Enforcement cases, where the enforcers have total discretion about what to do, don't often motivate dissents from one of those enforcers, but one did recently before the SEC, in a case where a CPA CFO misstated earnings, and agreed to a Rule 102(e) suspension, or, if you like, a "wrist slap." Commissioner Aguillar thought that the CPA role was crucial.
Accountants—especially CPAs—serve as gatekeepers in our securities markets. They play an important role in maintaining investor confidence and fostering fair and efficient markets. When they serve as officers of public companies, they take on an even greater responsibility by virtue of holding a position of public trust.
Aguillar appears to be worried that CPAs are getting pled down into relatively innocent offenses even when there is strong evidence of intentional fraud.
I am concerned that this case is emblematic of a broader trend at the Commission where fraud charges—particularly non-scienter fraud charges—are warranted, but instead are downgraded to books and records and internal control charges. This practice often results in individuals who willingly engaged in fraudulent misconduct retaining their ability to appear and practice before the Commission.
So there you go, a commissioner who is particularly insistent on holding the accounting profession to high standards, and thinks the SEC is too willing to plead down everything. As an empirical matter, it is difficult to know whether the SEC is indeed guilty of Aguillar's charge (though he is, presumably, an expert on the matter). It's hard to know how much conduct is going unprosecuted, and for settleed cases, whether stiffer charges would have been likely to stick.
This week’s Economist has a column praising my UCLAW colleague Stephen Bainbridge’s and University of Chicago law professor Todd Henderson’s creative proposal, published in the Stanford Law Review, to replace individual directors with professional-services firms acting as Board Service Providers (BSPs). (That article can be accessed here.) The column nicely summarizes the possible impact of such a change:
“Messrs Bainbridge and Henderson argue that this would require only a simple legal change but could revolutionise the stick-in-the-mud world of boards. It would replace today’s nod-and-a-wink arrangements with a market in which rival BSPs compete. It would create a new category of professional director. And it would allow BSPs to exploit economies of scale to recruit the best board members, introduce more rigorous training programmes and develop the best proprietary knowledge. Now, even the most diligent board member can only draw on his or her experience. BSPs would be able to draw on the expertise of hundreds. This would increase the chances that corporate incompetence will be corrected, corporate malfeasance found out and corporate self-dealing, in the form of inflated pay, countermanded.”
The BSP idea is very creative. (Frankly, I am always puzzled by the extent to which academics have trouble appreciating creativity. Perhaps—and I’m speculating here—traits such as creativity are weakly correlated with succeeding in the academic tournament—getting high LSAT scores, writing good law school exams, getting judicial clerkships, and placing law review articles?) I also agree that introducing market competition by enabling firms to compete on performance will likely benefit consumers and shareholders, as well as increase the leverage of the board vis-à-vis executive officers.
That said, I worry about uncontrolled expenditures as BSPs find yet another reason to bill the corporation another $250,000 for yet another “critical project.” My prior experience as general counsel of a corporation (plus my six years of practicing law in a law firm) make me skeptical of the incentives of partners within firms (“Bill, bill, bill!”). I worry about the ratio of the value of services to cost. While we may see a decrease in executive compensation as a result of increased board leverage, are we going to see an increase in the effective compensation (i.e., including billings) of the board? My guess is yes.
I also worry about the audit/gatekeeping function of the Board. After all, we have plenty of experience with auditors being firms, rather than individuals. And the record there doesn’t look so hot. Remember Enron and Arthur Andersen? And remember Ted Eisenberg’s and Jonathan Macey’s empirical study suggesting that Andersen was not an outlier but typical? While gatekeeping theory provides that market gatekeepers, such as investment banks and accounting firms, are incentivized to work hard to prevent malfeasance out of fear that their longstanding reputations will be damaged, the reality is that the reputational informational markets are noisy and manipulable. Moreover, the incentives of the firm’s agent – the functional gatekeeper – may diverge from the incentives of the firm. In other words, large firms may suffer from principal-agent problems, as has often been alleged with David Duncan, the lead audit partner responsible for the Enron account at Andersen. (In prior work, I wrote about the incentives of firms vs. individuals for the audit/gatekeeping function.)
But I suppose Henderson and Bainbridge would respond that still, those reputation markets would work better with firms competing with one another than the status quo—little to no competition with respect to individual directors (for various reasons).
Perhaps there’s room for compromise. If you’ve been following the accounting profession, you know that the PCAOB (the body that regulates the accounting of public companies) in an effort to improve the transparency of audits has proposed to require the disclosure of the name of the engagement partner for the most recent period’s audit. Also, it has been suggested that the engagement partner individually sign the audit report. It should not be surprising that accounting firms uniformly dislike these suggestions. This indicates that they are probably good ideas. Perhaps, then, as a means of dealing with the principal-agent problem within BSPs themselves and to ensure that the incentives of the firm’s agents (the persons who actually sit in board meetings) are more properly aligned, similar measures should be taken.
I, at least, have been learning a lot from the back and forth with Alan over whose consent, and in what form, counts for determining whether a corporation has chosen a religious purpose for purposes of applying RFRA. To recap: I think that the board has the core power to make such a determination, while Alan believes that shareholders must explicitly consent. The questions are: which side should the Supreme Court take, and has it already done so?
In his latest post, Alan recognizes that the facts of the cases in Hobby Lobby pose a problem for his theory, because there does not appear to be formal approval by the shareholders acting as shareholders. However, in these corporations the shareholders are also directors, and in that capacity they have all clearly shown their consent. Is that enough? Alan struggles with this, and suggests a split answer: for purposes of federal law under RFRA it may be good enough, but for purposes of state fiduciary duty law, it is not good enough.
As to whether the Supreme Court has actually decided this question, I suspect the answer is rather clearly no. Seeing the problem that we have identified requires going deep into the weeds of corporate law theory. I actually think the opinion is pretty good on the corporate law side, but it does not go that far.
As to what the rule should be, I am skeptical about having a separate federal common law on this point. In part, that is because I doubt the competence of federal courts to come up with a rule of their own. That task is even harder because the rule must apply to all different sorts of entities, from different states with different rules. What about LLCs, for instance, just to throw out one complication?
More fundamentally, even if the federal courts could come up with a separate rule, I doubt that is conceptually appropriate. The issue posed by RFRA is what sort of purposes a particular corporation has, considered as an entity. RFRA sometimes give entities standing because individuals sometimes exercise their religious beliefs collectively in organizations. Where a particular organization has enough commitment to a religious purpose, it makes sense to allow that organization to claim RFRA's protection. The question then becomes whether or not a particular organization has adopted a religious purpose.
Answering that question requires looking to how such an entity defines its purposes, and that requires looking to the basic rules which constitute the entity. Those rules are the relevant state corporate law, both statutory and common law, along with the firm-specific documents (charters, bylaws, shareholder agreements) which work within that state law framework. The core logic of RFRA points us to the rules defining the entity, and for corporations those rules are set by state law. That of course leaves us with our disagreement over what procedure state law requires. Hobby Lobby does not end that debate, although I will point out that if the Court thinks its approach fits within state law, under Alan's view it should have found this a hard, borderline case for determining corporate purpose, whereas under mine it is pretty easy--which seems closer to the Court's own perception.
With a hat tip to Corp Counsel, this story about Milton Webster, board member of the Chinese firm AgFeed, who blew the whistle on his company, is really unique. He was a member of the audit committee! He thought that a name brand law firm was more conflicted than solution-oriented! He resigned, and then went to the authorities (or, at least, the paintiffs)! I don't think I've ever heard of a member of the firm's audit committee dropping a dime on the firm he directs. You'll want to read this probe by Francine McKenna, but here's the Bloomberg long read as well.
What you'll hear from me, as a general matter, is a story about the increasing convergence on matters financial regulatory across borders. But this is not to say that this convergence will be a story of cosmopolitan triumphalism, sans bumps, disputes, and difficulties.
Take auditor rotation, which is the shorthand for "the government requires you to fire your auditor and hire a different one everyone so often, lest your auditor become captured, or you start speaking to it in a strange shorthand outsiders can't understand." It's something that will really make a difference to the lives of CFOs and their reports everywhere. It will also either disrupt the multi-billion dollar accounting business, or end competition in the sector. And the EU now requires it every 10 years or so, while the US has dropped its auditor rotation plans. You might even call the emerging approaches to auditor independence completely inconsistent with one another.
The interesting question will be whether the EU makes foreign listed companies rotate auditors if they solicit or somehow end up with a substantial number of European investors (the current answer appears to be no, but stay tuned). If it does that, it will be yet another example of the way that the EU makes regulatory policy for the rest of the world. HT: Corp Counsel
With the possiblity of debt ceiling default arising quarterly these days, it is worth thinking through the Article III consequences of prioritizing debt payments over its other obligations. Can Treasury do that without facing a ton of big, fat, lawsuits?
Or, to put it another way, why can't it? As Felix Salmon observes:
[W]hy is Matt Yglesias so convinced that prioritization is impossible? He gives four reasons.
The first is that prioritization is illegal: “Treasury is not authorized to unilaterally decide to pay certain bills and not others”. This is true — but also a bit irrelevant. Treasury is under unambiguous Congressional orders to pay lots of bills — all of them, in fact. If it fails to pay those bills, it will be violating the law as laid down by Congress. Hence the 14th Amendment argument that the president should simply ignore the debt ceiling entirely, if it comes to that. But underneath it all, it’s hard to credit any argument which says “Treasury isn’t allowed to pay its own bonds”. If that’s what Treasury wants to do, then surely it can do so. Besides, who would even have standing to sue?
I can think of some people who would have standing to sue - they would suffer a concrete and particularized injury, caused by the government, and fairly traceable to its actions if Treasury took a dwindling pot of money, and stiffed General Dynamics on contracts due for submarine repair or whatever, while instead paying interest on maturing sovereign debt. But that doesn't mean that they could sue and win; here, I agree with Felix Salmon. The courts have found - unless Congress has provided otherwise in its statutory guidance - that managing lump sum budgets is committed to agency discretion by law. Under the logic of Lincoln v. Vigil, the leading case for this proposition, I accordingly think that lawsuits against Treasury for prioritizing debt repayments would be unlikely to succeed. As the Supreme Court said then:
Dan Doctoroff is giving $5 million to the law school in Hyde Park to develop a law and business curriculum, which isn't exactly a vast amount of money, but congratulations to UC nonetheless. Like Wharton, Chicago has a 5-years-in-4 MBA-JD program already; there is a lot of happiness about the program in these parts, but it does require students to pay a ton of tuition, and compresses their schedule flexibility massively. It sounds the Doctoroff donation will permit law students to take classes at Booth, or maybe buy out some Booth teachers to teach a class exclusively comprised of law students on asset valuation, managerial economics, and &c.
One bridge that must be crossed for such classes concerns the basic level of knowledge of the law students. Some Wharton students are coming from the army or Teach For America, but most have been spending a few years working on spreadsheets and going through quarterly statements. This sort of thing provides a critical background (and a culture spreadable to those who are abandoning their careers in ballet or publishing) that just being smart and eager does not, and my case study for that would be the accounting for lawyers classes you might have taken in law school, and promptly forgot about. Good luck to Chicago as it seeks to deliver classes that law students can find instructive; oddly enough, it might be easier to focus on undergraduate finance offerings rather than on the MBA program.
In the recent edition of The Atlantic, Frank Partnoy (law & finance professor at the Univ. of San Diego who recently wrote Wait: The Art and Science of Delay) and Jesse Eisinger (a journalist with ProPublica and columnist for the New York Times DealBook) authored What’s Inside America’s Banks?. They present an extensive analysis of the public disclosures made by major banks. The centerpiece of the article was an effort by Partnoy and Eisinger to unpack and understand the annual statement of Wells Fargo, a large bank that has been less associated with complex derivatives and trading activities than firms such as JP Morgan, Citi, and Goldman Sachs. They conclude that the public securities disclosure makes it impossible to understand adequately the risk-taking of even a more “traditional” large bank.
Frank agreed to engage in the following e-mail q&a on the article:
Q: You paint a pretty bleak picture of opaque disclosure and potential hidden time bombs lurking in the balance sheets of big banks. How does this problem compare to the toxic assets hidden in Japan’s zombie banks in the 1990s after their real estate bubble collapsed?
A: It’s a great comparison, and the degree and type of opacity are very similar. For example, I wrote in F.I.A.S.C.O. about the AMIT deals we were selling to Japanese banks back then, and looking back from today I think that the games played during the real estate bubble echo the games played in Japan during the 1990s. (And the zombie point is also a good one; we actually used that word in an early draft of the piece.)
Q: Is this a post-crisis phenomenon? Is it a function of banks trying to hide bad assets from before the bubble burst? Did the problem start there?
A: Yes, and I think it’s a friendly amendment to Charles Kindleberger’s work on crises, or even Hyman Minsky’s. As the bubble builds, credit expands, and risk increases, and inevitably the banks at the center of the expansion increasingly hide their risky assets. The assets aren’t necessarily bad – at least not at first – but they are hidden because they are risky. Then there is a dislocation and a panic as the assets “become” bad and ultimately the losses are disclosed.
Q: Is the opaque disclosure a sign that the United States runs the risk of a zombified banking sector like Japan’s?
A: That remains unclear. Bank stocks have performed well recently, in part because of the faith in the implicit U.S. government guarantee. Japanese banks weren’t as fortunate. But we think the risk is a real one, and it was a major reason why we wanted to write the piece. I don’t know if the right metaphor is zombie or rot or something else, but historically opacity has been at the center of major financial problems, especially over the long term.
Q: Do you have a sense whether the problem is as acute for large banks overseas – the Barclays, UBSs, and Deutsche Banks of Europe?
A: The gap between disclosure and reality is not nearly as wide in Europe, though banks there have plenty of other problems. For example, European regulators and bankers continue to rely heavily on credit ratings; that is a huge ongoing problem and will almost certainly result in massive misallocation of capital and future crises.
Q: You don’t seem to have much confidence in the ability of regulators or even bank management to understand the risks these banks are taking despite having nonpublic information. Is there other evidence of this besides the London Whale tale of JP Morgan?
A: Oh, there are so many. Regulators have failed to comprehend the risks at banks over and over during the previous two decades. My book Infectious Greed documents many of those incidents from the 1980s through 2003. As for more recent examples, the recent revelations about what Fed officials thought in 2007 is notable. So are the regulators’ positions about risks at Citigroup in late 2007 and early 2008. I attended several conferences with regulators during 2007-08 and was surprised by how little they knew about Structured Investment Vehicles. And so on. Kids, you really need to get out more.
Q: Why did Warren Buffett invest in banks after the crisis? What could he figure out that you (or other investment fund managers you interviewed) couldn’t? Did he have special access? Why is Berskshire Hathaway still invested in Wells Fargo if the disclosure is so opaque?
A: Buffett obviously has special access and his bet turned out to be a good one last year. He’s experienced investing in companies with opaque derivatives exposure, going back to General Re, and while sometimes he is warning that derivatives are financial weapons of mass destruction he is also often profiting from them. The key to Buffett’s investing style has always been timing – he is a genius at managing delay, waiting for the “fat pitch,” and I suspect he’ll know when it’s the right time to unload bank stocks so that he doesn’t get burned again. He understands that just because something is a black box doesn’t necessarily mean you should avoid it. Even buying into a pyramid scheme can be very profitable if you get the timing right.
Q: Why wouldn’t the market address this? Wouldn’t one large bank collect new investors and be able to sell equity above book value by offering better disclosure?
A: Oh, you’re right – how silly of me. The market addresses all such problems. Never mind.
(But seriously, imagine what our economy would look like today if the markets actually had worked. What if all of the major banks had failed in 2008 and Google, Microsoft, Amazon, and Walmart had stepped in to provide basic financial functions?)
Q: If this opacity scares away equity investors, why isn’t it also scaring away the creditors and derivative counterparties of these big banks? Why aren’t they demanding more margin or collateral or higher effective interest rates? Do these counterparties assume that the problem would have to be large enough to threaten the big bank?
A: Implicit government guarantees. And even so, they are demanding more collateral and clearer contractual arrangements, which are creating another set of problems. Also, there is some truth to the notion that the banks are so large and diversified today that creditors and counterparties probably aren’t at huge risk of failure. Catastrophe yes, but maybe nothing so big to cause insolvency. JPMorgan’s $6 billion loss was a nit.
Q: You offer a detailed indictment of Levels 2 and 3 of fair value accounting. What did you make of the outcry during the financial crisis that mark-to-market accounting was exacerbating the crisis by causing fire sales? Might some of the reforms you suggest, including improving fair value disclosure, have nasty procyclical effects?
A: No, quite the opposite. The outcry during the crisis was about marking down assets to more realistic levels – obviously bank managers didn’t want to do that. But if managers had understood they would be required to mark assets down immediately when they declined in value, they would have been less likely to buy them during a bubble – hence, an anti-cyclical effect. The smartest investors and managers say that if you can’t mark something every day, you shouldn’t buy it. Period.
Q: Your analysis of Wells Fargo’s “customer accommodation” trading focuses on some of the fudged language in the disclosure, namely that this trading might not be driven by actual customer demands, but “expected” customer order flow. You also write that
“Some traders can disguise speculative positions as “hedges” and claim their purpose is to reduce risk, when in fact the traders are purposely taking on more risk to make a profit.”
Does this mean that you are skeptical of the Volcker rule’s effectiveness in reducing risk-taking because the built-in statutory exceptions to proprietary trading are too easily manipulable?
A: Absolutely. I use the metaphor of a piece of Swiss cheese with holes that get bigger and bigger – until it is gone.
Q: Are you really limiting your proposed fixes to better disclosure and more vigorous securities enforcement? Or are you saying, as Felix Salmon blogged, that banks need to become much simpler? Do you agree with his assessment that moving back to a simpler age of banking or a simpler age of disclosure is quixotic?
A: I think getting simpler would be a result of better disclosure and enforcement. And I have very little confidence that regulators could draft a set of “simplicity rules” to pare down what banks are permitted to do and what they are not, especially in the face of the financial services lobby. I don’t think ex post adjudication in a principles-based regime is quixotic. If anything it’s a more sophisticated way of impounding market information in regulatory decisions. But good use of the word “quixotic.”
Q: Doesn’t disclosure still have the “you can lead a horse to water…” problem? Would even sophisticated investors demand or make use of the disclosure you envision? How do you know?
A: True. Some of the reception to our piece has made me wonder whether some supposedly “sophisticated” investors are in fact not wearing any clothes. On the Wells Fargo earnings call after our piece was published, one person asked about it, but the various investors and analysts seemed placated by the CEO’s response that Wells Fargo is “pretty plain vanilla” and “I’ve never seen us be more transparent.” There’s been virtually no follow-up about the bank’s Variable Interest Entity disclosures, for example. But I think there are enough truly sophisticated investors out there, and they have huge amounts of wealth under management – as long as they drink, the other horses eventually should come along. And the most sophisticated investors tend to pile on very effectively once even one of their ilk has made a good case. Which is why managers hate (and fear) them so much.
Q: Are you coming out in favor of principles in the old rules vs. principles debate on accounting standards? Aren’t simple, broad standards also subject to gamesmanship?
A: Yes, I am. It is much more difficult to game broad standards when they are adjudicated ex post. This after-the-fact element is just as important as rules vs. principles.
Q: How much promise do you think technology offers in improving the quality of disclosure (for example, the SEC’s XBRL initiative)? [Editorial note: this is my latest research project]
A: It’s a fantastic project, and I wish you the best with it. In theory, technology can vastly improve the quality of disclosure. But one problem with systematizing disclosure is that you can miss crucial angles that are “outside-the-box” or more like narrative. What would XBRL have done with Enron’s footnote 16?
Q: If you were to offer a few concrete suggestions for the new SEC Chair on improving disclosure and enforcement, what would they be?
A: Keep it simple and be willing to be vague. Single out financial firm disclosure as a hot topic, and make it clear that banks must make better disclosures of risks and worst-case scenarios, or face consequences. Get the board members of the major banks to sign on to these initiatives, through a series of early meetings and then a highly-publicized roundtable. Keep trying to win “should have known” cases, especially against employees of financial firms. Good luck!
Even though Europe is explicitly more willing to consider competitive injury than is the United States, and rather clearly a more active enforcer, there are still a couple of things you hear suggesting that really, we're moving towards one law of antitrust:
- The last time the EU reversed a merger approved in the US was Honeywell-GE in 2001.
- The EU and US talk all the time, through the ICN, through the Translatlantic Dialogue, you name it.
- They both use HH indexes.
I generally believe that international economic law harmonization is likely in many things, but antitrust, perhaps because of strong differences in the competition cultures of the two jurisdictions, is probably going to harmonize slower than most. The jurisdictions took very different views about Microsoft, the ICN has been sidetracked into technical training, and antitrust in general is becoming a little like accounting, where Europe has the world's standard, and the US has the idiosyncratic one. Unlike in acccounting, however, the pressure to change American exceptionalism is not likely to be as great.
Anyway, the UPS-TNT deal's undoing underscores this. America has blocked mergers - it blocked T-Mobile - AT&T - but this doesn't feel like something that would have suffered the same fate in the American context.
Accounting firms in China have found themselves on the horns of a dilemma as of yesterday, as the SEC launched administrative proceedings against pretty much all of them for "for refusing to produce audit work papers and other documents related to China-based companies under investigation by the SEC for potential accounting fraud against U.S. investors," as the agency put it. The claim is administrative (i.e., not in court, but headed before an agency ALJ), and you can look at it here.
But the thing is, defendants feel that complying with the SEC's requests for documents is legally prohibited under China law. Or so they have told the SEC:
Each of the Respondents has informed the Commission that it will not produce the documents to the Commission as requested in the Section 106 requests because, among other things, Respondents interpret the law of the People’s Republic of China as prohibiting Respondents from doing so.
What is really needed here is an agreement with the Chinese government on access to the papers the SEC believes is required. Without it, the agency is going to have to either take it easy or delist a lot of Chinese companies; this action appears to be a signal that it is serious about doing the latter. But I'd say the target here are not the accounting firms named in the complaint, but the Chinese regulators standing behind them.
On Thursday, I travelled to Houston and gave a statement before the Public Company Accounting Oversight Board in a roundtable hearing, as the PCAOB considers whether to impose a mandatory auditor rotation rule. In using its new inspection powers, the PCAOB has found worrying evidence of auditors compromising their independence, objectivity, and professional skepticism (see the PCAOB’s concept release soliciting public feedback).
This problem and whether mandatory auditor rotation is an appropriate solution present a bramble bush of questions that have solicited a great deal of comments (you can see the statements at the Houston roundtable (including my own) here); the PCAOB also held roundtables previously in Washington, D.C. and San Francisco).
For me, the roundtable represented an opportunity to revisit some of the legal scholarship on audit failure that deserves renewed attention, even as public attention has shifted from Enron/SOX to “Subprime”/Dodd-Frank. Let me highlight the works of two scholars in particular.
First, Sean O’Connor (Univ. of Washington) authored a great series of articles that examined “the creation” of the problem of auditor independence. In one work, O’Connor looks at how certain accountants pushed for, and Congress created, requirements for mandatory “independent” auditing of issuer financial statements in public offerings (the ’33 Act) and in periodic reporting (the ’34 Act). Professor O’Connor looks at how the New Deal Congress imported much of these requirements from provisions in Britain’s Companies Act but without considering key differences in status and governance between chartered accountants in Britain versus the accounting industry in the United States. Moreover, Congress failed to spell out what makes auditors “independent.” This omission left the job to the SEC and resulted in Boards and not shareholders selecting and paying auditors. In a later work, O’Connor looks at how these legal requirements and the “issuer pays” model mean that true auditor independence will always be elusive. His work parallels work in other scholarship on gatekeepers (for example, Frank Partnoy’s theory of how “regulatory licenses” endow credit rating agencies with government-granted oligopoly power that undermines their effective gatekeeping). O’Connor presents a fairly radical set of solutions, including ending the ’34 Act (but not the ’33 Act) statutory requirements for independent audits and giving shareholders control of auditor selection.
Bill Bratton (Penn) had a second and different spin on the problem of auditor independence. He agrees that the issuer-pays model fundamentally compromises auditor independence. But, he argues that making auditors responsive to shareholders is problematic, as different groups of shareholders have radically different investing interests and time horizons. This article represents part of a series of articles by Bratton on the “dark side” of shareholder value and the downsides of shareholder primacy. Instead of making auditors beholden to shareholder, Bratton recommends strengthening the fidelity of auditors to accounting rules. Less radical than O’Connor’s suggestions, Bratton’s proposal raises a number of questions, including whether fidelity to rules can provide adequate discipline of audit firms without a third-party strenuously enforcing those rules on behalf of shareholders, whether professional and social norms provide a meaningful disciplining device for auditors, and, most vexing, how effective can rules be when industry wields a powerful hand in writing them.
Both sets of works deserve renewed scrutiny as the problems of auditor independence persist.
As in a bad horror movie (or a great Rolling Stones song), observers of the current crisis may have been disquieted that one of the central characters in this disaster also played a central role in the Enron era. Is it coincidence that special purpose entities (SPEs) were at the core of both the Enron transactions and many of the structured finance deals that fell part in the Panic of 2007-2008?
Bill Bratton (Penn) and Adam Levitin (Georgetown) think not. Bratton and Levin have a really fine new paper out, A Transactional Genealogy of Scandal, that not only draws deep connections between these two episodes, but also traces back the lineage of collateralized debt obligations (CDOs) back to Michael Millken. The paper provides a masterful guided tour of the history of CDOs from the S&L/junk bond era to the innovations of J.P. Morgan through to the Goldman ABACUS deals and the freeze of the asset-backed commercial paper market .
Their account argues that the development of the SPE is the apotheosis of the firm as “nexus of contracts.” These shell companies, after all, are nothing but contracts. This feature, according to Bratton & Levin, allows SPEs to become ideal tools either for deceiving investors or arbitraging financial regulations.
Here is their abstract:
Three scandals have fundamentally reshaped business regulation over the past thirty years: the securities fraud prosecution of Michael Milken in 1988, the Enron implosion of 2001, and the Goldman Sachs “Abacus” enforcement action of 2010. The scandals have always been seen as unrelated. This Article highlights a previously unnoticed transactional affinity tying these scandals together — a deal structure known as the synthetic collateralized debt obligation (“CDO”) involving the use of a special purpose entity (“SPE”). The SPE is a new and widely used form of corporate alter ego designed to undertake transactions for its creator’s accounting and regulatory benefit.
The SPE remains mysterious and poorly understood, despite its use in framing transactions involving trillions of dollars and its prominence in foundational scandals. The traditional corporate alter ego was a subsidiary or affiliate with equity control. The SPE eschews equity control in favor of control through pre-set instructions emanating from transactional documents. In theory, these instructions are complete or very close thereto, making SPEs a real world manifestation of the “nexus of contracts” firm of economic and legal theory. In practice, however, formal designations of separateness do not always stand up under the strain of economic reality.
When coupled with financial disaster, the use of an SPE alter ego can turn even a minor compliance problem into scandal because of the mismatch between the traditional legal model of the firm and the SPE’s economic reality. The standard legal model looks to equity ownership to determine the boundaries of the firm: equity is inside the firm, while contract is outside. Regulatory regimes make inter-firm connections by tracking equity ownership. SPEs escape regulation by funneling inter-firm connections through contracts, rather than equity ownership.
The integration of SPEs into regulatory systems requires a ground-up rethinking of traditional legal models of the firm. A theory is emerging, not from corporate law or financial economics but from accounting principles. Accounting has responded to these scandals by abandoning the equity touchstone in favor of an analysis in which contractual allocations of risk, reward, and control operate as functional equivalents of equity ownership, and approach that redraws the boundaries of the firm. Transaction engineers need to come to terms with this new functional model as it could herald unexpected liability, as Goldman Sachs learned with its Abacus CDO.
The paper should be on the reading list of scholars in securities and financial institution regulation. The historical account also provides a rich source of material for corporate law scholars engaged in the Theory of the Firm literature.
Permalink | Accounting| Bankruptcy| Business Organizations| Corporate Law| Economics| Enron| Finance| Financial Crisis| Financial Institutions| Innovation| Legal History| Legal Scholarship| Securities| Transactional Law| White Collar Crime | Comments (0) | TrackBack (0) | Bookmark
Glom readers know I've been thinking a lot about SharesPost, one of two major sites where trading of pre-IPO shares is flourishing. Secondary markets were in the news twice last week. First, SharesPost agreed to pay the SEC an $80,000 fine for failing to register as a broker-dealer--which seems like a slap on the wrist, particularly since everyone knew that it was breaking the rules. Second, the SEC sued two money managers for failing to disclose hidden commissions when trading for their clients on the secondary market.
Descriptions of the secondary market for pre-IPO shares range from "a bit of a free for all" to "an illiquid, opaque bazaar populated by shady characters" Everyone seems to agree that the Facebook IPO frenzy is fueling a lot of the excitement. But it seems to me that when Facebook eventually does go public, the SharesPost might catch some flak. I see two possible scenarios:
Scenario One: Facebook experiences a huge first-day pop, that much-desired wild ride where the shares' initial offering price is outstripped-sometimes wildly outstripped--by the price at the market's close. A big pop would be good for those lucky enough to buy Facebook at the IPO, and fantastic for those who bought pre-IPO. Traditionally, this latter group included early employees, friends and family, angel investors, and venture capitalists. Now it also probably includes everyone who bought Facebook on the secondary market.
So what's the problem? The risk for SharesPost is that the public sees this as another example of what Reuters terms "special rules for the rich." Because not just anyone can buy shares on the secondary market. You need to be an accredited investor--i.e., rich. I could see popular opinion taking this as another case where the rich get access to special deals the rest of us poor schlubs can't, and they make money as a result while we're left on the sideline. Not good for SharesPost.
Scenario Two: Facebook shares don't pop on the IPO. They go sideways or even down. It's not unheard of. Then what matters is the delta between the price secondary market investors paid and the offering price. If that gap is high enough, then secondary market buyers will still make a profit. If it's low--or if some secondary market investors lose money on Facebook (it IS possible, especially when factoring in those commissions), then suddenly buyers will cry foul. And fraud. And that's bad for SharesPost, too.
Does anyone else feel like the secondary market right now is like the NYSE in September of 1929?
Originally, I was hoping to start this post with a link to some research a colleague and I just completed that discusses how lenders may be overestimating property values prior to foreclosure. But it has not made it through formatting and on to the web yet, so I will instead share the findings with you.
In this research we find that lenders may be overestimating property values prior to foreclosure in weak housing submarkets. (By “lender” I mean banks servicing their own loans or securitized loans.) We find evidence of overestimating values by looking at the difference between the sale price at foreclosure auction (in this case the lender’s reserve/minimum bid) and the subsequent sale price of the home out of REO in submarkets in Cuyahoga County, OH (home to Cleveland). As the housing market gets weaker, the gap between those two sale prices grows. We also find that lenders’ value estimates may be dramatically improved by incorporating a few simple factors such as the age of the home and the poverty level in the home’s census tract. So we would expect lenders to pick up on this at some point and adjust their models accordingly. But we don’t see that happening. There are three possible explanations I can think of, though I welcome others.
First, lenders may not be overestimating the value at all. The price they pay for property may represent bidding in accord with an Ohio law that automatically sets the minimum bid at the first foreclosure auction, rather than waiting for subsequent auctions when the minimum bid can be adjusted. The way Cuyahoga County interprets this law, prior to foreclosure the County pays for a drive-by or walk-around appraisal. The initial minimum bid is set at two thirds of that appraisal. (If anyone can think of a good reason for this law, please share in the comments.) If no one bids at the first auction, the lender can lower the minimum bid at subsequent auctions. Anecdotally, bankers report credit-bidding their judgment to meet the minimum bid to obtain control of, and begin marketing, the property.
Automatically placing the minimum bid may be routine for bankers, but it probably does not always payoff: we find that the worst 25% of REO property sells for less than half of its minimum bid, if it sells in the quarter it is taken into REO. If it stays in REO for four quarters, it sells for less than 10% of its minimum bid. If the property’s minimum bid was $50,000 (remember, this is the worst 25% of property taken into REO), the lender recovers $5,000 before the broker’s commission, maintenance, taxes, and transfer costs. It is unclear why lenders would be in such a rush to obtain such low-quality properties if they were valuing them correctly.
The next two explanations differ from the first, because they assume that lenders are actually bidding at or close to their estimated value of the property. The second explanation may be that the methods used to value property just don’t work well in weak submarkets, and lenders’ valuation models are not correcting for that. It is not hard to imagine that a walk-around appraisal is a reasonably accurate way to value most property in most markets. If brokers want to find non-foreclosure sales to use as comparables, they have to reach back further in time in weak markets than they do in others, so the prices they use are more likely to be stale. Walk-around appraisals may also miss interior damage(stripped copper pipe and wire, appliances, etc.) that properties are more likely to have suffered in weak markets.
The third possible explanation is that lenders are shifting accounting losses from loan portfolios to REO portfolios. This could be accomplished by using the inflated estimated value to prevent recognizing losses on the loan, and instead writing down the value in the REO portfolio. There are two potential benefits to this. The first is that capital markets tend to pay more attention to loan portfolio performance than REO portfolio performance. The second benefit is that most solvency tests for banks focus on loan portfolio performance metrics, and pay little or no attention to REO portfolio performance. So shifting these losses could potentially make lenders look healthier and more attractive than they actually are.
Any way you slice it large REO portfolios are bad for banks and communities. One way to reduce the size of these portfolios is to lower foreclosure auction reserves, increasing the chance that others will purchase the property at auction instead of it becoming REO. If there is no market for the property, then donation to a land bank or similar entity may be the answer.
As this Glommer prepares to make himself somewhat scarce over the holidays, he'll (I'll?) point you to two posts by two of the finest corporate law bloggers not to be found on these pages (and, oddly enough, both are co-authors). Anyway, here's Larry Cunningham with an especially useful post on what kind of fine Ernst & Young could handle, and Steven Davidoff with something on Abercrombie's charter switch out of Delaware, and into takeover defense friendly Ohio.
They'll keep you thinking as you prepare to roast various sorts of meats, or however else you plan to spend the next week or so.