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.
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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.
Why would Andrew Cuomo, the tough, but seemingly-less-tough-than-Elliot-Spitzer AG, file civil fraud charges against Ernst & Young on his way out the office door and into the governor's mansion? If the case kills the company, Cuomo is going to have a reputation that makes Spitzer look like a piker, of course. But it probably won't kill E&Y, because it's a civil case, and the one way that criminal corporate sanctions matter is that they can put gatekeeper firms, like Arthur Anderson, out of business. Civil charges can't do that.
Anyway, here's Going Concern with an especially helpful roundup, concluded by a post from Matt Taibbi, which features him at his best and not so best.
Taibbi is good when he observes:
In the second quarter of 2008, [Lehman] lightened up their balance sheets with $50 billion worth of Repo agreements. This technique, apparently known as "window dressing," isn’t that much different conceptually from the Enron-style book-doctoring that used "independent" special purpose vehicles to hide liabilities. In this case Lehman didn’t use shell companies but instead scattered its dent in the financial atmosphere by booking loans as sales. Ernst and Young, which made over $100 million in fees between 2001 and 2008 working with Lehman, aided the process by signing off on Lehman’s crazy accounting.
This is totally true, right up to and including the Enron example, and I've never understood why the kind of end-of-the-quarter window-dressing that appears to be de rigeur corporate accounting is permitted. Seriously. If bankruptcy can undo pre-bankruptcy transfers of wealth, why can't accounting? At any rate, it's lucidly, not angrily, explained, and gets to one of the hearts of the matter.
Taibbi is not so good when he predicts that:
My guess is that this suit is the beginning of the end for Ernst and Young and, who knows, may be the beginning of a series of investigations that ultimately take down the auditors and ratings agencies that made the financial crisis possible. Without accountants and raters signing off on all the bogus derivative math and bad bookkeeping, a lot of this mess would never have happened. Zero Hedge has an excellent piece detailing all the ass-covering and finger-pointing going on at Ernst and Young; check it out if you have time.
Killing Arthur Anderson, a worldwide company with tens of thousands of employees, all but maybe four or five of whom had nothing to do with Enron, never struck me as particularly good policy, but more like, it's the cover-up-not-the-crime style discipline. So I think it is naive to wish for it, nor do I think it is in the least likely to happen. Zero Hedge is full of angry posters who have picked 30 of the last 2 fraud uncoveries. Those guys are nuts, and if Taibbi is using them as the basis for his confident predictions of the death of an accounting firm, he's sourcing, let's say, broadly.
Another thing - I always think that the bankster crowd should take a deep breath when presented with indictments, and pretend that the conduct that occurred happened to someone they like. You know, what if a union official was convicted of fraud? Kill the union?
The Wall Street Journal reports on its front page that the NY Attorney General is close to filing a civil suit against Ernst & Young for fraud in connection with its audit work for Lehman Brothers and the now infamous "Repo 105" transactions. Lehman allegedly used complex repurchase transactions to engage in "window dressing" and mask leverage and thus risk just before the close of financial quarters. (You can find the Examiner's Report from the Lehman Chapter 11 Proceedings, which analyzed Repo 105 among other transactions, here.)
It is hard to say anything detailed about a suit that has not been filed yet, but this type of suit could have even broader implications that this summer's SEC v. Goldman case for the sole reason that lots of financial institutions used repos and other financial instruments at the heart of the financial crisis to move assets -- and thus risk -- off-balance sheet and to arbitrage bank capital regulations. Think of it this way -- if the Goldman suit alleged that a big investment bank arranged complex transactions to help a hedge fund bet against asset-backed securities, this type of suit might focus on some of the reasons that firms invested on the other side of shadow banking transactions -- lowering leverage and engaging in capital arbitrage. This type of arbitrage would thus involve not only big investment banks, but their clients as well. Consider how one of the banks named in the SEC's suit against Goldman that suffered considerable losses, IKB of Germany, has itself been the subject of regulatory investigations and some of its executives prosecuted in connection with off-balance sheet transactions (an early PWC report on IKB (in German) here, and a more easy-to-follow IKB analyst conference call transcript on the fallout here; the IKB story continued after 2007, but that's for another day, another post -- see the FT blog here,).
General counsel might be very interested to see what a NY AG case says about when the flavor of aggressive off-balance sheet accounting becomes a poison. Moreover, the NY Attorney general can wield the Martin Act, one of the more fearsome weapons in the public litigation arsenal, even if the Journal report seems to indicate that the NY AG won't be seeking criminal penalties.
Bottom line: the normally sleepy weeks around Christmas and New Year could get very interesting. Moreover, repurchase transactions and their role in the crisis were left relatively unaddressed by the otherwise sprawling Dodd-Frank Act. For now, let's have some egg nog, but not too much, and see what materializes.
To: Freshman Senator/Member of Congress
Re: Making your mark
¡Felicidades! Maybe, like Robert Redford at the end of The Candidate, you find yourself asking “Now what?” How will you make your mark in the 112th Congress? Senior legislators are likely to give you some sage advice: focus on one or two important issues and become the master of those topics. It will show the seniors in the class that you are serious, deferential, and a resource for the party, rather than a dilettante and an egotist (you don’t want to be the first one of those on Capitol Hill). The more technical the issue, the less competition you’ll have and the less of a threat you’ll be to the old barons and baronesses.
Although technical (some would use the perjorative “boring”) issues may be a hit with the party bosses, you may be concerned that they won’t win you points with your public. But that depends on which issue you pick. One strategy – that also meshes well with your deeply ingrained sense of public service – is to find policy issues where the public is seriously underestimating the risk of problems and start raising the alarm. Do so in a sober way, of course, or risk becoming chicken little. (Just between the two of us, for all your jeremiads against the “elite”, I know you are secretly a wonkish egghead like me. Accordingly, you’ll be interested in some rich scholarship on the political opportunities that come from the gap between objective risk and public perceptions of risk. See Amitai Aviram).
Bearing this general strategy in mind, if you want to focus on financial regulation, there are three routes you can take: First, you can reach into the grab bag that was the Dodd-Frank Act and take an active role overseeing one of the major regulatory projects under that act.
As noted many times before, the last Congress delegated to federal agencies the task of putting the meat on that statute’s skeleton. There are lots of high profile rulemakings to choose from including the Volcker rule and the authority of the SEC to impose fiduciary duties on broker-dealers. But those two fields are likely to be crowded, so consider the host of other issues that are harder to understand, but no less important. Derivatives present a motherlode of important, but complex issues. For example, the “swaps pushout” requirements under the Act, which create push banks and other regulated entities that receive “federal assistance” to move their derivatives trading operations to affiliates that don’t receive that assistance. The politics of this regime can be clarified – should federal taxpayer dollars subsidize risk-taking on derivatives that might require a federal bailout? But the economics of this issue – measuring cross subsidization from one affiliate to another, determining when entities with an obscured subsidy compete unfairly with those that don’t – are hard. As are the legal issues of an agency writing rules to make sure that any subsidies from deposit insurance don’t leak even to “pushed out” affiliates. Bottom line: hire some experiences regulatory and transactional lawyers on your staff and reach out to economists.
You can go even deeper and ask about the unintended consequences of Dodd-Frank rules. For example, Dodd-Frank has numerous provisions designed to push over-the-counter derivatives to trade on exchanges and to be cleared through clearing companies. The intentions behind these provisions are good – to move derivatives to institutions where pricing is transparent and where counterparty risk (the risk that one party to a derivative contract will default, increasing the risk of a domino effect of defaults (the reason given for the bailout of AIG)) can be centralized, measured, and mitigated. But the risk of centralizing counterparty risk in clearing organizations is that we may be creating the mother-of-all-counterparty risks. This means that close attention will have to be paid to the rules for derivatives clearing organizations, including things like position limits and margin rules. Of course there will be plenty of experts in the agencies and in the private sector weighing in on these boring topics. However, one lesson from the financial crisis that should linger is the dangers of excessive reliance on technocratic experts to handle the boring stuff. Even technocrats are flawed and selfish, Principe/principessa.
A second approach is to focus less on the roadmap in Dodd-Frank and more on those factors in the global financial crisis that Dodd-Frank largely fails to address. I can think of many, but here are two starters.
One: the repurchase markets in which banks and other financial institutions borrow vast sums – often overnight. When lending in these “repo” markets (no – Emilio Estevez was not involved in this disaster) dried up, the credit system froze. Some economists liken the effect to a modern-day bank run. Dodd-Frank does too little to address repos.
Two: much of the complex financial transactions were a rhyme (not a repeat) of the type of off-balance sheet games we saw in the Enron era. Perhaps not the same shenanigans nor the same intent, but the effects were worse – assets were often moved off bank balance sheets even though the risk remained with the banks. Leverage was hidden. Bank regulators will tell you that they carefully look at off-balance sheet liabilities when examining financial institutions. Bologna! We’ve seen what a great job they’ve done with that. So let’s add an accountant to your list of committee staffers or outside advisors.
A third and final approach is to forget fighting the last war and focus on fighting the next one (nota bene: military and sports metaphors will get you far in your line of work). As I’ve written before, beware of a crisis in municipal finance. If underfunded government insurance programs are your thing, move past social security and consider the Pension Benefit Guaranty Corporation – a government corporation that assumes responsibility for certain private sector pension plans when the sponsoring companies are in financial “distress.”
Hope this is helpful. Mucha suerte con todo! Oh, and about those personal e-mails imploring me to donate to your campaign -- I think you mean the Erik Gerding who used to work at Cleary Gottlieb.
Among the hallmarks of a really good law review article for me are, first, when an article inspires me to have a storm of fresh thoughts about a given topic and, second, just as I think of an objection I then find that the author deals with the question on the very next page. Urska Velikonja’s piece meets both criteria. This paper is ambitious and engages a difficult subject of securities fraud deterrence. With all the moving parts in the legal system for deterring fraud, it is difficult to write a focused, cogent piece of scholarship and balance the need to be comprehensive without getting pulled in too many directions. Velikonja should be commended for it; she engages a number of the big fish in this particular pond yet manages to add many fresh ideas.
My main wish would be that Velikonja spend more time on the crux of her diagnosis of the problem and her proposal. One key element of Velikonja’s thesis is that individual culprits are under-deterred because management can protect itself by refusing to share information with enforcers (whether the SEC or private plaintiffs) about who was really responsible for an act of accounting fraud. We could spend a lot of time analyzing whether under-deterrence is a problem, but to keep my comments focused, I will assume it is real.
A more focused question is: what causes it? I’d like to read a little more about the scope of this particular problem of information sharing. Is information not being shared with enforcers via the discovery process? My brief and limited experience in practice with SEC enforcement actions suggested that the information requested and provided can be quite comprehensive. What information is being withheld on a systemic basis? The paper briefly touches on the ability of firms to stonewall with broad assertions of attorney-client privilege and work-product (p. 30, citing Sam Buell’s work). This could be fleshed out more, since ultimately information-forcing is a central rationale behind the paper’s proposal of leveraged sanctions.
One means of answering this question of what information is missing would be to speak with prosecutors and practitioners off-the-record to get a nuanced understanding of the games being played and the scope of information that might be missing. It may not be citable empirical research, but might let us know where to look for additional proof. (It might add some valuable practical insights to a fascinating theoretical piece, and help the author’s ideas gain policy traction.)
This same question of “what is the missing information” reappears in the details of the regime Velikonja proposes. Under the proposal, firms could reduce their liability, by cooperating with enforcers (p. 41). I would like to hear more about what would qualify as “cooperation.” To what extent are “internal accounting documents, memoranda, e-mails or other messages, and minutes of meetings” already being provided in discovery? If privilege is the central problem, is waiver of privilege the central part of the solution? There are a host of potential concerns with creating incentives for/coercing a waiver of privilege that recall the debates about the SEC attorney conduct rules several years ago. (For example, would pressure to waive privilege undermine close, trusting lawyer/client relationships and discourage clients from seeking counsel that would otherwise further compliance with the law?)
Velikonja’s proposal also brings to mind the debate seven years ago in the wake of the much-debated Thompson Memo, in which a Deputy Attorney General set forth guidelines for federal prosecutors to weigh cooperation from a corporation in making decisions to prosecute. The literature in the wake of that memo, although dominated by practitioners, has direct bearing on this paper. (As an aside, it would be interesting to re-examine (a) whether the Thompson Memo had any effect on prosecutor behavior, and (b) whether corporate cooperation changed).
Should cooperation be enough to release a firm completely from liability? Velikonja addresses the problem of whether innocent individuals may scapegoated, but I wonder even if the firm provided more information, might we still have under-deterrence of individuals. The probability of a prosecutor bringing a successful case against individuals even with full disclosure from a firm may be quite low for any number of other reasons. Just a few examples: the enforcer might be able to prove all of the elements of a case, just not for any one person. It may also prove harder to get a jury verdict against a person with pictures of kids in her/his wallet than against a corporation with no soul to damn or body to kick. If under-deterrence of individuals is the problem, is lack of cooperation from firms the main cause?
On the other hand, firms may rightly worry about a loose definition of “cooperation” leading to ratcheting by the government. If we are unsure if lack of cooperation is the dominant cause of under-deterrence or if we are concerned with how to define cooperation, the proposal might instead condition a liability release for the firm on a verdict or settlement against individuals. (I assume that the proposal would also have to constrict indemnification for individual settlements if not insurance). The problem with this alternative is that it might create too strong an incentive to scapegoat (a problem, my fellow commentator, Professor Krawiec, has written about). Calibrating the trigger for release of leveraged sanctions seems extremely tricky.
Then there is the question of calibrating the size and nature (civil, criminal) of the leveraged sanction. Would the sanction on the firm be larger than the liability an individual would face? Trying to work out the size of the sanction in more detail may be too much to add to this paper, and Velikonja makes the wise decision to frame the question in terms of comparing alternative solutions rather than talking about optimal deterrence. However, I am not yet convinced that these calibration problems with leveraged sanctions are easier to solve than the calibration problem Velikonja identifies with an alternative solution – namely better design of executive compensation.
Velikonja considers over-deterrence (p. 47), but I’d like to read just a little bit more on this too. Management and employees will still need to exercise judgment in divining the line between “aggressive accounting” and fraud. How careful should they be? Velikonja writes “…there is no social value in aggressive accounting.” (p. 48) To play devil’s advocate, where is the dividing line between aggressive accounting and a valid exercise of discretion among different options to reflect the financial results of the firm more accurately? Courts answer this problem all the time, but the challenge still remains for firms and employees in day-to-day decisions on accounting. Again, better designed compensation, orienting it towards long term firm performance, may be easier to resolve than this question of over-deterrence.
These comments shouldn’t be construed to mean the paper should have focused on executive compensation or some other solution to the problem of accounting fraud. Quite the contrary: this author, her ideas and her proposal are so engaging and stand out so much in a crowded field, that I would like to hear more of her.
David gave us a timely and accurate summary of Free Enterprise Fund v. Public Company Accounting Oversight Board shortly after the opinion was released, and Donna Nagy offered additional commentary. It took me a few days to get to the opinion, but now that I have read it, I have two brief comments:
- What passes for constitutional law in this opinion is a policy decision without (much) empirical foundation. Of course, this isn't the only instance when the Supreme Court is forced to make such decisions, but I thought Justice Breyer framed the central question of the case nicely: "To what extent ... is the Act’s 'for cause' provision likely, as a practical matter, to limit the President’s exercise of executive authority?"
This is an empirical question, and Justice Breyer offer several anecdotes illustrating ways in which a President informally exercises power over administrators, thus suggesting that the "for cause" provision is not unduly detrimental to Presidential power. The majority responds by deflection: "In its pursuit of a 'workable government,' Congress cannot reduce the Chief Magistrate to a cajoler-in-chief." Cute ... but it elides the issue. Where Justice Breyer seeks evidence of the effects of two layers of for-cause tenure, the majority settles for a rough sense of the right limit: "two layers are not the same as one."
I am happy with the majority's outcome because it comports with my sense of the right limit. I might be even happier if they would acknowledge that "one layer is not the same as none." In any event, the more interesting point to me is that a little evidence would go a long way in situations like this. Do for-cause provisions matter in the real world? How much to they change behavior? I don't know if anyone has done this research, but we are seeing more of this sort of scholarship as more law professors with training in empirical methods enter the academy.
- A second empirical question -- albeit one that seems harder to measure than the first -- is whether limitations on Presidential power necessarily result in expansions of legislative power. Again, Justice Breyer frames the issue, citing Freytag v. Commissioner, 501 U. S. 868, 878 (1991): "The Court has said that '[o]ur separation-of-powers jurisprudence generally focuses on the danger of one branch’s aggrandizing its power at the expense of another branch.'" According to Breyer, the statutory provisions in question do not aggrandize power to Congress because "Congress has not granted itself any role in removing the members of the Accounting Board." The majority, by contrast, observes: "Congress has plenary control over the salary, duties, and even existence of executive offices. Only Presidential oversight can counter its influence."
All very interesting, and I would probably give the nod to the majority, but I was also interested to note soon-to-be-Justice Kagan's views on this issue: “As a practical matter, successful insulation of administration from the President―even if accomplished in the name of ‘independence’―will tend to enhance Congress’s own authority over the insulated activity.” Elena Kagan, Presidential Administration, 114 Harv. L. Rev. 2245, 2271 n. 93 (2001).