ProfessorBainbridge.com

The CFPSC

Larry Cunningham has a nice run down of some of the problems raised by Obama's proposal for a Consumer Financial Products Safety Commission.

More on the Ability of Directors to Conduct Business for the Corporation

In an earlier post, prompted by a post by Dutch law professor Bastiaan F. Assink on tort liability of directors of Dutch corporations, I noted that, in US agency law:

... a director acting alone and qua director is not an agent of the corporation. See Restatement (Second) of Agency § 14C (1958) (an individual director is not an agent of the corporation or its shareholders); Arnold v. Soc'y for Sav. Bancorp, 678 A.2d 533, 539-40 (Del.1996) (“Directors, in the ordinary course of their service as directors, do not act as agents of the corporation ... A board of directors, in fulfilling its fiduciary duty, controls the corporation, not vice versa.”).

In response, Bastiaan updated his post to inform us that, among other things, under Dutch law "the board as well as individual board members have the power to act on behalf of the corporation, unless the articles of association provide otherwise." I take that observation to mean that, under Dutch law, an individual director is an actual agent of the corporation.

The US doctrine that a director, acting alone, is not an agent of the corporation follows conceptually from the notion that the board of directors, acting collectively, is the embodiment of the corporate principal. I explored the policy rationale behind that rule in my article Why a Board?, in which I noted that:

Acting alone, an individual director “has no power of his own to act on the corporation’s behalf, but only as one of a body of directors acting as a board.” Moreover, as the MBCA puts it, “directors may act only at a meeting unless otherwise expressly authorized by statute.”

Why this emphasis on collective rather than individual action? The MBCA’s drafters offer the following answer: “The underlying theory is that the consultation and exchange of views is an integral part of the functioning of the board.” Or, as Forbes and Milliken opine, “the very existence of the board as an institution is rooted in the wise belief that the effective oversight of an organization exceeds the capabilities of any individual and that collective knowledge and deliberation are better suited to this task.” These arguments run afoul of the old joke that a camel is a horse designed by a committee, but they find considerable support in the literature on individual versus group decision making.

I wonder what the origins of the seemingly contrary Dutch rule were and what policy rationale is understood as explaining that rule.

SEC Commish Paredes on Shareholder Access

Harvard's Corporate Governance blog has a transcript of a speech given by SEC Commissioner Troy Paredes on shareholder access:

As a practical matter, public company shareholders are not well-positioned to run the enterprises in which they invest. Managerial responsibility over a firm’s corporate strategy and day-to-day business and affairs instead is in the charge of directors and management. That said, shareholders retain the right to vote on fundamental corporate changes, such as a merger, a sale of all or substantially all of the corporation’s assets, and an amendment to the corporate charter or bylaws. Most notably, shareholders vote for board members. Shareholders also have the right of “exit,” as they can sell their shares if they disapprove of the company’s performance.

Precisely right. I made these same arguments, albeit in much greater detail in my article The Case for Limited Shareholder Voting Rights.

The animating question behind any discussion of shareholder rights thus presents itself: What is the proper institutional arrangement for ensuring that the company is managed in the best interests of shareholders when those who own the firm do not actively run it?

Easy. Director primacy.

Paredes goes on to explain clearly and concisely why the SEC's mandatory approach is less attractive than the enabling approach of state law. It is a must read for anyone interested in this area.

MBCA Shareholder Access Proposal

The ABA Committee on Corporate Laws, on which I serve, today announced proposed amendments to the Model Business Corporation Act re shareholder access to the corporate proxy statement for purposes of nominating directors:

The Committee on Corporate Laws of the American Bar Association Section of Business Law approved proposed amendments to the Model Business Corporation Act regarding proxy access for director nominations and reasonable reimbursement for shareholder expenses incurred in proxy contests for director elections.

The committee will publish these proposed amendments for public comment in the August edition of The Business Lawyer. Following publication, the committee will consider them for adoption.

These proposed amendments will expressly provide a vehicle for the directors or shareholders of corporations in Model Act states to establish their own procedures, through their corporation’s bylaws, to allow shareholder access to the corporation’s proxy statement to nominate directors and to allow shareholders to be reimbursed for reasonable expenses incurred in connection with proxy contests for director elections.

According to committee chair Herbert S. Wander, “the committee strongly believes that the best interests of all constituencies will be served by providing for private ordering by the board of directors and the shareholders in the nomination process.” He further noted that “these proposals demonstrate the dynamic and historical role state corporation statutes have had and are having in the positive development of corporation law in the United States."

As regular readers know, I'm no fan of shareholder access. I would much prefer the private ordering approach exemplified by the MBCA proposals to the top down, one size fits all approach the SEC is likely to take at the federal level.

Director Liability for Corporate Failure to Perform

The Defining Tension blog touches on a recent Dutch case dealing with director liability to third parties for corporate obligations:

It has long been held by the Supreme Court (see, e.g., here and here) that a director of a company commits a tort towards a company's creditor, and is therefore personally liable towards that creditor, if the director enters into an obligation on behalf of the company while he knew or reasonably should have known that the company would not - or not within a reasonable period - be able to fulfill its obligation and would not offer recourse for the damage suffered by the creditor as a result of the malperformance, unless the director is able to show that he personally did not make a sufficiently serious mistake in this respect. In other words, this framework concerns situations in which the director essentially raised a wrong impresson - in a culpable way - of the company's solvency when entering into an agreement on behalf of the company with a third party. The framework is designed to offer a third party some protection against directors who enter into obligations on behalf of the company too carelessly.

The whole business is curious from an American perspective. In the first instance, under American law, a director acting alone and qua director is not an agent of the corporation. See Restatement (Second) of Agency § 14C (1958) (an individual director is not an agent of the corporation or its shareholders); Arnold v. Soc'y for Sav. Bancorp, 678 A.2d 533, 539-40 (Del.1996) (“Directors, in the ordinary course of their service as directors, do not act as agents of the corporation ... A board of directors, in fulfilling its fiduciary duty, controls the corporation, not vice versa.”).

A director who purports to enter into an obligation on behalf of the corporation thus is not an actual agent of the corporation. As a matter of agency law, there simply is no corporate obligation.

I suppose that in some cases, there could be sufficient facts suggesting that the board of directors has cloaked a single one of its members with authority to act so as to create apparent authority. In such a case, however, the corporation would be liable to the third party (assuming all other elements of the claim are met), not the agent.

As for cases in which a director acting without either or apparent authority, "the director essentially raised a wrong impresson - in a culpable way - of the company's solvency when entering into an agreement on behalf of the company with a third party." I suppose there might be a claim for fraud, based on the director's own misconduct in making the representation:

"Under traditional agency and tort law doctrine, corporate officers and directors are generally immune from personal liability for the acts of the corporation. The exception, of course, is if the officer or director personally participates in the tortious or illegal acts of the corporation.  Under traditional principles of tort and agency law, corporate officers can be held personally liable for their own wrongful acts, regardless of whether they were acting in an official capacity or at the direction of their principal when they committed those acts."--Lynda Oswald, 44 IDEA 115 (2003)

Yet, given the well-established principle that directors acting alone cannot bind the corporation, query whether the plaintiff would be able to satisfy the reliance requirement. Also, the scienter requirement probably would pose a problem.

My sense is that in US law, these sort of tort claims are very rare. Anybody want to correct me?

Update: Israeli lawyer Itai Fiegenbaum sent along these interesting thoughts:

While the Dutch decision that you linked to might seem curious from an American perspective, I believe that international corporate law scholars (I myself am a JSD candidate in Israel) and practitioners view this decision with much less puzzlement.

I do not presume to be knowledgeable about corporate law intricacies of other jurisdictions, but potential tort liability for corporate officers has long been established in Israel. This liability is completely separate from veil piercing or liability stemming from agency law. The Israeli Supreme Court has held on numerous times that a "special relationship" existing between corporate officers and a third party may give rise to a duty of care whose breach amounts to a claim of negligence. These "special relationships" have been recognized, inter alia, in instances where a corporate officer was in charge of negotiations between the corporation and the third party which the corporation subsequently breached or when an employee suffered a work-related accident that the corporate officer "should have" prevented. I imagine that this seems peculiar to an American corporate scholar, but my uneducated guess would be that the American model (no special duty of care, liability based on agency law) is in fact the outlier.

Madoff's Middle Class Investors

Jayne Barnard reports on watching Bernie Madoff's sentencing:

The most powerful voice in the room was that of Judge Denny Chin in a closely-scripted but emotionally resonant ruling. He cited the many middle-class victims of Madoff's fraud -- a theme deftly created by the U.S. Attorney's Office. He recounted the story of a widow who had gone to Madoff's office to thank him for protecting her family's weatlh. "You're safe," Madoff assured her. Judge Chin noted the many decisions victims had made -- sometimes for decades -- based on their mistaken belief in Bernie Madoff.

Perhaps I'm lacking in the empathy President Obama famously thinks judges need, but I have a hard time working up much sympathy for Madoff's victims--middle class or elite celebrities:

• If something seems too good to be true, it probably is.

• Anybody with the common sense God gave gravel knows that you don't put all you eggs in one basket. Diversify.

• Trust but verify. Better yet, don't trust.

• Nobody beats the market over time.

These folks wanted to believe that they really had found a great and all-powerful Wall Street Wiz and that there was nobody behind the curtain. So they ignored basic precepts of investing. They got burnt. Whatever.

Pan Grilled Sea Bass with two Salads

For two: 

Green salad

• 3 slices bacon
• 4 to 6 fingerling potatoes, depending on how hungry you are
• 1 bunch frisée lettuce
• 1 handful mache leaves
• 3 green onions, chopped fine

I added about 1-½ quarts of cold water to my 2 quart All-Clad Stainless-Steel Saucier and tossed in a couple of heavy pinches of salt. I brought the water to a boil over high heat, added the fingerling potatoes, reduced the heat to a simmer and let them cook for about 20 minutes or until they were just al dente. I transferred the potatoes to an ice bath to stop them from further cooking, drained them, and set them aside.

Once the potatoes had started cooking, I heated my Calphalon One Nonstick 10-Inch Fry Pan over medium heat for about a minute and then added the bacon to the pan. Once the bacon was done, I transferred the slices to paper towels to drain. I took a tablespoon of the drippings for the salad dressing and left the remainder in the pan over very low heat to keep the fat from congealing.

After the bacon had cooked, I chopped the frisée lettuce into bite size pieces, discarding the tougher bottom ends of the stems. I transferred the leaves into a colander. I added the mache leaves and the green onions to the colander. I tossed the greens in the colander under running water and let them drain.

About 5 minutes before service, I cranked the heat under the bacon dripping pan to medium. I sliced the potatoes lengthwise. I seasoned the cut sides with salt and pepper and then transferred them to the pan, cut side down. I let them cook until the cut side was well-browned and the potatoes had heated through.

To serve, I tossed the greens, potatoes, and crumbled bacon slices together. I divided the salad into two bowls and topped with just enough of the salad dressing to wet the greens without turning everything into a sopping mess.

Salad Dressing

• ¼ cup extra virgin olive oil
• 1 tablespoon bacon drippings
• ¼ cup orange juice
• 2 tablespoons sherry vinegar
• 1 teaspoon Dijon mustard
• salt
• freshly ground black pepper

I combined the first 5 ingredients in a Pyrex Prepware 2-Cup Measuring Cup, blended them using my Cuisinart Stick Hand Blender, tasted the dressing and added salt and pepper to taste. Set it aside.

Fennel-Orange Salad

• 1 bulb fennel, rinsed and outermost layer removed
• any fennel fronds that came on the bulb, chopped fine
• 4 oranges, peeled (cutting off all the white pith) and segmented
• green parts of 3 scallions, chopped fine

I cut the bottom off the fennel bulb to create a smooth surface and then sliced it very fine using my Zyliss Mandoline. I removed the core sections, and chopped the rings into bite-sized pieces. I then mixed the chopped fennel with the other ingredients in a bowl. I added enough salad dressing to wet everything and set the mixture aside to marinate.

The Sea Bass

• 2 6-ounce filets of Chilean sea bass
• salt 
• pepper
• Pam Olive Oil Spray

I warmed my Le Creuset Square Skillet Grill over high heat for several minutes. Meanwhile, I seasoned both sides of the sea bass filets with salt and pepper, and sprayed both sides liberally with Pam. Once the grill pan was really hot, I added the sea bass and turned the heat down to medium-high (7 on my 10 point scale). I let the filets grill for 2 minutes and then turned them 90 degrees, putting them down on new spots, and let them cook 2 more minutes. Once a nice, golden crust had formed, I flipped them and cooked them 3 minutes more. I checked the filets with my Taylor Digital Instant-Read Thermometer inserted into the side of the filet about 1 inch. When it read 135°, I removed the filets from the pan, figuring residual heat would take them up to the recommended 140°mark.

Service

As noted above, I divided the green salad into two salad bowls.

I drained the fennel-orange salad in a colander to remove excess dressing and then divided it in half, mounding each half on one of my Rectangular Sushi Plates. I placed one filet on top of the salad on each plate and napped the filet with a teaspoon or so of the salad dressing. See photos (to come).

To drink, I poured a Bouchard Aîné & Fils Premier Cru Morgeot Chassagne-Montrachet 2005, which made a pleasant but not inspired match. It had enough acidity to deal with the citrus and other assertive flavors in the meal, but was a tad too oaky to develop any real synergy with the meal. When I make this meal again, which I will because both Helen and I loved it, I'll try either a classic-style Chablis or a really buttery California Chardonnay. The Bouchard didn't go enough in either direction to really work, while wines at those extremes probably would show better. An unoaked New Zealand Chardonnay or a California Viognier might also work nicely.

Corporate Waste

Larry Cunningham's got an interesting post on the relationship between corporate law's waste doctrine and contract law's doctrine of substantive unconscionability.

A question for securities lawyers in the audience

The federal mail[1] and wire fraud[2] statutes prohibit the use of the mails and of “wire, radio, or television communication,” respectively, for the purpose of executing any “scheme or artifice to defraud.” The mail and wire fraud statutes protect only tangible property rights, as opposed to intangible rights,[3] but confidential business information is deemed to be property for purposes of those statutes.[4] Accordingly, use of the mails and wire communications to trade on the basis of confidential information belonging to another constitutes the requisite scheme to defraud.[5] 

My understanding is that, although mail and wire fraud charges still are often brought against inside traders, this basis of liability became less important once the Supreme Court validated the misappropriation theory under Rule 10b-5. Because the mail and wire fraud theories are based on a misappropriation of confidential information belonging to another, the statutes were used to backstop Rule 10b-5 in misappropriation cases out of concern that courts might invalidate the misappropriation theory.

Am I right about that? Or are there still advantages for prosecutors who include mail and wire fraud charges in an insider trading indictment?

---

[1] 18 U.S.C. § 1341.

[2] 18 U.S.C. § 1343.

[3] McNally v. United States, 483 U.S. 350 (1987).

[4] Carpenter v. United States, 484 U.S. 19, 25 (1987).

[5] Carpenter, 484 U.S. 19, 27-28.

Was Steve Jobs' Health Material?

The WSJ Law Blog notes a brewing controversy over whether Apple should have been mre forthcoming to investors about Steve Jobs' health:

Back in January, erstwhile Law Blogger Dan Slater chatted with former SEC chairman Harvey Pitt over whether execs at Apple had a duty to make a more forthcoming disclosure about Steve Jobs’s medical condition. 

At the time, we knew a lot less about Jobs’s condition than we know now, what with last week’s news that Jobs recently underwent a liver transplant in Tennessee. In January, we just knew that Jobs, according to Apple, had a “more complex” medical condition than had been originally disclosed. Still, Pitt called into question the company’s conduct. And so, it seems, did the SEC, which opened an investigation into the matter.

An LA Times article out today reprises the issue — what did Apple have the duty to disclose and did the company satisfy that duty? — in light of the liver-transplant news.

The LAT article lays out the law: Companies are not required to divulge medical details about executive, but they are required to disclose “material” information, which is defined as what a reasonable investor would need to know to make an informed decision on buying or selling stock. The Pitt Q&A also tells us that once a company decides to go forth and make a disclosure, it has a duty to get that disclosure right.

The question pending, then, is whether what Apple said in January was adequate — and accurate. In making this determination, the SEC (the status of whose investigation is currently unclear) might consider these facts: that the Tennessee doctor who led the transplant team said this week that Jobs was “the sickest patient on the waiting list” at the time a donor liver became available.

Apple has maintained that the initial statement was enough to satisfy disclosure rules imposed on publicly traded companies.

There are two distinct issues here that we need to avoid getting bollixed up. First, was Jobs' health material? Under the prevailing standard, we need to ask whether there is a substantial likelihood that the reasonable investor would consider the information to be important in deciding to buy or sell Apple stock (or vote on a proxy or whatever). Assuming that Jobs' health was uncertain and the effects of treatment speculative, we would need to use the Basic v. Levinson test of whether the magnitude of the event (Jobs' death or retirement for health reasons) and the probability of it happening are high enough that the information becomes material under the foregoing standard. 

At first blush, you might say that Jobs is so important to Apple that a reasonable investor obviously would consider the information to be important. Yet, there are a number of doctrines in the materiality context that might lead to a finding of immateriality here. For example, as I explain in my Corporation Law and Economics treatise, information about director misconduct frequently is deemed immaterial:

The biographical information required of director candidates by the proxy rules includes such matters as bankruptcies, pending criminal charges and prior convictions, securities violations, and the like. To what extent must a director disclose other personal peccadilloes? Actual or potential conflicts of interest generally must be disclosed. But what about matters that go not to the loyalty and honesty of the directors, but rather to simple mismanagement?

Where plaintiff complains of noncriminal conduct allegedly constituting mismanagement, courts have been unwilling to require disclosure. In Amalgamated Clothing and Textile Workers Union, AFL-CIO v. J. P. Stevens & Co., for example, plaintiffs argued that the board of directors had either knowingly violated the labor laws or, at least, failed to prevent management from doing so. According to plaintiffs, this alleged misconduct had harmed the corporation’s reputation and exposed it to liability. The failure to disclose these purported facts in connection with the election of the directors allegedly constituted an omission of material facts. In rejecting plaintiff’s argument, the court distinguished conflicts of interest from allegedly illegal conduct intended to benefit the corporation. Only the former need be disclosed, as it would be “silly” to “require management to accuse itself of antisocial or illegal policies.”

A similar standard was set forth in Gaines v. Haughton. Defendants were directors of Lockheed Corporation, a major aerospace and defense firm, who failed to disclose in their proxy solicitation materials that Lockheed had made over $30 million in foreign corrupt payments. Paying bribes to foreign officials so that the corporation can get contracts may be immoral or even illegal, the court opined, but such allegations are not material absent charges of self-dealing. In addition, the court stressed the lack of a causal nexus between the alleged misconduct and the matter put to the shareholders for a vote. Because the shareholders were asked only to elect the board, not to approve the allegedly improper bribes, the bribes did not need to be disclosed.

As these cases suggest, there is a second issue here; namely, whether the corporation has a duty to disclose the information. The Basic case makes clear that withholding material information from investors is not illegal unless the company had an affirmative duty to disclose. Just as courts have been reluctant to deem personal information about directors material, so they have also been reluctant to deem it a subject as to which a duty of affirmative disclosure exists.

A relevant example of how these doctrines might impact the Jobs situation is provided by U.S. v. Heron, 525 F.Supp.2d 729 (E.D.Pa.,2007), rev'd on other grounds, the court rejected the Government's position that information is material simply because investors would want to know it: "Under that expansive standard, information as trivial and potentially invasive as the health of the CEO's marriage would become material since reasonable investors might “want to know” if he or she is so distracted." If the health of the CEO's marriage is immaterial as a matter of law, perhaps his health would also be immaterial.

Neither the misconduct nor the marriage cases are on all fours with the Jobs case, of course. Neither the SEC nor the courts have provided clear guidance as to when disclosure obligations trump personal privacy in this areas. Given the social--and even constitutional--emphasis on personal privacy, surely it would be “silly” to “require management to accuse itself of [being ill].” 

Short Sighted Attack on Short Selling

Over at the Harvard governance blog, Wachtell Lipton lawyers Edward D. Herlihy and Theodore A. Levine cut loose with a spirited call for regulation of short selling and offer proposals for doing so. Yet, as far as I'm concerned, the argument is loser from the start. They opine that:

The repeated abuse of short selling over the past eighteen months has led to the destruction of businesses, cost countless numbers of jobs and created systematic risk in the global economy. Though some have asserted that short selling aids liquidity and price discovery in the market, the possibility of such functions should not be used to justify the damaging and corrosive consequences of abusive short sales. Since the repeal of the uptick rule in 2007, the market has suffered a resurgence of manipulative short selling, including widespread “bear raids,” in which short sales of equity securities are employed, sometimes in combination with other trading strategies, in a concentrated effort to drive down their prices. These practices have badly damaged institutions, destroyed billions of dollars in shareholder value, and crippled investor confidence.

I'd like to see one iota of evidence for these over-the-top claims. Name one business that failed because of short selling. Explain how short selling cost anyone their job. How did short selling exacerbate systemic risk? It's all BS. There simply is no evidence. there's just a bunch of pissed off CEOs and investors who saw their stock driven down to its real economic value quicker than they would have liked. Want proof? Go here.

Corporate Social Responsibility versus Corporate Citizenship

Nokia Siemens Networks is denying a WSJ report questioning whether it provided Iranian authorities with the technology to engage in "deep packet inspection, which enables authorities to not only block communication but to monitor it to gather information about individuals, as well as alter it for disinformation purposes."

This story got me thinking about the distinction between corporate social responsibility and corporate citizenship. I define CSR using the draft ISO 26000 standard to mean "actions of an organization to take responsibility for the impacts of its activities on society and the environment, where these actions: are consistent with the interests of society and sustainable development; are based on ethical behaviour, compliance with applicable law and intergovernmental instruments; and are integrated into the ongoing activities of an organization.

In contrast, I would define corporate citizenship more narrowly. Unlike the affirmative obligations suggested by CSR, my view of good corporate citizenship is most negative. When dealing with state actors, for example, the corporation should not take actions that violate the human rights of the state's citizens directly nor should the corporation knowingly facilitate human rights violations by the state.

This is not a new idea. In the 1930s, GE CEO Owen D. Young famously opined that General Electric functions “in the public interest…performing its duties as a great and good citizen should.” Or, going back even further, as As stated by Judge Spencer Roane in 1809, if “associate individuals [want] to have the privileges of a corporation bestowed upon them; but if there object is merely private or selfish; if it is detrimental to, or not promotive of, the public good, they have no adequate claim upon the legislature for the privileges.” Currie’s Administrator v. Mutual Assurance, 14 Va. 315, 347 (1809). Even Milton Friedman recognized certain social restraints. He said that corporate managers and directors are “to conduct the business in accordance with their desires, which generally will be to make as much money as possible while conforming to the basic rules of the society, both those embodied in law and those embodied in ethical custom.” He also stated that pursuing profits was responsible “so long as it stays within the rules of the game."

To be clear, the argument is not that corporations should perform acts that are good for society; the claim is only that they should refrain from acts that are bad for society.

How do we operationalize such a proposal? In general, the business judgment rule should (and does) protect from judicial review board of director and manager decisions to decline business opportunities that pose a clear ethical or moral concern. Also, in general, however, there should be no affirmative obligation to do so. Certainly, neither a corporation nor its directors and officers should be held liable for engaging in lawful but ethically dubious conduct. They can be help up to social disapprobation, but not liability, except where their conduct violates domestic or international law.

If I were on the board of directors of Nokia Siemens Networks I probably would not have opposed providing cellular and internet services and equipment to Iran so long as the surveillance and censorship components of such technologies were no greater than the generally established needs of law enforcement. OTOH, I certainly would have objected to selling Iran technology that allows them to censor its citizens or repress them. Because the line between those two positions might turn out to be unclear, my thumb would be on the side of the scale weighing against doing business with a repressive regime.

Skeel defends Bankruptcy

Penn Law bankruptcy prof David Skeel tackles Obama's proposal to "give regulators the power to step in and take control of large nonbank financial institutions, as the FDIC already does with commercial banks" in an essay for the Weekly Standard:

The conventional wisdom about the bailouts of 2008 goes something like this. Federal regulators started off on the right foot by bailing out Bear Stearns and midwifing its sale to JPMorgan Chase. They were right to bail out AIG six months later, but botched the execution. And Lehman Brothers, the only exception to the bailout rule, showed once and for all that bankruptcy is not an adequate way to handle the collapse of a large financial institution.
But what if regulators hadn't bailed out Bear Stearns? If we conduct this simple thought experiment, it raises serious questions about both the conventional wisdom and the Obama administration's new proposals for regulating investment banks and bank and insurance holding companies. Bankruptcy starts to look much better, although it could use several market-correcting tweaks.

He then goes on to conduct just such a thought experiment, which you ought to go read in full, before concluding:

The bankruptcy alternative would not prevent regulators from regulating. Nothing would stop them from imposing high capital requirements on systemically important institutions, for instance, to make them less risky. But it would give creditors an incentive to pay close attention to the creditworthiness of systemically important institutions. And it would give the managers of these institutions a reason to file for bankruptcy before the house of cards crumbled, rather than running to regulators to beg for money.

What is there to say, but "ditto"?

The White Paper on Financial Market Regulation

The White House today announced the publication of the long-awaited Treasury Department White Paper on Financial Regulation. Here's the summary, with commentary in red:

(1) Promote robust supervision and regulation of financial firms. Financial institutions that are critical to market functioning should be subject to strong oversight. No financial firm that poses a significant risk to the financial system should be unregulated or weakly regulated. We need clear accountability in financial oversight and supervision. We propose:

• A new Financial Services Oversight Council of financial regulators to identify emerging systemic risks and improve interagency cooperation.

• • Instead of consolidating financial regulators, so as to eliminate forum-shopping, duplication, inconsistent regulation, and all the other problems associated with the regulatory alphabet soup, we're going to create a new regulatory body and an additional layer of regulatory hierarchy. We're making the system more rather than less complex.

• New authority for the Federal Reserve to supervise all firms that could pose a threat to financial stability, even those that do not own banks.

• • A massive expansion of Fed power and a massive expansion of government power to regulate the economy. Also dubious, because the Fed's expertise does not extend to regulation of non-banking industries.

  • In the long run, it may threaten the fed's independence. Query whether Congress will tolerate the Fed meddling in industries of local importance to powerful committee chairs.

• Stronger capital and other prudential standards for all financial firms, and even higher standards for large, interconnected firms.

• A new National Bank Supervisor to supervise all federally chartered banks.

• Elimination of the federal thrift charter and other loopholes that allowed some depository institutions to avoid bank holding company regulation by the Federal Reserve.

• The registration of advisers of hedge funds and other private pools of capital with the SEC.

• •  There is no evidence that hedge funds contributed to the financial crisis nor that regulation of them would have prevented or even mitigated the crisis.

  • Because hedge funds benefit the economy by bearing risks that others will not, engaging in transactions that tend to make securities more liquid, and ferreting out market inefficiencies, stricter regulation of hedge funds could do more harm than good. See Shadab on The Challenge of Hedge Fund Regulation.

  • Bear in mind that Bernie Madoff was a registered investment adviser, much good that did.

(2) Establish comprehensive supervision of financial markets. Our major financial markets must be strong enough to withstand both system-wide stress and the failure of one or more large institutions. We propose:

• Enhanced regulation of securitization markets, including new requirements for market transparency, stronger regulation of credit rating agencies, and a requirement that issuers and originators retain a financial interest in securitized loans.

  •  The whole idea of securitization is to enable firms to diversify by shedding originated loans. The problem was that the Lehmans of the world retained too many of their toxic assets. So the last element of this bullet is likely to do more harm than good.

• Comprehensive regulation of all over-the-counter derivatives.

• New authority for the Federal Reserve to oversee payment, clearing, and settlement systems.

(3) Protect consumers and investors from financial abuse. To rebuild trust in our markets, we need strong and consistent regulation and supervision of consumer financial services and investment markets. We should base this oversight not on speculation or abstract models, but on actual data about how people make financial decisions. We must promote transparency, simplicity, fairness, accountability, and access. We propose:

• A new Consumer Financial Protection Agency to protect consumers across the financial sector from unfair, deceptive, and abusive practices.

  • The federal government has long eschewed merit regulation of securities, in large part because it threatens to restrict and constrain innovation. I worry that the new agency will have that impact.

• Stronger regulations to improve the transparency, fairness, and appropriateness of consumer and investor products and services.

• A level playing field and higher standards for providers of consumer financial products and services, whether or not they are part of a bank.

(4) Provide the government with the tools it needs to manage financial crises. We need to be sure that the government has the tools it needs to manage crises, if and when they arise, so that we are not left with untenable choices between bailouts and financial collapse. We propose:

• A new regime to resolve nonbank financial institutions whose failure could have serious systemic effects.

  •   We've got to get away from the moral hazard problem and the probelm of de facto federal guarantees. Making clear that these problems will be resolved in the future via the bankruptcy process would be far more preferable.

• Revisions to the Federal Reserve’s emergency lending authority to improve accountability.

(5) Raise international regulatory standards and improve international cooperation. The challenges we face are not just American challenges, they are global challenges. So, as we work to set high regulatory standards here in the United States, we must ask the world to do the same. We propose:

• International reforms to support our efforts at home, including strengthening the capital framework; improving oversight of global financial markets; coordinating supervision of internationally active firms; and enhancing crisis management tools.

In addition to substantive reforms of the authorities and practices of regulation and supervision, the proposals contained in this report entail a significant restructuring of our regulatory system. We propose the creation of a Financial Services Oversight Council, chaired by Treasury and including the heads of the principal federal financial regulators as members. We also propose the creation of two new agencies. We propose the creation of the Consumer Financial Protection Agency, which will be an independent entity dedicated to consumer protection in credit, savings, and payments markets. We also propose the creation of the National Bank Supervisor, which will be a single agency with separate status in Treasury with responsibility for federally chartered depository institutions. To promote national coordination in the insurance sector, we propose the creation of an Office of National Insurance within Treasury.

Under our proposal, the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) would maintain their respective roles in the supervision and regulation of state-chartered banks, and the National Credit Union Administration (NCUA) would maintain its authorities with regard to credit unions. The Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) would maintain their current responsibilities and authorities as market regulators, though we propose to harmonize the statutory and regulatory frameworks for futures and securities.

What's striking about this last paragraph is the regulatory cowardice it exhibits. It makes no sense for the SEC and CFTC to remain separate, for example. The only reason they do so is because the SEC is regulated by the Senate Banking and House Financial Services Committee, while the CFTC is regulated by the House and Senate Agriculture Committees. An agency merger would have deprived one of these committees of jurisdiction. The Obama administration was unwilling to challenge the old bulls that run those committees.

Bloggers on the Financial Regulation White Paper

Arnold Kling has some preliminary thoughts.

So does Megan McArdle.