If you like worrying about the future of business news, you might like this profile of Henry Blodget in the New Yorker, with the Times take here. Business Insider is so, so dumb, and yet the new model for content, where good writing appears to be discouraged (see also Huffington Post, eHow, LiveStrong, Amalgamated Content, etc, etc). That said, I'm generally impressed with Blodget, who was a pretty sympathetic defendant during the Eliot Spitzer era, and who completely reinvented himself as a journalist, and then as a content entrepreneur. He's a pretty good journalist, too (his eye for talent, though...I'm just going to assume he's excellent at paying low).
The newsy bit is that he's contemplating seeking to have his lifetime bar overturned. And the question to me is "why bother?" You'd only want to do it if he's looking to sell BI asap, and if - and this could be true - it isn't very profitable, meaning he'd prefer to be back in finance. That would be yet another career change, and in its own way depressing from the perspective of consumers of business journalism too - a field so unprofitable that it does not even pay to do it poorly.
Andrew Mason, the CEO of Groupon, wrote a pretty nice exit letter when the board fired him. But the annotation by Marc Andreesen and Bo Horowitz is also illuminating, if you like that tech start-up kind of thing.
HT: Felix Salmon
Avis is buying Zipcar for $500 million. That's a hefty premium over Zipcar's current stock price, but a hefty discount on the 2011 IPO price for Zipcar. Way back in 2003, when I first heard about Zipcar, I wrote: "this does not look like it has the potential to be a big business, and it will not survive as a small business." It took 10 years to play out, but I was right.
Now the question turns to this: is car-sharing a viable business for the large car rental companies? While car sharing has a constituency -- "we live in a Zipcar world right now" -- it's still small. The hoped-for synergy in this alliance is that Zipcar and Avis have different usage cycles:
Zipcar utilization is low during weekdays but spikes during weekends, resulting in excess fleet vehicles during the week that often aren't used. Avis, meanwhile, has utilization that peaks during the midweek commercial-travel period and has excess capacity on the weekends.
That makes sense, and Avis investors are applauding.
Today saw yet another big ticket government lawsuit against yet another large financial conglomerate alleging deceptive conduct in selling either mortgages or mortgage-backed securities. What is truly interesting is not the similarities among the October lawsuits, but the differences. The various recent lawsuits against Wall Street firms have been brought by both federal and state officials using an arsenal of different statutes and targeting different pipes in the mortgage market plumbing. Instead of using federal securities laws, federal and state prosecutors have looked to older statutes like the Civil War era False Claims Act and New York's pre-New Deal Martin Act in bringing the three big October cases.
Here is a rough rundown of these three big headline-grabbing cases from October as well as another cluster of suits brought last September by the Federal Housing Finance Agency (the conservator that took control of Freddie and Fannie): (David Zaring has summarized and analyzed the individual October cases as they have come out):
Government Entity Bringing Suit
Principal Statutes Used
U.S. Attorney SDNY suing for loans sold to Freddie Mac and Fannie Mae; (FHFA and TARP also involved).
Federal False Claims Act; FIRREA
U.S. Attorney SDNY suing based on FHA insured mortgages (HUD also involved in suit).
Federal False Claims Act; FiRREA
New York AG
NY Martin Act
FHFA as conservator of Freddie and Fannie
Mix of federal and state securities antifraud provisions
Each lawsuit involves a fairly discrete set of causes of action. In each case, the government theory is slightly different.
What explains this? Why not bring a similar suit against every bank or throw in the kitchen sink of claims in each case? The federal and state actions have become much more coordinated – as witnessed by the federal mortgage task force involvement in New York state's JP Morgan suit.
It could be that the conduct of different banks, their different business models, and their interactions with different entities in the federal mortgage universe merited different causes of action or legal theories. That explanation doesn’t seem to offer a complete explanation given the breadth of mortgage operations at large financial conglomerates and the likelihood that any deceptive conduct that occurred would be unlikely to be concentrated in only one corner (whether FHA-insured mortgages or sales of mortgages to Freddie/Fannie or representations to MBS investors).
Perhaps the federal/state coordination created a division of labor strategy or a move to share the litigation risk and reward.
Or these lawsuits might involve a diversification strategy. Rather than putting all the litigation eggs in the basket of one statute or legal theory, the prosecutors and government lawyers involved might look to try different causes of action against different firms. If one theory fails, the whole litigation enterprise doesn’t go up in smoke. If one theory appears to be sticking, perhaps it can be copied against other banks (assuming the statute of limitations hasn’t run out and other legal hurdles can be cleared).
A number of targeted suits may allow for quicker and cleaner litigation and make a case easier to present to a judge or jury than a kitchen-sink of multiple claims. One could take the idea of a “theory of the case” seriously and see this approach to litigation as a series of experiments – where individual causes of action are tested.
This more targeted approach is not free from criticism. It doesn’t offer a cathartic Ragnarök. However, that view of litigation is more a construct of Hollywood. More importantly, this diversity of cases opens federal and state officials up to criticisms of the potential unfairness and waste of multiple lawsuits brought by multiple parties.
Another question lingers: why did it take so long for these October lawsuits to be brought?
At midnight, several hours before Vikram Pandit resigned, Bloomberg ran a story about a speech in which Pandit criticized federal regulators for not addressing the shadow banking system. I have previously expressed some views on shadow banking. I told Bloomberg about the irony of the CEO of a global investment bank calling for more regulation of a system in which investment banks not only actively participate but, moreover, serve as central hubs.
Events in Mr. Pandit's career today overtook the story.
But it is useful to remember the key role that shadow banking markets (asset-backed securities, asset-backed commercial paper, money-market mutual funds, repos, credit derivatives) played in the financial crisis and in Citi's operations. These markets served many of the same economic functions as traditional depository banks (providing credit and theoretically safe and liquid investments). The crisis revealed that these markets suffered the same types of crises as banks (shadow bank runs). The federal bailouts then deployed the same conceptual tools that governments historically used to address banking crises (government as lender-of-last-resort and effective deposit insurance). Now the question is whether these markets should be regulated to reduce moral hazard, just like banks are.
Pandit's abrupt resignation may have deprived us of having a clearer sense of what shadow banking is and the risks it poses. It is not a rhetorical device to hint at some unspecified set of institutions that sit outside regulation. Shadow banking is actually very much about investment banks and regulated entities at play in less regulated markets.
We have decided to convene a late summer forum of the Conglomerate Masters -- our roster of distinguished corporate and financial law professors -- to discuss the current state of corporate social responsibility. In particular, we wanted to address the controversy over Chick-fil-A's corporate stance against same sex marriage and to use this Economist blog post as a jumping off-point.
The Economist blogger contends that Chick-fil-A's culture is in fact a prime example of a firm embracing corporate social responsibility (or "CSR") - albeit not with the politics that one traditionally associates with that movement. The blogger concludes that the Chick-fil-A example demonstrates that matters of social policy should best be left to democratic institutions. He or she writes:
Matters of moral truth aside, what's the difference between buying a little social justice with your coffee and buying a little Christian traditionalism with your chicken? There is no difference. Which speaks to my proposition that CSR, when married to norms of ethical consumption, will inevitably incite bouts of culture-war strife. CSR with honest moral content, as opposed to anodyne public-relations campaigns about "values", is a recipe for the politicisation of production and sales. But if we also promote politicised consumption, we're asking consumers to punish companies whose ideas about social responsibility clash with our own. Or, to put it another way, CSR that takes moral disagreement and diversity seriously—that really isn't a way of using corporations as instruments for the enactment of progressive social change that voters can't be convinced to support—asks companies with controversial ideas about social responsibility to screw over their owners and creditors and employees for...what?
It is a provocative argument. Although one wonders if the author would have made this same series of arguments in the 1960s: would the author have encouraged civil rights protesters to abandon lunch-counter sit-ins and lobby state legislators instead?
Still, the Chick-fil-A example raises some disquieting questions for CSR, which our Masters may address. These include:
Is corporate law the most effective or legitimate tool for social change? If we are worried about environmental degradation, is the solution to broaden the stakeholders to whom a corporation must answer? Or shouldn't we look instead to environmental law?
Is CSR viewpoint neutral? When covering CSR in a Corporations course, I ask students whether social activists who are lobbying a corporation to change what they see as immoral employment practices, should be able to put their views to a shareholder vote? Then I ask whether the answer would or should change based on whether the activists are looking to end racial or gender discrimination or whether they are lobbying a company to stop offering benefits to partners in same sex couples.
At the same time, the current state of legal affairs raises some disquieting questions for opponents of CSR too. The conclusion in the Economist blog -- leave social policy to democratic institutions and public law -- has a long lineage. It harkens back to Milton Friedman's arguments that corporations and the states do and should exist in separate spheres; if citizens want to change corporate policy, the argument goes, they should act through the political process and push through public regulation.
But, the separate spheres argument looks more and more outdated, as corporations influence and permeate the sphere of government. Do arguments to leave regulating the public dimension of corporate behavior out of corporate law and governance -- and leave it to traditional legislative and regulatory bodies -- appear naive in a post-Citizens United (and post-public choice)world?
Also, do these same questions for proponents and critics of CSR apply in equal measure to the growing field of social entrepreneurship? Can entrepreneurs do well while doing good? Should we expect them too? Is social entrepreneurship a workable, stable, and viewpoint neutral concept? If so, what does it entail? Does/should CSR apply equally to small businesses and startups as to global corporations?
We look forward to hearing from our Masters...
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Massey Energy and Walmart made headlines last week for different reasons. Massey had the worst mining disaster in 40 years, killing 29 employees and entered into a nonprescution agreement with the Department of Justice. The DOJ has stated in the past that these agreements balance the interests of penalizing offending companies, compensating victims and stopping criminal conduct “without the loss of jobs, the loss of pensions, and other significant negative consequences to innocent parties who played no role in the criminal conduct, were unaware of it, or were unable to prevent it.”
Massey’s new owner Alpha Natural Resources, has agreed to pay $210 million dollars in fines to the government, compensation to the families of the deceased miners and for safety improvements (the latter may be tax-deductible). The government’s 972-page report concluded that the root cause was Massey’s “systematic, intentional and aggressive efforts” to conceal life threatening safety violations. The company maintained a doctored set of safety records for investigators, intimidated workers who complained of safety issues, warned miners when inspectors were coming (a crime), and had 370 violations. The mine had been shut down 48 times in the previous year and reopened once violations were fixed. 112 miners had had no basic safety training at all. Only one executive has been convicted of destroying documents and obstruction, and investigations on other executives are pending. However, the company itself has escaped prosecution for violations of the Mine Safety and Health Act, conspiracy or obstruction of justice. Perhaps new ownership swayed prosecutors and if Massey had its same owners, things would be different. But is this really justice? The miner’s families receiving the settlement certainly don’t think so.
Walmart announced in its 10-Q that based upon a compliance review and other sources (Dodd-Frank whistleblowers maybe?), it had informed both the SEC and DOJ that it was conducting a worldwide review of its practices to ensure that there were no violations of the Foreign Corrupt Practices Act (“FCPA”). Although no facts have come out in the Walmart case and I have no personal knowledge of the circumstances, let’s assume for the sake of this post that Walmart has a robust compliance program, which takes a risk based approach to training its two million employees in what they need to know (the greeter in Tulsa may not need in-depth training on bribery and corruption but the warehouse manager and office workers in Brazil and China do). Let’s also assume that Walmart can hire the best attorneys, investigators and consultants around, and based on their advice, chose to disclose to the government that they were conducting an internal investigation. Let’s further assume that the incidents are not widespread and may involve a few rogue managers around the world, who have chosen to ignore the training and the policies and a strong tone at the top.
As is common today, let’s also assume that depending on what they find, the company will do what every good “corporate citizen” does to avoid indictment --disclose all factual findings and underlying information of its internal investigation, waive the attorney client privilege and work product protection, fire employees, replace management, possibly cut off payment of legal fees for those under investigation, and actively participate in any government investigations of employees, competitors, agents and vendors.
Should this idealized version of Walmart be treated the same as Massey Energy? (For a great compilation of essays on the potential conflicts between the company and its employees, read Prosecutors in the Boardroom: Using Criminal Law to Regulate Corporate Conduct, edited by Anthony and Rachel Barkow). Should they both be charged and face trial or should they get deferred or nonprosecution agreements for cooperation? Do these NPAs and DPAs erode our sense of justice or should there be an additional alternative for companies that have done the right thing -- an affirmative defense?
A discussion of the history of corporate criminal liability would be too detailed for this post, but in its most simplistic form, ever since the 1909 case of New York Central & Hudson River Railroad Co v. United States, companies have endured strict liability for the criminal acts of employees who were acting within the scope of their employment and who were motivated in part by an intent to benefit the corporation. As case law has evolved, companies face this liability even if the employee flouted clear rules and mandates and the company has a state of the art compliance program and corporate culture. In reality, no matter how much money, time or effort a company spends to train and inculcate values into its employees, agents and vendors, there is no guarantee that their employees will neither intentionally nor unintentionally violate the law.
The DOJ has reiterated this 1909 standard in its policy documents. And because so few corporations go to trial and instead enter into DPAs or NPAs, we don’t know whether the compliance programs in place would have led to either the potential 400% increase or 95% decrease in fines and penalties under the Federal Sentencing Guidelines because judges aren’t making those determinations. The DPAs are now providing more information about corporate compliance reporting provisions, but again, even if a company already had all of those practices in place, and a rogue group of employees ignored them, the company faces the criminal liability. The Ethical Resource Center is preparing a report in celebration of the 20th Anniversary of the Sentencing Guidelines with recommendations for the U.S. Sentencing Commission, members of Congress, the DOJ and other enforcement agencies. They are excellent and timely, but they do not go far enough.
A Massey Energy should not receive the same treatment as my idealized model corporate citizen Walmart. Instead, I agree with Larry Thompson, formerly of the DOJ and now a general counsel and others who propose an affirmative defense for an effective compliance program- not simply as possible reduction in a fine or a DPA or NPA.
While the ideal standard would require prosecutors to prove that upper management was willfully blind or negligent regarding the conduct, this proposed standard may presume corporate involvement or condonation of wrongful conduct but allow the company to rebut this presumption with a defense.
In the past decade, companies drastically changed their antiharassment programs after the Supreme Court cases of Fargher and Ellerth allowed for an affirmative defense. The UK Bribery Act also allows for an affirmative defense for implementing “adequate procedures” with six principles of bribery prevention. Interestingly, they too are looking at instituting DPAs.
I would limit a proposed affirmative defense to when nonpolicymaking employees have committed misconduct contrary to law, policy or management instructions. If the company adopted or ratified the conduct and/or did not correct it, it could not avail itself of the defense. The company would have to prove by a preponderance of the evidence that: it has implemented a state of the art program approved and overseen by the board or a designated committee; clearly communicated the corporation’s intent to comply with the law and announced employee penalties for prohibited acts; met or exceeded industry standards and norms; is periodically audited and benchmarked by a third party and has made modifications if necessary; has financial incentives for lawful and penalties unlawful behavior; elevated the compliance officer to report directly to the board or a designated committee (a suggestion rejected in the 2010 amendments to the Sentencing Guidelines); has consistently applied anti-retaliation policies for whistleblowers; voluntarily reported wrongdoing to authorities when appropriate; and of course taken into account what the DOJ has required of offending companies and which is now becoming the standard. The court should have to rule on the defense pre-trial.
Instead of serving as vicarious or deputized prosecutors, under this proposed standard, a corporation’s cooperation with prosecutors will be based on factors more within the corporation's control,rather than the catch-22 they currently face where if employees are guilty, there is no defense. And if the employees are guilty, this would not preclude the government from prosecuting them, as they should.
Responsible corporations now spend significant sums on compliance programs and the reward is simply a reduction in a fine for conduct for which it is vicariously liable and which its policies strictly prohibited. A defense will promote earlier detection and remedying of the wrongdoing, reduce government expenditures, provide more assurance to investors and regulators, allow the government to focus on companies that don’t have effective compliance program, and most important provide incentives for companies to invest in more state of the art programs rather than a cosmetic, check the box initiative because the standard would be higher than what is currently Sentencing Guidelines.
Perhaps only a small number of companies may be able to prevail with this defense. Frankly, corporations won’t want to bear the risk of a trial, but they will at least have a better negotiating position with prosecutors. Moreover, companies that try in good faith to do the right thing won’t be lumped into the same categories as those who invest in the least expensive programs that may pass muster or worse, engage in clearly intentional criminal behavior. If companies have the certainty that there is a chance to use a defense, that will invariably lead to stronger programs that can truly detect and prevent criminal behavior.
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I must admit I have been a bit surprised (though happily so) by the seeming strength of the endorsement and support for Breast Cancer Awareness Month by some sports programs. I have seen this support not only at the professional level, but also with respect to college and even high school sports. Certainly the NFL has done a lot in this regard, from coaches and players' hats, players' cleats, and arm bands to pink symbols on the football field and padding on goal posts. The NFL has provided visible signs of its support and endorsement of the fight against breast cancer. The NFL also has a website pinpointing critical issues related to breast cancer, indicating ways in which people can support the fight, and highlighting personal stories from NFL players and others connected to the NFL. Given the impact and influence of sports in this country, this kind of partnership sends a strong message (with some equally strong resources behind it). Recently, as I was riding in a cab, I noticed a pink cab, and my cab driver told me that the owner of the cab dedicated her all of her fares to the fight against breast cancer. Intrigued, I decided to dig a bit deeper. While I did not find information about that particular pink cab, I did discover that many cab companies across the nation had agreed to paint at least one of their cabs pink and engage in a variety of endeavors aimed at support the fight against breast cancer from donating a portion of their cab fares, to providing free cab rides to those in need of transportation for breast cancer treatment. Like the companies here and here. I think one of the key goals of the CSR movement should be to promote partnerships between the nonprofit and for-profit sectors pursuant to which the for-profit entity helps raise awareness regarding important issues and responsibly uses its particular business resources, expertise, and influence to address those issues. Pink cabs appear to reflect this goal, which is why I found myself trying to hail one when I next needed a cab ride. . .
Another college football scandal, another round of calls for the NCAA to get tough on schools.
Why can’t we just admit that the NCAA is doomed to perpetual failure? Enforcing amateurism in big revenue sports is just a price control on the labor of college-age athletes. Price controls succeed mainly in creating black markets. Although, if they are effectively enforced, price controls can reduce supply.
But does the NCAA really want to reduce supply? Does it really want to enforce its rules? Miami won’t be treated like SMU and have its football program shut down because that would hurt television revenue.
There are really three explanations for why the NCAA seeks to enforce price controls:
1. It sincerely believes that doing so will encourage schools to provide the students who are generating the billions of dollars in revenue to NCAA schools with an education. (This focuses only on the supply side of education and ignores the demand side. It also is only lightly tethered to reality.).
2. It wants to prevent rising labor prices for student athletes from eating into the revenue to schools.
3. It needs to protect the “amateur” brand that it thinks creates such strong demand for its product.
If this last assumption is true, it leads to a perverse result: demand for amateurism threatens to undermine that amateurism. As a result, the NCAA would have to do just enough enforcement to maintain a perception of amateurism.
Likely some combination of all three of the above explanations accounts for the continuing NCAA game: being “shocked, shocked” to find that college athletes are getting paid under the table and then imposing some penalties on schools, but not enough to actually hurt the egg-laying goose.
So let’s be frank. Division 1 football and basketball is about gobs and gobs of money. If universities would like to engage in a little less hypocrisy and actually serve the interests of its money-generating athletes, isn’t it time to actually test the premise of reason number three above? Is amateurism really essential to rabid demand for college football and basketball? Let’s pay college athletes a market rate for bringing in revenue to their schools. Better yet, let’s have schools sponsor professional athletic teams.
Marketplace ran a story on Friday about Walmart's banking operations in Mexico. Glom friend Anna Gelpern has written about the Walmart bank, and she was interviewed for the Marketplace story. I blogged about Walmart's prospects as a U.S. bank here, inspired by my now-colleague Mehrsa Baradaran. The U.S. Walmart bank that Mehrsa and I were imagining bears only a slight resemblance to the Mexican version, which "does not offer car loans or mortgages, but ... offer[s] a credit card so customers can buy Wal-Mart merchandise." By the way, the annual interest rate on the credit card is 60 percent. Still, Anna is sanguine about the development for Mexico, where most of the population does not use a bank:
Whatever the pros and cons of a Wal-Mart bank might be in the United States, they look quite different in an environment where, despite recent growth, there is little credit, no competition, and a fresh history of political, economic, and legal instability. Wal-Mart is among the few actors capable of dislodging the dysfunctional status quo.
Banco Walmart "presents a transnational regulatory dilemma," Anna tells us, and that is the subject of her paper. But Walmart is quickly getting on the map for bank regulators. Earlier this summer, the company opened banking operations in Canada, and Sam's Club has started making small business loans. It looks to me like Walmart is developing institutional competence in banking that will serve it well when it moves on a bigger scale into the U.S.
I love to read "Corner Office" in the Sunday NYT Business section, which presents micro-interviews with interesting executives. On Sunday, Corner Office featured Aaron Levie, who is 25 years old and a co-founder of Box.net. Box.net is a successful venture capital-funded start-up that provides a web-based platform for companies to store and share documents.
I like to read the answers to question about what the executive looks for in hiring, particularly if there are any nuggest of wisdom we can use in the law firm hiring world. Two things stood out here.
One, Levie says that he looks for are "energy and persistence. . . in addition to just having a clean résumé where there's nothing crazy going on. In a business like ours, we have to be super, super competitive." What does that mean? I'm not sure. The "clean résumé" says to me that he looks for a very linear, driven personality. Someone that goes from high school to college to grad school to being CEO in one swoop without any veering off path. The résumé that doesn't show you switching colleges or jobs multiple times. Most people tend to look for people who remind them of themselves, and he is an energetic, persistent person who followed a pretty straight course.
Unfortunately, I think a lot of folks hiring, even in the law school world, look for the "clean résumé." Why do I think this is unfortunate? Because you can't fix a muddy résumé once it's muddy. You can try to make the most recent part as clean as possible, and maybe over time early stuff can fall off the résumé, but it's tough. Is the clean résumé a good proxy for energetic and persistent? Maybe, but one can also grow in energy and persistence over time.
Second, Levie values curiosity as a proxy for "who's going to be energetic and have the right attitude." He wants to interview people who are curious about his business. This reminds me of the dreaded law firm interview question "So, do you have any questions for us?" (Also related to the dreaded law school interview question.) Yes, great questions would show curiosity. But, a few obstacles. One, most law firms have the same business model, so coming up with an authentic question here is difficult. Second, law firm life is fairly conservative and hierarchical, and there may be a fine line between curious and intermeddling. Levie may be looking for someone who'll come in and think outside to improve the business model. Most law firms are not. And maybe that's a problem.
My efforts to prepay my summer rent in Berlin have been a fascinating tour of modern payment systems and foreign currency risk. Here’s the scoop: my rent is due in full June 1st. My landlord would like the money early and agreed to pay the transfer fees if I could prepay. One additional complication, I need to use my University’s credit card.
Xoom is just one of a bevy of new payment systems that have emerged in the last several years. Glompetitor Tim Zinnecker has already pointed out the great article in Wired magazine two months ago on the future of payment systems. When I agreed to prepay, I thought the fees I saved would more than offset the time value of money. What I didn’t anticipate was that little ‘ole me would also be subject to foreign currency risk; I guess I need to read Kim Krawiec’s posts over at the Glompetition on the Greek debt crisis on a more regular basis. In all seriousness, I do feel blessed though that my personal stakes in the foreign currency swings are so trivial (so far) compared to what many in Europe are going through.
My first reaction to the SEC's Goldman case was skeptical, and it now appears that there are plenty of commentators who agree. I've since had a chance to look more closely at the complaint, and, while as complaints go, it is a model of brevity and clarity, I'm still unconvinced by the case.
- Much has been made of the fact that Paulson helped pick the securities in the instrument that he wanted to short. I'm not sure that we'd want to start policing real estate brokers for getting tips on properties to sell from people interested in selling, and that doesn't seem too different to me than this. Someone had to pick the assets referenced by the CDO, and requiring them to be a mirror of the state of the residential market is both silly and impossible. And as the complaint itself notes, ACA (the manager of the debt obligation at issue in the case) was getting emails entitled "Paulson Portfolio" during their involvement in selecting collateral.
- Fraud of omission is always a troubling claim to make, but that's what the SEC's complaint relies on in large part. Paulson's role "was not mentioned" to purchasers of the upside of the CDO. Again, Paulson was hardly known for his brilliance when the transaction was designed, so I doubt it would have made a difference. As for the number of things that could have been mentioned, but were not, when some big banks made long bets in favor of US residential mortgage market (and see John Carney on this), the imagination runs riot.
- Most compelling, to me at least, is the fact that ACA may not have known that Paulson was short, when Goldman knew it. This is because ACA kind of asked Goldman what Paulson was doing. On P46 of the complaint, they sent an email to Goldman after meeting with Paulson saying "we didn't know exactly how they [Paulson] want to participate in the space. Can you give us some feedback?" That feedback is not, potentially, fraud by omission, it's fraud by commission. Still, ACA knew Paulson's fingerprints were all over the deal.
- And, of course, a fundamental problem for the SEC is the sophisticated nature of every party to the transaction. The SEC often describes its mission as one of consumer protection. But the consumers in this case didn't need to be protected. They weren't even consumers, as you or I often think of that term. They were traders.
- A final note on relief. The prayer for relief is standard, but most banks can overcome fines and disgorgement - Goldman certainly can. That prayer for a judgment "Permanently restraining and enjoining GS&Co and Tourre from violating section 17(a) of the Securities Act....Section 10(b) of the Exchange Act....and Exchange Act Rule 10b-5" is a bit like the yellow card of securities enforcement. Violate it again, and you could get red carded from the securities industry, let alone exposed to contempt of court orders, which are no laughing matter.
While we are on the subject of pure bets, when will there be a prediction market on the outcome of this case? When will you be able to place your bets?
I am not ready to take an official position - "Goldman is liable" or the "SEC will lose." What law professor would given that we are only at the beginning of learning the facts?
But that doesn't stop you from making educated guesses and bets. There is of course an active arbitrage market on Wall Street betting on the outcome of things like high profile litigation and whether a regulator will allow a merger to go through.
When there is a Goldman prediction market, prices will change as new facts come up.
Is there any social value to this type of bet? -- you can probably predict what I will say if you read a previous post -- depends if any party to a bet has a pre-existing risk.
And there is entertainment value.
Would there be any intellectual value to a prediction market beyond giving me something to blog about? Remember Oliver Wendell Holmes' old adage that law is just a prediction of what a court will do.
Does that mean a prediction market is the law?
Addendum: I wouldn't be at all shocked if lawyers -- even law professors -- will be hired by arbitrageurs to evaluate bets on the case. There may be a lot less professional risk if you are placing a bet without putting your name in writing or on a blog.
Here is a more gossipy question: if you were hiring a lawyer or law professor to help you place a bet on the outcome of the case, who would you pick?
Here is a half serious legal question: could there be market manipulation if a professor then writes statements to influence the price without disclosing her interest?
In a previous post, I noted that the SEC's case that Goldman failed to disclose the Paulson & Co hedge fund's role in selecting the collateral might be weakened, because the investors themselves likely were told which assets went into the CDO. To rehash my metaphor, it isn't as critical to know who selected the deck when you know the cards in the deck. Evidently, I was not alone in this conclusion -- see some of the reactions of other law professors in the NY Times.
Offline, a reader pointed me to a paper that convinced me that I might be completely wrong about this. The paper's conclusions may turn out to have pretty significant implications for this case.
Here's the insight, an October 2009 paper by a team of computer scientists and an economist at Princeton argues that the parties that structure a CDO may be able to hide lemons -- that is assets that they know are subpar -- in the collateral of a CDO through carefully structuring the CDO. The investors in the CDO may find it impossible to detect these lemons even when the collateral is fully disclosed and the investors are sophisticated and have significant computing resources.
Why? The paper (Arora et al., "Computational Complexity and Information Asymmetry in Financial Products") argues that the complex structuring of derivatives can create "computational intractability." In layperson terms, finding the "lemons" can become an inordinately difficult mathematical problem. Unless an investor has unlimited computational power, it may not be able to "solve" the problem and detect the lemons. It's the same problem that occurs with trying to decode computer messages protected with a certain level of encryption. The structuring of the deal functions as a kind of encryption to camoflauge the bad assets.
This means that the party that both selects the collateral and structures a complex derivative (like a synthetic CDO) has a potentially insurmountable information advantage over its counterparties. One blog commentary on the paper likened this advantage of the structurer to being able to hide a booby trap in plain sight. (In an amusing twist, the paper argues that "even Goldman Sachs" wouldn't be able to detect the lemons).
What could this mean for the Goldman case? Many things. First, we shouldn't assume that even when the investors (or ACA, the collateral manager for that matter) knew what the collateral was that they could easily detect any lemons. Arguments that the investors and ACA were sophisticated and should have been able to fend for themselves should be given less weight. Conversely, arguments that investors need to rely on the proper incentives (or at least the disclosure) of both the party that selected the collateral and the party that structured the deal gain a lot more weight.
Second, how the deal was structured (not just how the collateral was selected) may prove to be crucial. From the SEC Complaint, it looks like Goldman structured the deal and that ACA was mainly involved in the collateral selection. It is unclear if Paulson played a role in structuring the deal. Did Goldman structure the deal to "hide" the Paulson-selected assets? Unfortunately, based on the conclusions of the Princeton paper, detecting this hiding is subject to the same intractibility problem. Unless there is some "smoking gun" evidence -- e.g. loose-lipped e-mail correspondence, testimony from Goldman employees. Even the absence of a smoking gun doesn't detract from the first point -- that the investors wouldn't be able to detect lemons even if the collateral was fully disclosed to them.
Third, this insight means that an already complex case may require even more expert witnesses -- let's see if the Princeton team gets a call.
On a personal level, I need to think more about what this means for my own research on using technology to improve securities disclosure and address "complexity."
(I would like to thank the reader (who'd like to remain anonymous) who prompted this post and pointed me to the Princeton paper.)
Addendum 4/21: Several readers have noted that the Princeton study that a seller of assets can hide "lemons" in a CDO through structuring is premised on the fact that the seller enjoys an advantage of asymetric information. We don't know if Paulson had nonpublic information about the assets it wanted in the CDO. If ACA and the CDO investors had access to all the information Paulson did about the assets Paulson requested go into the portfolio. Drawing a bright line between public and nonpublic information is not as easy at it may sound. We could always say that an investor should have done more homework on a particular asset-backed security -- even, to use the Princeton example, inquiring whether there were "liar's loans" backing certain collateral a seller is putting into a CDO. This goes back to a recurring point in my posts -- that how much homework the ACA/investors would do on Paulson-requested collateral and how toughly they would negotiate with Paulson depends on whether they thought he was betting with them or against them.