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).
So, we've seen a few movies this winter break. I will spare you a run-down of Alvin and the Chipmunks: The Squeakquel, which is exactly what you would expect it to be, no more and no less. However, for the sake of the older child, I have seen 3 movies steered at an older crowd, and they have slightly more complex appeal.
Avatar. I had seen the preview to this and actually said, "I have no interest in seeing that." But then our sixth graders and her two friends absolutely had to see it in opening night, in 3-D. So, somebody had to sit through it. However, I really enjoyed it. Yes, the plot sort of goes where you think it will go, and yes, it is a mash-up of Dances With Wolves and a lot of other movies you've already seen. But it's still great. Sort of like how Star Wars was great in spite of the story, dialogue, acting, etc. Now that every other movie is coming out in 3-D, it's hard to see the attraction, until you see a movie that was really made for 3-D, which this one is. The first preview started at 9:00 p.m. and we walked out at 12:15 a.m., but I could have seen it again. The big forces in today's world are all represented: Science, Capitalism, the Military and Nature. Guess who wins? If you haven't seen it, put your skepticism aside and go. As for kids, it really isn't meant for kids, even though the movie was featured on Happy Meal bags for some reason. It is pretty violent, and the human character likes to say PG-13 words over and over and over. The sixth grade girls liked it though because it's really a love story.
The Blind Side. We have an eight-year-old who is crazy about football, but we knew we had to see it first before we could take him. Good call. There were definitely a couple of scenes that are worth waiting for the DVD to skip over. We had both read the excellent book by Michael Lewis and were hoping that the movie didn't ruin the story. It didn't. We really enjoyed the movie and thought it kept the heart of the story. Yes, it's all sweet and mushy, but it's a feel-good kind of story. If you have no idea what I'm talking about, here's an excerpt from the book in the NYT Magazine -- Michael Oher, a boy who literally had no home and lived on friends' couches and barely went to school, lucks into Briarcrest Christian school in Memphis. However, he still has no reliable source of food, clothes or shelter until a family there takes him into their home. The mom turns his life around so that he can qualify to play football in college. Oher is now on the Baltimore Ravens and up for Rookie of the Year. The movie has a few scenes that try to depict the grittiness of Michael's life before he met up with the Tuohys, and I think they do a good job. But no, the real focus is on Michael's life after he begins school and meets up with his new family. Again, don't be a skeptic and enjoy the great story for what it is.
Sherlock Holmes. Our sixth grader wanted to see this movie, so here we went again. The movie is a great romp, and of course Robert Downey, Jr. makes the whole movie. I have to confess never having read any Sherlock Holmes book or even having seen any other book based on the character. I think this put me somewhat behind because I spent too much brain power thinking about who the "mystery character" was, when everyone else knew it was Moriarty. Other than that, I really liked the movie. Some quibbles. To get into the super mind of Sherlock Holmes, the camera does a lot of freeze-frame, slow motion, instant replay, etc. This got a little distracting. Also, I'm never a fan of "brilliant deductive reasoning" that actually hinges both on powers of observation and a huge body of knowledge that the audience does not have. So, is it really an "Aha" moment for the audience when Sherlock Holmes tells us that the flower we all saw was a rhododendron, and we all know that that flower secretes yadda, yadda, yadda that in certain circumstances can do blah, blah, blah. It's a different kind of mystery revelation, but can't be a "how did I miss that?" moment when there's a lot to miss. The movie also involves the now-obligatory secret society Temple of the Four Orders, which seems ho-hum after the Da Vinci Code, et al. and National Treasure, et al. All in all, though, it was very enjoyable and ok for older kids who don't get scared too easily.
Remember all of that talk about how fair-value accounting was exacerbating the financial crisis? A new paper by Christian Laux and Christian Leuz examines that argument and concludes that it is "unlikely that fair-value accounting added to the severity of the 2008 financial crisis in a major way."
If you are attentive to qualifiers -- "unlikely" and "major" -- you can see that the argument is not a slam dunk, but the authors do a nice job of walking through the fair-value accounting rules and explaining the exceptions and safeguards that would have muted their effect. If you don't want to wade through the whole paper, you may prefer the blog post.
I read a WSJ op-ed last week, and it's still bothering me. The SEC vs. CEO Pay bubbles with outrage from its opening sentence: "A lawsuit filed on July 22 by the Securities and Exchange Commission (SEC) should send a mid-summer chill down the spine of every chief executive and chief financial officer of a U.S. public company."
What's amiss in corporate America, you ask? Well, the problem is a change in the SEC's enforcement of Sarbanes-Oxley Section 304, the clawback provision. Section 304 provides that if a company issues an accounting restatement "as a result of misconduct", and the CEO or CFO received bonuses or made money on stock sales based on numbers that were later proved to be inflated (thus necessitating the restatement), then those bonuses or stock sales could be "clawed back," i.e., paid back to the company.
Until recently the SEC only went after CEOs that perpetuated or were aware of the "misconduct" under 304, but a few weeks ago the agency sued a CEO without alleging that he himself engaged in the fraud. Russell Ryan, author of the op-ed, is outraged, asserting that the SEC has "stretched the law". But elsewhere he acknowledges that
in its haste to “do something” about the scandal of the day, Congress muddied the question of whether the “misconduct” required for such a clawback had to be committed by the executive himself (or at least known to him), or could be that of a subordinate, completely unbeknownst to the executive.
Because of these "muddy waters," it wasn't entirely clear what 304 meant, and "[m]any executives and legal advisers have cautiously assumed that bonuses and stock proceeds were at risk only for executives who actually engaged in misconduct themselves—or at least were aware of it and acquiesced." An all-too-familiar story these days: hasty legislation that leaves executives walking on eggshells, unsure of exactly what the law requires.
Ryan concludes: "On a visceral level, it seems shocking that a U.S. law enforcement agency could take more than $4 million from any citizen without so much as an accusation of personal misconduct, or at least knowing acquiescence in someone else’s misconduct."
Are my viscera out of step with everyone else's? I'm just not all that fussed. I mean you could interpret SOX 304 to say to executives, "If you get a bonus because you meet a goal, and it later turns out that the goal wasn't really met because someone messed with the numbers, then you need to give the money back. Even if you didn't do anything wrong, you didn't really earn that money." As I read them, this is how the newer vintage TARP clawback provisions work: financial institutions can recover any bonus or incentive compensation paid to senior executives based on statements of earnings or gains later proven to be materially inaccurate--no misconduct needed.
What's troubling to me is that the SEC suddenly changed its interpretation. After 5 years, expectations become settled, and changing course seems arbitrary. This point underlines the amount of discretion the agency has over enforcement, which might be the biggest lesson to come out of my recent work with Mike Stegemoller: there's the law on the books and then there's the law as enforced. But Ryan seems to me to be barking up the wrong tree by attacking the SEC's interpretation of 304. Or is my gut wrong?
Gordon pointed you to Donna Nagy's brief (and Larry Ribstein's) yesterday for the Free Enterprise Fund v. PCOAB case, in which she and a number of other eminent law professors point out the constitutional problems with the Board, which, they argue, is inconsistent with constitutional separation of powers principles.
I wanted to follow up a bit here, because the Board is a strange entity indeed - a pretty independent creature of the SEC, which is itself pretty independent from presidential control. There are not many (or even any) agencies set up like it. How did Congress think it up? I think the Nagy brief has an interesting point here:
So in other words, PCAOB is set up like an SRO, which is constitutional, but SROs are private entities, while PCAOB is a public entity. It is the public-private distinction which she thinks has tripped up the government - and it wouldn't be the first time. While I don't know if this is a dealbreaker, it is an interesting exercise in how laws get made by looking to the old models ... something that would be rationalizers of our financial regulatory system are realizing to their chagrin.
UPDATE: And yes again.
The Court just granted cert. on the case raising the question whether PCAOB's structure interferes with the President's removal powers. PCAOB's members can only be fired for cause, and are appointed by the SEC, whose members can also only be fired for cause. That insulates them from politicization, but conservatives think it interferes with the "unitary executive" theory by which the president must have a great deal of control over his bureaucracy, due to his responsibility for taking care that the laws be executed.
PCAOB survived D.C. Circuit review over a fiery dissent by a former aide to independent counsel Ken Starr. I don't think it is very difficult to justify the board on constitutional grounds - the unitary executive theory's best day was when Myers v. United States was decided, in 1926, and ever since, various impositions on the President's removal power have been permitted. But I'd bet on it being thrown out by this Court, given this grant, considering the plaintiff (a libertarian public interest group), and the bona fides of the dissent. PCAOB's defenders will have to make a strong case for the functional necessity of the agency (centrist justices may not wish to throw out a unit that is actually performing a critical function or two); that's what saved the SEC itself from the unitary executive theory during the 1930s. It also saved the independent counsel in the mid-1980s, much to everyone's regret later. HT: Volokh
UPDATE: Rick Pildes, who knows a great deal about separation of powers and has represented some former SEC commissioners in the case, makes the case for constitutionality over at Balkinization.
According to the WSJ, the Financial Accounting Standards Board (FASB) is changing its mark-to-market rules tomorrow, "allowing banks to set their own values for certain hard-to-value troubled mortgages, corporate loans and consumer loans...The change was meant to assist U.S. banks after bankers complained current mark-to-market accounting rules forced them to undervalue their assets, by setting prices at deeply discounted, fire-sale values."
The most alarming part of the article is the observation that there is a "disconnect" between this accounting change and the Treasury Plan for banks. Both try to address the central problem of valuing so-called
toxic assets legacy funds. Everyone seems to believe that these assets are "really" worth more than they're selling for now, and therefore that anyone who sells now is losing money they don't have to, because at least some will increase in value.
What do we want banks to do? Hunker down until the storm passes and the assets can be sold for more money than they can get now? If so, and banks are hindered by an accounting rule that forces them to "mark" them down to an artificially low "market" price, then FASB's change of heart could help them eventually see more money. But if we want banks to get rid of these assets, then Treasury's Public-Private Investment Fund (PPIF) could help banks. But then PPIF investors and taxpayers would get the benefit from the expected up-tick in value.
I favor the PPIF idea, on the theory that relaxing mark-to-market gives banks an incentive to "wait it out," rather than deal with the central problem of valuation and facing up to losses. Still, I'd hate to have sell anything--a house, a car, a teacher's manual--in this market. Actually, if you're looking for that last one...
The SEC has now chargedFriehling & Horowitz, P.C. with securities fraud in connection with acting as auditor for Bernard Madoff Investment Securities LLC. Press release here.
Whatever this accounting firm did since 1991, it didn't seem to audit anything in connection with BMIS. I can't even imagine a defense that the firm would have in a situation in which it signed off on financial statements that were completely fabricated. In the words of the press release: "Friehling essentially sold his license to Madoff for more than 17 years."
Early reports of accounting fraud at Indian outsourcing giant Satyam Computer Services sound eerily familiar:
The final blow came in the past few days. The lenders who had loaned money to Mr. Raju to keep the company running began to sell the pledged shares to meet margin calls, or the forced selling of shares to cover losses.
The leader for the WSJ:
The chairman of one of India's largest information technology companies admitted he concocted key financial results including a fictitious cash balance of more than $1 billion.10 years ago I was a lowly paralegal, fresh from an abortive career in literature, working on a securities class action against a California chip-maker. I had always thought business was mysterious and impenetrable, and that financial fraud must be sophisticated beyond my ken. It was a revelation that smart, powerful businesspeople occassionally decide that it's a good idea to make numbers up, trusting that "gaps" will close and everything will turn out okay in the end. I may be naive, or even gullible, but my reaction is still, "You really thought no one was going to notice? A billion dollars? Really?"
We've told you that valuing assets ain't easy these days. Indeed, "these the times that try one's sells" (love that line). Bainbridge thinks that the SEC advice on mark to market flexibility doesn't do anything. Larry Cunningham thinks it could, but it's a novel use of accountancy. Ribstein thinks it is corrupt, John Carney thinks it requires guessing how the government will price the assets, and well-known short James Chanos says that valuation flexibility will just mean that the banks overprice them more.
The SEC revisited its fair value accounting standards today, as Usha predicted. Here's the SEC statement, and Floyd Norris has insights here and here. We speculated that the bailout would eventually take a criminal tinge, Doug Berman agrees.