Corporation Finance director Keith Higgins has stated that the “real challenge” of writing the mandated rule is developing a methodology for calculating the “median” annual total pay of the issuer's workers. Higgins also reportedly predicted that calculating employee pay will involve some statistical sampling.
I observed in Corporate Governance after the Financial Crisis:
This requirement is going to be hugely burdensome:
[It] means that for every employee, the company would have to calculate his or her salary, bonus, stock awards, option awards, nonequity incentive plan compensation, change in pension value and nonqualified deferred compensation earnings, and all other compensation (e.g., perquisites). This information would undoubtedly be extremely time-consuming to collect and analyze, making it virtually impossible for a company with thousands of employees to comply with this section of the Act.
Statistical sampling likely would somewhat reduce that burden, but will raise new questions, such as: Did Dodd Frank authorize sampling? The statutory language is the median of all employees, which may require a rule that counts everybody (recall the Supreme Court cases about the census using sampling?).
Will the SEC finally do a sufficiently robust economic analysis of the costs and benefits to avoid adding to the string of rules that have been struck down?
Will there be safe harbors for firms that use the mandated statistical sampling but still end up with incorrect disclosures?
Appropriately for Shark Week, Keith Paul Bishop spanks one of my least favorite groups of "people":
In enacting the Dodd-Frank Act, Congress made it clear to everyone, other than the plaintiffs’ bar, that say-on-pay votes were advisory only, did not create or imply any change in fiduciary duties of directors, or create or imply any additional fiduciary duties of directors.
In today's WSJ, economist Richard Grossman argues we should scrap the London Interbank Offering benchmark rate (LIBOR). To be sure, as Grossman argues, the LIBOR rate has been plagued by scandal:
Because so much money is riding on Libor, banks have an incentive to alter submissions—up or down, depending on the situation—to improve their bottom lines. Many in the financial community had long known about Libor manipulation. As early as 2008, then-president of the Federal Reserve Bank of New York Timothy Geithnerwarned the Bank of England that Libor's credibility needed to be enhanced. E-mails between bankers that have come to light since the scandal broke almost a year ago prove conclusively that cheating was commonplace.
Instead of fixing LIBOR, however, Grossman wants to scrap it:
The British government should announce that, six months from today, Libor will cease to exist. The British Bankers' Association, which technically owns the interest-rate index, has been so wounded by the scandal that it has been willing to follow the government's lead and will no doubt agree.
And how will markets react? The way they always do. They will adapt.
Financial firms will have six months to devise alternative benchmarks for their floating rate products. Given the low repute in which Libor—and the people responsible for it—are held, it would be logical for one or more market-determined rates to take the place of Libor.
Grossman's argument is fraught with error. First, he far too glibly assumes that markets will easily adjust. But LIBOR is not just used in spot markets, which could adjust in the short term, but is also used in countless long-term contracts. As I explain in my article, Reforming LIBOR, attempting to replace LIBOR with an alternative benchmark likely would have triggered massive dislocation--and, as a result, massive litigation. In addition, the extensive network effects associated with LIBOR suggest that change would be costly due to path dependency.
Second, it's not obvious that there are any plausible alternatives to benchmarks based on interbank lending. Grossman argues that there are at least two:
One often mentioned candidate is the GCF Repo index published by the Depository Trust & Clearing Corp. This index is based on actual repurchase agreement transactions, and is thus a better indicator of the cost of funds than banks' internal estimates—even if those estimates were unbiased. Another option might be some newly constructed index based on credit-default swaps transactions, corporate bonds and commercial paper.
Like other interbank offering rate benchmarks, however, LIBOR submissions combine three components: (1) compensation to the lender for the time value of money, (2) compensation for the risk that the counterparty bank will default, and (3) a liquidity premium reflecting market transaction costs. This combination has proved highly useful for lenders. It allows lenders to pass on changes in their funding costs to borrowers and thus minimize basis risk, for example, by pegging the borrower’s interest rate to LIBOR plus an appropriate risk premium reflecting the borrower’s creditworthiness. As such, if the lending bank’s funding rate rises, so too will the rate the borrower must pay, ensuring that the lending bank will continue to receive the full risk premium. Grossman's alternative index based on CDSs etc... lack those characteristics.
The GCF Repo index also differs from bank funding costs, consisting of "the average daily interest rate paid for the most-traded GCF Repo contracts for U.S. Treasury bonds, federal agency paper and mortgage-backed securities [MBS] issued by Fannie Mae and Freddie Mac." The GCF Repo index also is problematic because it's based on US instruments. One of LIBOR’s major advantage is that the London time zone allows it to straddle the Asian and U.S. markets.
Finally, Grossman ignores the reforms that the UK government has put into place to ensure that the reformed LIBOR benchmark will be less vulnerable to manipulation. Specifically, LIBOR submissions will be based on a hierarchy of transaction types. A panel bank first looks to its own transactions in the inter-bank deposit market, in other deposit markets such as commercial paper, and finally in other related markets such as derivatives. In the absence of good data from such transactions, a panel bank next looks to its observations of third party transactions in those markets. The third tier of the hierarchy consists of third party quotes to panel member banks in those markets. Only in the absence of any such transaction data should a panel member rely on an estimate in making its LIBOR submission.
In order to further strengthen the link between LIBOR and actual transaction data, the number of currencies and maturities for which a LIBOR benchmark is quoted are to be reduced by eliminating currencies and maturities traded in particularly thin markets.
In sum, the case simply has not been made for scrapping LIBOR. Instead, we need to be careful to ensure that the new administrator is well supervised. This is so, because Grossman is right about one thing: NYSE Euronext is a suspect administrator. The BBA failed in large part because it had no skin in the game. NYSE Euronext has the opposite problem; i.e., too much skin in the game:
British authorities earlier this month granted a contract to run the index to NYSE Euronext, a company that owns the New York Stock Exchange, the London International Financial Futures and Options Exchange, and a number of other stock, bond, and derivatives exchanges. NYSE Euronext is scheduled to be taken over by IntercontinentalExchange, a firm which owns even more derivatives markets.
In other words, the company that will be responsible for making sure that Libor is set responsibly and fairly will be in a position to profit like no one else from even the slightest movements in Libor.
The UK regulators will need to closely supervise NYSE Euronext to ensure it doesn't cheat and be prepared to force NYSE Euronext to step aside if necessary. But that's an argument for supervision, not for scrapping the whole project.
Senator Elizabeth Warren is a former Harvard business law professor, so she ought to know better than to peddle this sort of nonsense:
United States Senator Elizabeth Warren (D-MA) today sent a letter to New York Stock Exchange (NYSE) Vice President John Carey and NASDAQ Executive Vice President & General Counsel Edward Knight, urging their organizations to consider proposing rules requiring "one share, one vote" corporate structures for listed companies.
Sen. Warren asks NYSE and NASDAQ to declare companies ineligible for an initial listing if they have unequal voting rights, and to prohibit already listed companies from issuing additional classes of common stock with unequal voting rights - a request made by the Council of Institutional Investors in an October letter. "If a company goes to the public markets to raise money, long-term ordinary common stock investors - a category that includes directly or indirectly millions of retirees and workers - should be entitled to certain basic rights," writes Sen. Warren. "One of the most basic of those rights is one-share-one-vote."
Sen. Warren highlights several problems with unequal voting arrangements. She notes that under these structures, "Long-term investors will have limited recourse in holding management and the board accountable if the company heads in a wrong direction." Sen. Warren's letter asks NYSE and NASDAQ to issue proposed rules addressing this issue for public comment.
I've written extensively about one share/one vote over the years and am confident that everything Senator Warren said here was wrong.
First, shareholders do not have "rights," if by right you mean something “that is conceived as part of natural law and that is therefore thought to exist independently of rights created by government or society.” Black's Law Dictionary 1323 (7th ed. 1999). Instead, shareholders "rights" are defined entirely by a contract comprised of the corporation's organic documents and the default rules of corporate law. See Alta Berkeley VI C.V. v. Omneon, Inc., 41 A.3d 381, 385 (Del.2012) (noting that the articles of incorporation are regarded as contracts between shareholders and the corporation and are interpreted as such). There has never been a time in US history in which those default rules mandated one share/one vote. (I trace this history in Revisiting the One-Share/One-Vote Controversy: The Exchanges’ Uniform Voting Rights Policy, 22 Securities Regulation Law Journal 175 (1994).)
What we have here thus is Sen. Warren engaing in what her Harvard colleague Mary Ann Glendon calls Rights Talk, in which the term right is invoked as a sort of trump card to delegitimate opposistion.
As I also explain in Revisiting the One-Share/One-Vote Controversy, while some argue that equal voting rights help reduce agency costs by ensuring that management accountability to shareholders, this argument proves unpersuasive on close examination. Shareholder voting as such is a relatively inefficient accountability mechanism. The shareholders’ incentives to be rationally apathetic, coupled with their relative powerlessness, renders them the corporate constituency perhaps least able to hold management accountable for misbehavior.
To be sure, voting rights enable shareholders to indirectly hold management’s feet to the fire via a proxy contest or by selling their shares to a takeover bidder. From this perspective, dual class capital structures are problematic not because they deprive shareholders of voting rights, but because they shield management from exposure to the full force of these other accountability mechanisms. Having said that, however, the anti-takeover effects of dual class stock do not justify prohibiting such a capital structure. Proscribing dual class stock because of its takeover effects puts one on a very slippery slope indeed. Taken to its logical extreme, the argument against dual class stock based on its anti-takeover effect would justify a sweeping prohibition of all effective takeover defenses, a solution that no court or legislature has been willing to adopt.
Finally, Senator Warren ovelooks the a critical difference between one share/one vote capital structures created in the corporation's articles prior to the IPO and one created after the company has gone public via charter amendment or otherwise. While management’s conflict of interest may justify some restrictions on some disparate voting rights plans, it hardly justifies a sweeping prohibition of dual class stock. After all, not all such plans involve a conflict of interest. Dual class IPOs are the clearest case. Public investors who don’t want lesser voting rights stock simply won’t buy it. Those who are willing to purchase it presumably will be compensated by a lower per share price than full voting rights stock would command and/or by a higher dividend rate. In any event, assuming full disclosure, they become shareholders knowing that they will have lower voting rights than the insiders and having accepted as adequate whatever trade-off is offered by the firm in recompense. In effect, management’s conflict of interest is thus constrained by a form of market review.
At present, stock exchange listing standards permit dual class capital structures only when the company adopted one before going public. As we've seen, there is no policy justification for restrictions on dual class stock capital structures in that context.
In sum, Senator Warren blew it again.
Abstract: Unlike many other areas of regulation, financial regulation operates in the context of a complex interdependent system. The interconnections among firms, markets, and legal rules have implications for financial regulatory policy, especially the choice between ex ante regulation aimed at preventing financial failure and ex post regulation aimed at responding to that failure. Regulatory theory has paid relatively little attention to this distinction. Were regulation to consist solely of duty-imposing norms, such neglect might be defensible. In the context of a system, however, regulation can also take the form of interventions aimed at mitigating the potentially systemic consequences of a financial failure. We show that this dual role of financial regulation implies that ex ante regulation and ex post regulation should be balanced in setting financial regulatory policy, and we offer guidelines for achieving that balance.
Apropos the prior post on the fiduciary duties of bank directors, I just read an excellent and provocative article by Chris Bruner. Conceptions of Corporate Purpose in Post-Crisis Financial Firms (March 5, 2013). Seattle University Law Review, Vol. 36, p. 527, 2013; Washington & Lee Legal Studies Paper No. 2012-29. Available at SSRN: http://ssrn.com/abstract=2228845. Here's the abstract:
Abstract: American "populism" has had a major impact on the development of U.S. corporate governance throughout its history. Specifically, appeals to the perceived interests of average working people have exerted enormous social and political influence over prevailing conceptions of corporate purpose - the aims toward which society expects corporate decision-making to be directed. This article assesses the impact of American populism upon prevailing conceptions of corporate purpose - contrasting its unique expression in the context of financial firms with that arising in other contexts - and then examines its impact upon corporate governance reforms enacted in the wake of the financial and economic crisis that emerged in 2007.
I first explore how populism has historically shaped conceptions of corporate purpose in the United States. While the "employee" conceptual category best encapsulates the perceived interests of average working people in the non-financial context, the "depositor" conceptual category best encapsulates their perceived interests in the financial context. Accordingly, American populism has long fostered strong emphasis on the interests of bank depositors, resulting in striking corporate architectural strategies aimed at reducing risk-taking to ensure firm sustainability - notably, imposing heightened fiduciary duties on directors and personal liability on shareholders. I then turn to the crisis, arguing that growing shareholder-centrism over recent decades goes a long way toward explaining excessive risk-taking in financial firms - a conclusion rendering post-crisis reforms aimed at further strengthening shareholders a surprising and alarming development. While populism has remained a powerful political force, it has expressed itself differently in this new environment, fueling a crisis narrative and corresponding corporate governance reforms that not only fail to acknowledge the role of equity market pressures toward excessive risk-taking in financial firms, but that effectively reinforce such pressures moving forward.
I conclude that potential corporate governance reforms most worthy of consideration include those aimed at accomplishing precisely the opposite, which may require resurrecting corporate architectural strategies embraced in the past to reduce risk-taking in financial firms. As a threshold matter, however, we must first grapple effectively with a more fundamental and pressing social and political problem - the popular misconception that financial firms exist merely to maximize stock price for the short-term benefit of their shareholders.
I don't agree with all of his arguments or conclusions, but he raises a lot of important issues. I would limit the discussion to systemically important financial institutions. My preferred solution would be to solve the "too big to fail" problem by capping the size of large financial institutions at a level at which their failure would not jepoardize the entire financial system and thereby solve the moral hazard problem created by the implicit taxpayer guarantee currently enjoyed by TBTF institutions.
If that proves politically or economically infeasible, however, I'm prepared to consider corporate governance reforms at such banks--perhaps including creating a fiduciary duty for managers of TBTF institutions running to taxpayers--as a second best solution.
One-size-fits-all corporate governance doesn’t work because small public companies have a fraction of the resources of their larger counterparts. Limitations include smaller, less-diverse boards of directors, less-experienced management teams, and business-ending risks that crop up daily.