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Is This What Is Meant By 'Investor Protection'?

The early years of this century were not kind to investors. In 2000-2001, the stock market recorded back-to-back years of losses for the first time since 1973-74. When the market suffered a third consecutive losing year in 2002, it did so for the first time since the Great Depression. On top of the late 90s bubble bursting, came a string of bad news that further eroded investor confidence: Repeated accounting scandals, of which Enron and WorldCom are merely the most notorious. A high profile investigation by New York's attorney general calling into question the integrity of stock market analysts. And so on.

In response, Congress cobbled together the "Public Company Accounting Reform and Investor Protection Act" of 2002 -- popularly known as the Sarbanes-Oxley Act (SOX for short). As he signed it into law, President Bush praised SOX for making "the most far-reaching reforms of American business practices since the time of Franklin Delano Roosevelt." Others have been less kind; Yale law professor Roberta Romano, for example, memorably called SOX "quack corporate governance."

Congress hoped SOX would restore investor confidence by curbing various corporate governance excesses, encouraging director independence from management, and especially by toughening up accounting standards so as to enhance capital market transparency and the integrity of disclosures. Whether any of these benefits have been achieved is debatable and, if so, any such benefits have proven almost impossible to quantify.

What is clear after four years experience with the Act is that the costs have been far higher than anyone expected. Worse yet, as I've documented in prior TCS columns, such as SOXing It to Small Businesses, those costs have been born disproportionately by small publicly held corporations.

In response to growing concern with the deleterious impact SOX appeared to be having on smaller firms, the Securities and Exchange Commission (SEC) set up an Advisory Committee to assess the affect SOX and other securities laws have on small public corporations. The Committee released its final report on April 23, 2006. In its report, the Committee concluded that the costs imposed on smaller public corporations by a number of key SOX provisions significantly exceeded any benefit those provisions provide investors.

In particular, the Committee focused on SOX § 404, which requires inclusion of internal control disclosures in each public corporation's annual report. This disclosure statement must include: (1) a written confirmation by which firm management acknowledges its responsibility for establishing and maintaining a system of internal controls and procedures for financial reporting; (2) an assessment, as of the end of the most recent fiscal year, of the effectiveness of the firm's internal controls; and (3) a written attestation by the firm's outside auditor confirming the adequacy and accuracy of those controls and procedures. The Committee explained that:

From the earliest stages of its implementation, Sarbanes-Oxley Act Section 404 has posed special challenges for smaller public companies. To some extent, the problems smaller companies have in complying with Section 404 are the problems of companies generally:

• lack of clear guidance;
• an unfamiliar regulatory environment;
• an unfriendly legal and enforcement atmosphere that diminishes the use and acceptance of professional judgment because of fears of second-guessing by regulators and the plaintiffs bar;
• a focus on detailed control activities by auditors; and
• the lack of sufficient resources and competencies in an area in which companies and auditors have previously placed less emphasis.

But because of their different operating structures, smaller public companies have felt the effects of Section 404 in a manner different from their larger counterparts. With more limited resources, fewer internal personnel and less revenue with which to offset both implementation costs and the disproportionate fixed costs of Section 404 compliance, these companies have been disproportionately subject to the burdens associated with Section 404 compliance.

Accordingly, the Committee gave highest priority to a set of recommendations that would create a system of "scaled" securities regulation under which the smallest public corporations would be subject to less extensive disclosure and auditing requirements. In particular, the Committee recommended that the SEC exempt the smallest public corporations from SOX § 404, so long as they have a qualified audit committee and have adopted a qualifying code of ethics for disclosure and audit practices.

On May 17, the SEC responded by -- to be blunt -- tossing the Advisory Committee report in the circular file. Instead of even considering the Committee's detailed recommendations, which had gone well beyond the narrow problems created by § 404, the SEC announced a modest set of regulatory actions limited solely to § 404 issues. Even within those narrow confines, moreover, the SEC's plans can only be described as lame:

• "The Commission expects to issue a Concept Release covering a variety of issues that might be the subject of Commission guidance for management. With the Concept Release, the Commission will solicit views on the management assessment process to ensure that the guidance the Commission ultimately proposes addresses the needs and concerns of all public companies. ... The Commission anticipates that this forthcoming guidance will help organizations of all sizes to better understand and apply the control framework as it relates to internal control over financial reporting. ... To ensure that this guidance is of help to non-accelerated filers and smaller public companies, the Commission intends that this future guidance will be scalable and responsive to their individual circumstances. ... The form of the guidance has yet to be determined." (Emphasis added.)
• Subject to SEC oversight, the Public Corporation Accounting Oversight Board (PCAOB) will amend its auditing standards so as to reduce costs to companies by focusing auditor attention on "areas that pose higher risk of fraud or material error."
• Small public corporations will get an extension on the date by which they are required to be fully compliant with § 404. "It is anticipated that any such postponement would nonetheless require all filers to comply with the management assessment required by Section 404(a) of Sarbanes-Oxley for fiscal years beginning on or after Dec. 16, 2006."

In sum, a couple of extra months before full compliance is required, a tweak to auditing standards that might reduce costs in one area, and unknown guidance to be provided in an unknown form.

Unlike the recommendations made by its own Advisory Committee, which would have provided significant and comprehensive regulatory relief for smaller public corporations, the SEC has taken a narrow and trivial approach to the problem. It's like using a band-aid to fix a gaping puncture wound.

Our capital market's bleeding thus is unlikely to be staunched by the SEC's action. Since SOX became law, our economy and capital markets have suffered from higher compliance costs in several ways:

• The number of companies going private (so-called "going dark") has increased dramatically, with many firms citing SOX compliance costs as a principal reason for choosing to do so
• A growing number of firms choosing to rely on retained earnings or private equity rather than raising money by going public via an IPO
• Pre-SOX, 9 out of the ten largest IPOs had a US component; in the last year, 9 out of the 10 largest were entirely foreign
• Fewer acquisitions and ADR offerings by foreign issuers

The bottom line? SOX is costing our economy the proverbial bundle and the SEC's response is little more than whistling past the graveyard.

Is This What Is Meant By 'Investor Protection'?

The early years of this century were not kind to investors. In 2000-2001, the stock market recorded back-to-back years of losses for the first time since 1973-74. When the market suffered a third consecutive losing year in 2002, it did so for the first time since the Great Depression. On top of the late 90s bubble bursting, came a string of bad news that further eroded investor confidence: Repeated accounting scandals, of which Enron and WorldCom are merely the most notorious. A high profile investigation by New York's attorney general calling into question the integrity of stock market analysts. And so on.

In response, Congress cobbled together the "Public Company Accounting Reform and Investor Protection Act" of 2002 -- popularly known as the Sarbanes-Oxley Act (SOX for short). As he signed it into law, President Bush praised SOX for making "the most far-reaching reforms of American business practices since the time of Franklin Delano Roosevelt." Others have been less kind; Yale law professor Roberta Romano, for example, memorably called SOX "quack corporate governance."

Congress hoped SOX would restore investor confidence by curbing various corporate governance excesses, encouraging director independence from management, and especially by toughening up accounting standards so as to enhance capital market transparency and the integrity of disclosures. Whether any of these benefits have been achieved is debatable and, if so, any such benefits have proven almost impossible to quantify.

What is clear after four years experience with the Act is that the costs have been far higher than anyone expected. Worse yet, as I've documented in prior TCS columns, such as SOXing It to Small Businesses, those costs have been born disproportionately by small publicly held corporations.

In response to growing concern with the deleterious impact SOX appeared to be having on smaller firms, the Securities and Exchange Commission (SEC) set up an Advisory Committee to assess the affect SOX and other securities laws have on small public corporations. The Committee released its final report on April 23, 2006. In its report, the Committee concluded that the costs imposed on smaller public corporations by a number of key SOX provisions significantly exceeded any benefit those provisions provide investors.

In particular, the Committee focused on SOX § 404, which requires inclusion of internal control disclosures in each public corporation's annual report. This disclosure statement must include: (1) a written confirmation by which firm management acknowledges its responsibility for establishing and maintaining a system of internal controls and procedures for financial reporting; (2) an assessment, as of the end of the most recent fiscal year, of the effectiveness of the firm's internal controls; and (3) a written attestation by the firm's outside auditor confirming the adequacy and accuracy of those controls and procedures. The Committee explained that:

From the earliest stages of its implementation, Sarbanes-Oxley Act Section 404 has posed special challenges for smaller public companies. To some extent, the problems smaller companies have in complying with Section 404 are the problems of companies generally:

• lack of clear guidance;
• an unfamiliar regulatory environment;
• an unfriendly legal and enforcement atmosphere that diminishes the use and acceptance of professional judgment because of fears of second-guessing by regulators and the plaintiffs bar;
• a focus on detailed control activities by auditors; and
• the lack of sufficient resources and competencies in an area in which companies and auditors have previously placed less emphasis.

But because of their different operating structures, smaller public companies have felt the effects of Section 404 in a manner different from their larger counterparts. With more limited resources, fewer internal personnel and less revenue with which to offset both implementation costs and the disproportionate fixed costs of Section 404 compliance, these companies have been disproportionately subject to the burdens associated with Section 404 compliance.

Accordingly, the Committee gave highest priority to a set of recommendations that would create a system of "scaled" securities regulation under which the smallest public corporations would be subject to less extensive disclosure and auditing requirements. In particular, the Committee recommended that the SEC exempt the smallest public corporations from SOX § 404, so long as they have a qualified audit committee and have adopted a qualifying code of ethics for disclosure and audit practices.

On May 17, the SEC responded by -- to be blunt -- tossing the Advisory Committee report in the circular file. Instead of even considering the Committee's detailed recommendations, which had gone well beyond the narrow problems created by § 404, the SEC announced a modest set of regulatory actions limited solely to § 404 issues. Even within those narrow confines, moreover, the SEC's plans can only be described as lame:

• "The Commission expects to issue a Concept Release covering a variety of issues that might be the subject of Commission guidance for management. With the Concept Release, the Commission will solicit views on the management assessment process to ensure that the guidance the Commission ultimately proposes addresses the needs and concerns of all public companies. ... The Commission anticipates that this forthcoming guidance will help organizations of all sizes to better understand and apply the control framework as it relates to internal control over financial reporting. ... To ensure that this guidance is of help to non-accelerated filers and smaller public companies, the Commission intends that this future guidance will be scalable and responsive to their individual circumstances. ... The form of the guidance has yet to be determined." (Emphasis added.)
• Subject to SEC oversight, the Public Corporation Accounting Oversight Board (PCAOB) will amend its auditing standards so as to reduce costs to companies by focusing auditor attention on "areas that pose higher risk of fraud or material error."
• Small public corporations will get an extension on the date by which they are required to be fully compliant with § 404. "It is anticipated that any such postponement would nonetheless require all filers to comply with the management assessment required by Section 404(a) of Sarbanes-Oxley for fiscal years beginning on or after Dec. 16, 2006."

In sum, a couple of extra months before full compliance is required, a tweak to auditing standards that might reduce costs in one area, and unknown guidance to be provided in an unknown form.

Unlike the recommendations made by its own Advisory Committee, which would have provided significant and comprehensive regulatory relief for smaller public corporations, the SEC has taken a narrow and trivial approach to the problem. It's like using a band-aid to fix a gaping puncture wound.

Our capital market's bleeding thus is unlikely to be staunched by the SEC's action. Since SOX became law, our economy and capital markets have suffered from higher compliance costs in several ways:

• The number of companies going private (so-called "going dark") has increased dramatically, with many firms citing SOX compliance costs as a principal reason for choosing to do so
• A growing number of firms choosing to rely on retained earnings or private equity rather than raising money by going public via an IPO
• Pre-SOX, 9 out of the ten largest IPOs had a US component; in the last year, 9 out of the 10 largest were entirely foreign
• Fewer acquisitions and ADR offerings by foreign issuers

The bottom line? SOX is costing our economy the proverbial bundle and the SEC's response is little more than whistling past the graveyard.

The SEC's Response to SOX Costs

My latest TCS column addresses the SEC's woefully inadequate action on controlling Sarbanes- Oxley compliance costs:

Unlike the recommendations made by its own Advisory Committee, which would have provided significant and comprehensive regulatory relief for smaller public corporations, the SEC has taken a narrow and trivial approach to the problem. It's like using a band-aid to fix a gaping puncture wound.

Benedict on the Holocaust

The press reports that after visiting Auschwitz Pope Benedict said:

"In a place like this, words fail; in the end, there can be only a dread silence, a silence which itself is a heartfelt cry to God: Why, Lord, did you remain silent? How could you tolerate all this?"

A perfectly valid question, of course, especially for a WWII veteran of the German army. As Pope John Paul II wrote of the problem of evil in Salvifici Doloris:

Man can put this question to God with all the emotion of his heart and with his mind full of dismay and anxiety; and God expects the question and listens to it ....

Even so, however, I would love to see a full transcript of Benedict's remarks, because his reported remarks bump up against a warning issued by JPII:

Why does evil exist? Why is there evil in the world? When we put the question in this way, we are always, at least to a certain extent, asking a question about suffering too.

Both questions are difficult, when an individual puts them to another individual, when people put them to other people, as also when man puts them to God. For man does not put this question to the world, even though it is from the world that suffering often comes to him, but he puts it to God as the Creator and Lord of the world. And it is well known that concerning this question there not only arise many frustrations and conflicts in the relations of man with God, but it also happens that people reach the point of actually denying God.

In Benedict's case, posing the question without also offering a reference to the answers worked out by Christian and Jewish scholars of theodicy opened the door to the press dragging up (1) Benedict's service in the German army and, worse yet, (2) the persistent canards about Pope Pius XII (refuted here and here, among others). Benedict cannot count on the rock star treatment the press gave JPII; Benedict can count on the press misreporting him, whether from malice or mere misunderstanding.

A commentator provided a link to http://www.vatican.va/holy_father/benedict_xvi/speeches/2006/may/documents/hf_ben-xvi_spe_20060528_auschwitz-birkenau_en.html, which reports that Benedict did address the question:

"We cannot peer into God’s mysterious plan - we see only piecemeal, and we would be wrong to set ourselves up as judges of God and history. Then we would not be defending man, but only contributing to his downfall. No - when all is said and done, we must continue to cry out humbly yet insistently to God: Rouse yourself! Do not forget mankind, your creature! And our cry to God must also be a cry that pierces our very heart, a cry that awakens within us God’s hidden presence - so that his power, the power he has planted in our hearts, will not be buried or choked within us by the mire of selfishness, pusillanimity, indifference or opportunism. Let us cry out to God, with all our hearts, at the present hour, when new misfortunes befall us, when all the forces of darkness seem to issue anew from human hearts: whether it is the abuse of God’s name as a means of justifying senseless violence against innocent persons, or the cynicism which refuses to acknowledge God and ridicules faith in him. Let us cry out to God, that he may draw men and women to conversion and help them to see that violence does not bring peace, but only generates more violence - a morass of devastation in which everyone is ultimately the loser. The God in whom we believe is a God of reason - a reason, to be sure, which is not a kind of cold mathematics of the universe, but is one with love and with goodness. We make our prayer to God and we appeal to humanity, that this reason, the logic of love and the recognition of the power of reconciliation and peace, may prevail over the threats arising from irrationalism or from a spurious and godless reason."

Cafferty and Serwer on Enron

Query: Is there a more anti-business/anti-capitalism "business news" program than Jack Cafferty's "In the Money" on CNN? As evidence for a "no" answer, I put forward Cafferty's co mments on the Enron verdicts:

So it took the government a while but they got 'em. We're talking Skilling and Lay, those two worms that were at the top of the Enron debacle. I suppose some vindication in order for the people who lost their jobs, their pensions, their hope for the future and everything else, because of the malfeasance of these two clowns.

But the thing that bothers me is they walked out of that courtroom on Thursday, they're free men pending appeal, pending sentencing, pending, pending, pending. I mean, why didn't they put them in those funny looking little orange jump suits, slap some chains on them, and throw them in Leavenworth and say, you know, if you win this on appeal, we'll let you out.

I have no wish to defend Lay and Skilling, but at this point Lay and Skilling have only been allowed to remain out on bail pending sentence. Besides making a factual misstatement about the court's ruling, Cafferty also grossly misrepresents the rules governing bail pending sentence or appeal. Under the federal bail reform act, a trial court is not supposed to allow a convicted defendant to remain out on bail pending sentence or appeal unless the court makes a specific finding that he is not likely to flee or to pose a danger if released, that the appeal is not for the purposes of delay, and that the appeal has substantial merit. Hardly, a case of "pending, pending, pending."

Then there's this comment from co-host Andy Serwer:

Yes, at some point, I guess, they are going to do some hard time, Jack. And they are probably going to do the rest of their lives in jail. I don't think it's very surprising, though, the verdicts. And you know, to me, it's not that complicated. These guys were in charge of this organization that just went belly up. They're responsible and that's what the jury found out.

Note the naive assumption that we ought to criminalize agency costs. Just "if the boat sinks on your watch, you go to jail." For a more nuanced view, check out my article Are We Criminalizing Agency Costs? Should You Care? In short, executives who commit fraud ought to go to jail, but sending executives to jail just because they were "in charge of this organization that just went belly up" is just plain dumb:

The problem is that business decisions rarely involve black-and-white issues; instead, they typically involve prudential judgments among a number of plausible alternatives. Given the vagaries of business, moreover, even carefully made choices among such alternatives may turn out badly.

If prosecutors, judges, and juries are unable to distinguish between competent risk taking and criminal mismanagement, however, the threat of criminal sanctions may discourage managers from taking risks.

Yet, risk-taking is precisely what shareholders want managers to do. As the corporation's residual claimants, shareholders don't get paid until all other claims on the corporation are satisfied. Because risk and return are positively correlated, the high returns on corporate investment necessary to leave something for the shareholders require high risks.

The problem of criminalizing agency costs should now be apparent. Obviously, shareholders want managers who steal from the company or defraud investors to be punished. Yet, they also want managers to take risks. If prosecutors and juries can't tell the difference between the two, however, criminal sanctions may leave shareholders worse off by making managers more risk averse.

The problem with Cafferty and Serwer isn't just that they're anti-business; it's that they're either too dumb or too lazy to try understanding how business and the law work.

Pine Ridge Oakville Cabernet Sauvignon (Napa Valley) 2003

A very fine young California Cabernet Sauvignon. Lots of berry and black cherry flavors, plus a dash of oriental spice and anise. Firm tannins and acids suggest good aging potential, but it works well now with rich or spicy foods. Grade: B++

Martha to Contest IT Charge

According to AP:

Martha Stewart, who completed a five-month prison sentence a year ago for lying about her sale of ImClone stock, has decided to fight rather than settle civil insider trading charges brought by the U.S. Securities and Exchange Commission. In an 11-page response to the SEC complaint filed late Thursday with the U.S. District Court for the Southern District of New York, Stewart denied allegations that she used nonpublic information when she sold 3,928 shares of ImClone Systems Inc. stock in December 2001. Instead, she said she "acted in good faith."

I've long thought the SEC's insider trading argument was a bit of a stretch, but I'm not sure I would have advised Martha to fight these charges. If she goes to trial, the SEC is likely to seek the maximum fine, which is disgorgement of her profits plus a fine equal to three times her profits. Plus, the SEC may seek to bar her from service as a director or officer of a public corporation. (Although I don't think the Sarbanes-Oxley provisions making it easier for the SEC to do so can apply retroactively to Martha's case.)

Interviewed re Skilling and Lay

From TWN's press release:

TransWorldNews announces release of audio interview with Stephen Bainbridge, professor of securities law at UCLA. The audio interview, conducted on May 25th, 2006 by TransWorldNews, has been uploaded for listeners.

The seventeen minute interview with Bainbridge offers insight into today?s verdict convicting top Enron executives Kenneth Lay and Jeffrey Skilling of conspiracy to commit securities and wire fraud. Bainbridge further discusseD the involvement of Andrew Fastow, Chief Financial Officer of Enron, who pleaded guilty to conspiracy charges in January 2004. ...

To hear this audio interview go here.

Skilling's Insider Trading Charge: "On the Basis of" versus "Possession of"

Gordon Smith joins Larry Ribstein and James Joyner in wondering why Jeffrey Skilling was convicted on all the fraud and conspiracy but acquitted on all but one of the insider trading counts:

So the question remains: how could he have been engaged in fraud during 2000, but not been engaged in insider trading?

As I explain in my book Insider Trading, there is a long standing debate as to whether a defendant can be convicted for trading while merely in the possession of material nonpublic information or whether the defendant must have traded on the basis of such information. In this case, the jury instructions specifically required the jury to find beyond a reasonable doubt that Skilling traded not just while possessing but also on the basis of material nonpublic information. The jury instructions further explained that this meant that the government had to prove beyond a reasonable doubt that Skilling "used the material, nonpublic information in making his decision to sell Enron stock." My guess thus is that Skilling had a sufficiently plausible explanation for most of the trades (excepting the last trade, as to which there apparently was some sort of smoking gun), such as plan of regular trading or some personal reason for selling when he did.

In fact, according to the jury instructions, as to the set of trades challenged in Count 50 of the indictment, Skilling claimed he had a plan for regularly selling securities, which the court described as constituting a potential "complete defense" for the trades in question. In any case, because of the distinction between trading on the basis of material nonpublic information and trading while in possession of such information, there is no necessary inconsistency between the verdicts.

The SEC long has argued that trading while in knowing possession of material nonpublic information satisfies Rule 10b-5’s scienter requirement. In United States v. Teicher, the Second Circuit agreed, albeit in a passage that appears to be dictum. An attorney tipped stock market speculators about transactions involving clients of his firm. On appeal, defendants objected to a jury instruction pursuant to which they could be found guilty of securities fraud based upon the mere possession of fraudulently obtained material nonpublic information without regard to whether that information was the actual cause of their transactions. The Second Circuit held that any error in the instruction was harmless, but went on to opine in favor of a knowing possession test. The court interpreted Chiarella as comporting with “the oft-quoted maxim that one with a fiduciary or similar duty to hold material nonpublic information in confidence must either ‘disclose or abstain’ with regard to trading.” The court also favored the possession standard because it “recognizes that one who trades while knowingly possessing material inside information has an informational advantage over other traders.”

The difficulties with the court’s reasoning should be apparent. In the first place, a mere possession test is inconsistent with Rule 10b-5’s scienter requirement, which requires fraudulent intent (or, at least, recklessness). In the second, contrary to the court’s view, Chiarella simply did not address the distinction between a knowing possession and a use standard. Finally, the court’s reliance on the trader’s informational advantage is inconsistent with Chiarella’s rejection of the equal access test.

In SEC v. Adler, the Eleventh Circuit rejected Teicher 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 choice between Adler and Teicher is difficult. On the one hand, in adopting the Insider Trading Sanctions Act of 1984, Congress imposed treble money civil fines on those who illegally trade “while in possession” of material nonpublic information. In addition, a use standard significantly complicates the government’s burden in insider trading cases, because motivation is always harder to establish than possession, although the inference of use permitted by Adler substantially alleviates this concern.

On the other hand, a number of decisions have acknowledged that a pre-existing plan and/or prior trading pattern can be introduced as an affirmative defense in insider trading cases, as such evidence tends to disprove that defendant acted with the requisite scienter. Dictum in each of the Supreme Court’s insider trading opinions also appears to endorse the use standard. In light of the Circuit split that now exists between Teicher and Adler, the Supreme Court may eventually have to resolve the conflict.

In 2000, the SEC addressed 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, Rule 10b5-1 formally rejects the Adler position. In practice, however, the difference between Adler and Rule 10b5-1 may prove insignificant. On the one hand, Adler created a presumption of use when the insider was aware of material nonpublic information. Conversely, Rule 10b5-1 provides affirmative defenses for insiders who trade pursuant to a pre-existing plan, contract, or instructions. As a result, the two approaches should lead to comparable outcomes in most cases.

Rule 10b5-1 may not have applied to all the trades in which Skilling allegedly committed insider trading. Alternatively, the trial court may have been persuaded that SEC Rule 10b5-1 should not apply to criminal cases. Indeed, at least in the Ninth Circuit, not only is proof use, not mere possession, 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).

The Skilling trial court's pre-trial opinion denying Skilling's motion to dismiss the insider trading charges cited and discussed all the foregoing authorities, but did not attempt to resolve the discrepancies between them. Instead, the court simply held that it was "not persuaded that ¶ 120 fails to allege that he used material, nonpublic information when making the charged trades." At the very least, of course, this language does appear to adopt the use standard.

Lay and Skilling Convicted: Ongoing Reaction

From CNN:

Skilling was found guilty on 19 counts of conspiracy, fraud, false statements and insider trading. He was found not guilty on eight counts of insider trading.

Lay was found guilty on all six counts of conspiracy and fraud.

Quick Many thoughts, updated periodically and in no particular order:

• Another victory for prediction markets: As I wrote back in April: "The latest contract at Tradesports for Lay to be convicted on at least 4 counts was 65.5 and for Skilling to be convicted on a whopping 16 or more counts was 66. In other words, roughly 1-2 odds in favor of conviction."
• The acquittal of Skilling on some of the insider trading counts suggests the jury approached the issues with an open mind, contrary to defense claims that they could not get a fair trial in Houston.
• It's not the crime, it's the cover up. The real crimes at Enron mainly consisted of turncoat government witness Andrew Fastow's shady deals, but Skilling and, especially, Lay are going down for improperly misrepresenting Enron's fortunes.
• Mega-coverage by the Houston Chronicle's multiple blogs. The Chron's Enron blogs have been a breakthrough in showing how the MSM can make highly effective use of the new media when it wants to.
• Lay will not be required to wear one of those electronic positioning ankle bracelets, but will not be allowed to leave the courthouse until he surrenders his passport. Query: Does surrendering your passport really make it all that hard for a wealthy guy to leave the country? Do you have to clear customs/immigration before taking a private plane flight out of the country? How about by yacht? I assume that the real problem is that a person without a passport would find it difficult to live abroad. But Andrew Luster managed to skip bail despite having surrendered his passport and being required to wear an ankle bracelet. Not that I think Lay or Skilling will skip. Just curious. [No illegal immigrant comments, please!]
• One of the curious things about this case is the documented evidence that "a number of people were contradicting Enron's own rosy view of itself long before the middle of 2001." At what point does a lie by top management cease to matter if the market doesn't believe it? Presumably the government convinced the jury that people believed the lies Skilling and Lay told, but did the market really do so?
• The Powers Report is still your "go to" document for background on the Enron mess. Here's what the Report says about Skilling with respect to one of the many related party transactions the company used to disguise expenses and losses: "As the magnitude and significance of the related party transactions to Enron increased over time, it is difficult to understand why Skilling did not ensure that those controls were rigorously adhered to and enforced. Based upon his own description of events, Skilling does not appear to have given much attention to these duties. Skilling certainly knew or should have known of the magnitude and the risks associated with these transactions. Skilling, who prides himself on the controls he put in place in many areas at Enron, bears substantial responsibility for the failure of the system of internal controls to mitigate the risk inherent in the relationship between Enron and the LJM partnerships."
• Blogger/law prof Christine Hurt observes that the verdict came "as a surprise after journalists assumed that the jury would not come to a decision until after the holiday weekend." Maybe the jury wanted to enjoy the holiday? Or start wearing white shoes?
• Blogger/law prof Larry Ribstein asks an interesting question about the acquittal of Skilling on most of the insider trading counts: "Does this mean that the jury thought he didn't know enough about what was happening to bar him from trading, but that he did know enough to go to jail for fraud?"
• After the jury verdict was announced, the judge found Lay guilty on bank fraud charges that had been tried to the bench.
• Will losing the Skilling case seriously harm star trial lawyer Daniel Petrocelli's reputation? (You'll recall that Petrocelli famously won the wrongful death suit against OJ Simpson, as documented in his book Triumph of Justice). The WSJ has free video of Petrocelli's reaction to the jury verdict.
  • According to news reports before the verdict: "Daniel Petrocelli and his law firm probably won't get fully compensated for their work defending Jeffrey Skilling, as the former Enron Corp. chief executive appears to have exhausted his defense fund. But the payoff down the road could be well worth it, even if Skilling is convicted. The decision to defend Skilling is seen as a calculated business move by Petrocelli and his Century City law firm, O'Melveny & Myers, to burnish their reputation and expertise in white-collar criminal defense."
  • It's the "even if Skilling is convicted part" about which I have questions.
• Peter Lattman's identified two critical points that I suspect will quickly become (and correctly so) part of the conventional wisdom (or received learning, if you prefer):
  • "Credit the prosecutors for emphasizing narratives the jury could understand rather than focusing on complex tales of off-balance sheet partnerships and byzantine accounting." (Link)
  • " Lay’s testimony proved fatal. Everyone expected a charming, avuncular presence on the witness stand; instead, what they got was an argumentative, challenging, embittered man who refused to accept any personal responsibility for Enron’s collapse." (Link)
• Over at Air America's blog, the first comment in a thread on the verdict is a message for Ken Lay: "While spending your final years in a Federal prison, as you are anally-probed by the huge throbbing member of your cellmate, I hope you think about your Enron traders laughing at the way they screwed the little ol' ladies in California out of their money."
  • It's not just the fringe, either. You'll recall that California Democratic attorney general attorney general Bill Lockyer said: "I would love to personally escort Lay to an 8-by-10 cell that he could share with a tattooed dude who says, 'Hi, my name is Spike, honey.'"
  • So is prison rape now part of the left's penal philosophy? [Update: Yes, pun intended.]
  • Apropos of which, see my TCS column Crime? And Punishment, which asked  "Should Dennis Kozlowski spend the rest of his life worrying about prison rape?" More seriously, the column argues against criminalization as a solution to the agency cost problem in corporations.
• Conservative (?) pundit's Tammy Bruce's reaction is more Old Testament than old school: "Let's hope some is left for the victims, while the Lay and Skilling families can reap what their men have sown on others - poverty and fear of the future." Cf. Deuteronomy 5:9-10 ("I, the LORD your God, am a jealous God, visiting the iniquity of the fathers on the children, and on the third and the fourth generations of those who hate Me, but showing lovingkindness to ... those who love Me and keep My commandments.")
  • To be sure, according to some scholars, the Old Testament passages in question suggest God will punish the children only if the children themselves are morally blameworthy. But Ms Bruce apparently doesn't think moral blameworthiness is necessary when it comes to the families of white collar criminals.
• James Joyner is not surprised: "Jurors are composed of ordinary people who hold corporate titans in very low esteem. Unlike pop culture figures like singers and athletes, who tend to get a break from jurors awed by their celebrity, people hate CEOs."

SOX: Looking under the surface

At TCS, Alex Pollock gets it exactly right:

Debates about the Sarbanes-Oxley Act continue, but one thing is clear: its implementation has created unintended consequences. As every Member of Congress knows from many constituents, it has caused a tremendously expensive amount of paperwork and bureaucracy. And the smaller the company, the greater the proportional burden that has been imposed.

Curiously, however, in today's W$J, James Quigley blithely opines that:

A Small Business Advisory Committee to the SEC recommended earlier this year that a majority of all public companies be exempted from at least a portion of these requirements, acting on a concern that the cost fell disproportionately on smaller issuers. Members of Congress have also proposed legislation with similar exemptions. The SEC has opted against such exemptions, instead announcing a plan to substantially expand guidance to issuers, and make other changes aimed at scaling implementation of these requirements for smaller issuers. Concurrently, the PCAOB announced a decision to revise a related audit standard.

... I believe that the SEC and PCAOB acted wisely, shifting the debate to a discussion of how to make the law work effectively for all companies and their investors. I believe that costs, which have steadily declined in the past two years, can be reduced further through SEC- and PCAOB-proposed measures.

How can Quigley take such a Panglossian view of the SEC's decision to throw the report of its own advisory committee into the circular file? Easy, he's the CEO of Deloitte & Touche USA LLP, one of the remaining big 4 accounting firms. SOX has been very good to accounting ... very good, indeed, as Pollock explains:

Sarbanes-Oxley implementation caused separate engagements and caused fees charged by accounting firms to soar dramatically. It thus caused a profit bonanza for the partners of accounting firms at the expense of corporate shareholders, who have absolutely no say in the matter.

At the same time as the public accounting firms have received this unintended, windfall enrichment, they have also become excessively risk-averse and reluctant to give professional advice to their clients on the application of America's complicated rules-based accounting standards.

So forgive me if I'm unwilling to take Mr. Quigley very seriously. Instead, I agree with Larry Ribstein:

Let?s face it: SOX, and the compliance industry, are a gigantic leech on the back of American industry. Quigley may be right that if we?re only patient we?ll get used to this leech as we have to all the others, including the 1933 Act. Industry grows around the leeches and adapts like the body of the hapless character in the Kafka story. But that doesn?t mean that we wouldn?t be better off if our blood was being put to more productive uses.

Viewpoint Diversity in the Legal Academy

A brilliant one-liner:

"As the Anglican church was once described as the Tory Party at prayer, the legal academy today is best seen as the Democratic Party at the lectern."

So writes Northwestern law professor John McGinnis in an article on his study of law professors' political campaign contributions. The results of McGinnis' survey of professors at America's top-22 law schools show that 80 percent of professors who donate to political campaigns give predominantly or exclusively to Democratic candidates.

There's no doubt that, as McGinnis puts it, "mainstream conservative ideas are no better represented than those on the leftist fringe," but why is that the case? Simple bias or is something else going on?

That question was a widely discussed on on this blog back in its early days. I summarized a bunch of blog posts (and feedback from comments) in my TCS column Network Effects: Liberals and Conservatives in the Academy, which rejected conventional arguments about liberals being smarter or more altruistic, and argued that:

Actual bias is a problem, but probably isn't as much a one as conservatives outside the academy would like to believe. As Volokh Conspiracy blogger Juan Non-Volokh observed: My experience in the academy ... confirms [that most] of the hostility faced by conservatives (and libertarians) is not explicit, and often not conscious or deliberate. Mine too, although there have been a fair number of questionable moments.

The real culprit is the law school hiring process. Each fall the Association of American Law Schools collects resumes from prospective law teaching candidates, which are then transmitted to the appointments committee of each law school. The members of that committee then face the unenviable task of winnowing down well over a 1000 applications to a list of 25 or so candidates with whom the committee will meet at the so-called "meat market" convention. After which, the committee must further winnow those 25 or so down to a smaller number, 3-5, who are invited out to the law school for on campus interviews.

As a result, the hiring process is almost entirely negative. You spend the vast majority of your time winnowing the application pile -- i.e., finding reasons not to hire someone. If you have on-site interviews of 0.3% of the applicant pool, any opposition by any committee member is enough to exclude someone. At the early stages of the process, they barely need to posit a reason.

In my experience, it thus is a lot harder to get somebody hired than it is to block them from being hired. The process isn't as explicit as the blackballing scene in Animal House, but the law school hiring process is just as weighted against hiring. (And I mean hiring anybody, regardless of political affiliation.) Any opposition (for whatever reason) therefore is usually enough, absent a very strongly committed pro-hiring faction.

In most cases, a candidates best chance of surviving the winnowing process is for someone on the committee to become the candidates champion. The champion will pull the candidates resume out of the slush pile and make sure it gets flagged for close review. Because most law schools lack a critical mass of libertarian and conservative faculty members, however, there is nobody predisposed to pulling conservative candidates' AALS forms out of the slush pile (and a fair number of folks inclined, whether consciously or subconsciously, to bury them). Applicants with conservative lines on their resume -- an Olin fellowship, Federalist Society membership, or, heaven help you, a Scalia clerkship -- thus tend to be passed over no matter how sterling the rest of their credentials may be.

In contrast, the latest left-leaning prodigy from Harvard or Yale has a mentor at one of those schools who makes calls to his/her buddies and ideological soulmates at other law schools. The recipients of those calls then flag the prodigy's file, giving them a critical leg-up in the process. Law school hiring tends to be driven by the self-perpetuating network of left-leaning senior faculty.

It may not be deliberate bias, but there still is a disparate impact.

Olson on Milberg Weiss

Walter Olson has a great op-ed on the Milberg Weiss indictment in today's W$J, with excerpts for nonsubscribers on his blog. Although WO's no fan of MW, he points out what I regard as the one really problematic aspect of this case:

... the Justice Department, following the line laid down by the now-infamous Thompson memorandum, insisted that Milberg waive attorney-client confidentiality if it wanted a favorable plea deal. The business community is in an uproar over the Thompson rules, with the U.S. Chamber of Commerce joining with groups like the ACLU and National Association of Criminal Defense Lawyers to challenge the waiver provisions as unfairly arm-twisting defendants into yielding up their employees' rights.

By threatening to indict the firm, the government is effectively coercing the firm's leadership into waiving important protections for their employees. As the ABA exp lains:

• These government waiver policies weaken the attorney- client privilege between companies and their lawyers and undermine the companies? internal compliance programs, resulting in great harm both to companies and the investing public. Lawyers for companies and other organizations play a key role in helping these entities and their officials to comply with the law and to act in the entity?s best interests. To fulfill this role, lawyers must enjoy the trust and confidence of the managers and the board and must be provided with all relevant information necessary to properly represent the entity. By requiring routine waiver of the attorney-client and work product privileges, these government policies discourage entities from consulting with their lawyers, thereby impeding the lawyers? ability to effectively counsel compliance with the law, and discourage them from conducting internal investigations designed to quickly detect and remedy misconduct. This harms not only companies, but the investing public as well.

• These government waiver policies also unfairly harm employees by infringing on their individual rights. By fostering a system of routine waiver, these policies place the employees of a company or other organization in a very difficult position when their employers ask them to cooperate in an investigation. They can cooperate and risk that their privileged statements will be turned over to the government or they can decline to cooperate and risk their employment. It is fundamentally unfair to force employees to choose between keeping their jobs and preserving their legal rights.

Top 10 Driving Peeves

Hagerty Insurance did a survey of drivers to find out what annoys them most about the behavior of other drivers. Here's their top 10, with their somewhat too cutsey shorthand names included:

10. Drivers who leave their turn signal on for miles (Morse Coders) Now let’s be fair. Perhaps these Morse Coders are part of the SETI project, their turn signals beaming out across the galaxies in search of other life forms – or not.

9. Women applying makeup and men shaving (Driving Divas) Don’t these Driving Divas have indoor plumbing? Please, spare the rest of us and handle personal grooming habits at home.

I see this all the time in LA and it drives me nuts. I even see people brushing their teeth in the car! It's a car, not a bathroom. Get up five minutes earlier and do it at home. (And let's not get started on the nose pickers. Do you think we can't see you? Does getting behind the wheel make you invisible?)

8. Motorcyclists who race down the middle of a lane, between cars (Speed Racers) This is the kind of behavior that gives some motorcyclists a bad rap. Not surprisingly, some of these Speed Racers end up high-sided, face down on the pavement, but not before they’ve left a new contour on your favorite ride or nearly given you cardiac arrest as they speed in between vehicles.

When changing lanes, I've nearly hit a couple of motorcyclists riding between lanes in my blind spot.

7. Road Rage (Road Ragers) We’ve all experienced Road Ragers. These offenders obviously will not stop until you respond to their “need to communicate” which comes in many forms including “sign language” (flipping of the middle finger), the “shout out” (using words that no good Samaritan should say), as well as the ever-popular “Honk-a-holic” (no description needed!)

Let's just say I've done penance on this one more than once.

6. Hasty drivers who change lanes without signaling (Space Invaders) Over the years, auto manufacturers have refined the operations of that little stalk that extends from every vehicle’s steering column (turn signal duh). Space Invaders obviously haven’t caught on to this radical, cutting-edge technology yet.

LA must surely be the world's capital of non-signalling lane changers. Are your lane change plans a top secret?

5. Obnoxious drivers who speed up to keep you from changing lanes (Gap Snatchers) It’s a mystery why these Gap Snatchers, who can clearly see fellow drivers’ signals to change lanes, find it necessary to keep other drivers “in their place.”

4. Drivers who weave through traffic to gain one or two car lengths (Wacky Weavers) These Wacky Weavers employ what’s known as “cut and thrust” motoring techniques, chopping off fellow motorists, changing lanes with abandon – all in an effort to roll up to the next red light 10 seconds before you do.

An LA cop once told me that he pulls wacky weavers over every time. Why I happened to be having that conversation with a LA cop is a subject I'd rather not go into.

3. Pushy drivers who tailgate (Piggybackers) Unless you’re at Daytona racing Dale Jr. for the lead, there’s no reason to climb up another driver’s bumper. Piggybackers should leave the bump-drafting to NASCAR.

2. Slow drivers in the fast lane (Turtle Racers) It doesn’t matter to these Turtle Racers that the average traffic flow is 15-20 mph faster than they are traveling; they just “cruise” at their own pace!

1. Distracted drivers talking on cell phones (Motor Mouths) Americans love to multi-task so it comes as no surprise that drivers drifting into other lanes while dialing, downloading, texting or just good old fashioned phone chatter, makes Motor Mouths the survey’s number one pet peeve.

Annoying mainly because it's so common. On a scale of absolute annoyance, I'd rank it below 2, 4, 6, and 9.

Swordfish and Gnocchi in Tomato Sauce

Very simple, but quite tasty.

• 1 swordfish steak (about 1 pound)
• 8 Roma tomatoes, cored, seeded, and cut into large dice (peel if you want)
• 5 cloves garlic sliced thin
• 1 small bunch fresh basil, chiffonaded
• salt, white pepper, and red pepper flakes to taste
• 2 tablespoons olive oil
• 2 tablespoons extra virgin olive oil
• 1 16 oz. package pre-made gnocchi

Bring a large pot of lightly salted water to a rolling boil.

Grill the swordfish steak over medium heat 4 minutes per side. Let it rest uncovered.

While the swordfish is grilling, warm the regular olive oil and half the EVOO over medium heat in a large skillet. Add the garlic and turn down the heat to medium low. Stir regularly until the garlic is translucent but not colored. Add the tomatoes, half the basil, and the seasonings to the skillet. Add the gnocchi to the boiling water. When the gnocchi begin floating to the top of the boiling water (about 3-4 minutes), skim them out with a slotted spoon and add to the tomato sauce.

Divide the swordfish steak onto two plates. Top with the gnocchi and tomato sauce. Drizzle the remaining EVOO and sprinkle the remaining basil over the plates. Serve.

A California Chardonnay works well as a match.