Category: Securities Regulation


Countrywide Sub Prime Suit May Proceed


Many securities lawsuits arising out of the sub-prime mortgage lending debacle are not showing much promise of success. But an important exception may be that concerning Countrywide. Kevin LaCroix provides analysis of the 112-opinion issued last week denying most defendants’ motions to dismiss the Countrywide securities class action complaint.

The opinion contains several points of special interest because they may seem to go against the weight of authority. This may simply reflect the procedural stage of the case. But they may also suggest that the scale and unusual nature of the sub-prime market may invite judicial reconsideration of some traditional securities law doctrines.

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SEC Schizophrenic on Global Accounting

SEC Seal.gifWith surprising absence of fanfare, the Securities and Exchange Commission released over the weekend a 165-page document outlining its delayed and long-awaited proposals for how the US might switch from using its own generally accepted accounting principles to new international financial reporting standards. The release bears a schizophrenic quality. It offers one unsurprising and one surprising proposal.

The unsurprising portion reflects what the Commission reluctantly came to accept last summer: the US is not ready for such a switch and is not likely to be until 2014 at the earliest. Accordingly, the release principally outlines the many obstacles to such a switch and lays out milestones that would have to be met before considering such a radical move.

The surprising portion contemplates allowing selected US issuers voluntarily to make the switch as early as the year after next—2010. This radical proposal would be limited to US issuers whose industry uses IFRS as the basis of financial reporting more than any other set of standards. The release struggles to explain why this special approach for such issuers overcomes the many obstacles facing other US issuers.

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Crisis Yields Turnabout by SEC Chair

SEC Seal.gifIn a speech Wednesday

at the Practising Law Institute’s program on securities regulation, the historically arch-conservative, deregulatory Chair of the Securities and Exchange Commission, Christopher Cox, offered very surprising recommendations for financial regulation reform based on lessons taught by the current economic meltdown. Highlights include:

1. Establishing a Congressional Select Committee on Financial Services Regulatory Reform.

2. Merging the SEC and the Commodity Futures Trading Commission “with a clear mandate to protect investors by regulating the markets in all financial investments, including securities, futures, and derivatives.” Many such calls have been made, dating to the 1987 market crash to the Treasury Department’s March 2008 blueprint for financial regulation reform. Most propose diluting the resulting agency by having the merged agency adopt the lax approach to regulation used by the CFTC rather than the relatively tight approach of the SEC. Mr. Cox’s statement emphatically prescribes sticking with traditional SEC approaches in the resulting merged agency. He says the crises “highlight the need for a strong SEC.”

3. Merging all existing bank regulators, of which there are six at the federal level and scores at state levels. Again, this proposal has been often made, including by Treasury, although Mr. Cox again signals an urgency and muscularity that differs from the looser supervisory approach Treasury contemplated. Mr. Cox says: “the lessons of the credit crisis all point to the need for strong and effective regulation.” He contrasts the traditionally “strong SEC” with the comparatively lax banking regulatory structure: the SEC is independent of those it regulates. In contrast: “banks regulated by the Federal Reserve Bank of New York elect six of the nine seats on the board of the New York Fed. Both the CEOs of J.P. Morgan Chase and Lehman Brothers served on the New York Fed board at the beginning of the credit crisis.”

4. Mr. Cox also takes the lessons from the crisis to reject proposals, made as recently as a year ago, to weaken US regulations on the grounds such regulation results in the US losing financial business to less-regulated markets. The “mortgage meltdown” and “credit crisis” show that what is needed is strong regulation backed by statute, not mere supervision, voluntary compliance, weaker regulation or limited enforcement, Mr. Cox said.

The speech overall is an impassioned defense of a strong SEC, and strong regulation. Numerous SEC observers over Mr. Cox’s tenure may recognize this as a bit of a turnabout for him.


Capitalism and Regulation

dollar sign.jpgThis weekend’s talk among world leaders will be accompanied by opposing diagnoses of economic failure and prescriptions for correction and prevention. The outgoing President of the United States sought to frame discussion in a speech yesterday extolling the virtues of unbridled free-market capitalism, warning that government regulation is a danger not a solution. In contrast, the continuing President of France and Prime Minister of Great Britain signal interest in devising an elaborate international, government-sponsored regulatory structure at global levels, to modulate capitalism’s most acute downsides.

Neither of these extremes is likely to hold. All modern capitalistic economies involve considerable government regulation and no advanced modern government is likely to cede sufficient national sovereignty to international regulatory authorities to forge a single global financial regulator. Reality suggests a combination of continued or enhanced national regulatory oversight with perhaps greater international coordination among senior national regulators.

Deeper policy talk may turn to the form regulations should assume within nations to enhance oversight and facilitate coordination. This may refashion discussion about whether rules or standards are superior. No slogan has been more popular in financial regulatory circles in the past few years than “principles-based systems” as contrasted to “rules-based systems.” Conservative reformers in the US, including current Treasury Department leadership, had been condemning the US system as “rules-based” and celebrating the “principles-based systems” they assert exist in the UK and Europe.

Regulation in general, and rules in particular, are a problem not a solution, in this view. If any regulation is politically necessary or economically justified, it would assume the form of broad general expressions of expected conduct, as standards or principles, not rules. This approach enables reposing maximal discretion in targeted actors, letting them exploit opportunities and take risks sans regulatory shackles. Opponents, skeptical of such discretion, contend that, at least for some purposes, strict rules are required to restrain excesses to which such actions can lead. When taking stances on the form of national and international financial regulation in coming discussions, participants may need to confront several fundamental questions.

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Rating Agencies: Disease and Cure

Today Congress put credit rating agencies on the hot seat during intense hearings. Rating agencies, including Moody’s and Standard & Poor’s, gave top grades to debt the credit crisis is now showing everyone was junky. Scholars have long berated the rating agencies, especially Frank Partnoy. The fundamental problem is that securities issuers pay the rating agencies their fees. The proverbial result: whose bread I eat, his song I sing. Also, law requires very little of rating agencies and essentially insulates them from liability to investors harmed by irresponsible ratings.

As Congress turns hearings into policymaking, Members should consider new scholarship from Jeffrey Manns forthcoming in North Carolina Law Review. He proposes that investors, not issuers, pay rating agencies. The so-called user fee system is coordinated mainly by investors, those owning rated bonds, with a government agency coordinating the system in the pre-issuance stages of a rated debt offering. In addition, rating agencies would have to certify their ratings much as auditors certify their audits. Also like auditors, agencies would be required by law to disclose discovered fraud or illegal acts at issuers whose securities they rate.

The proposal is timely and sensible. Inevitably, it contains elements worthy of debate as well. In particular, the proposal contemplates applying a standard of gross negligence for investor recovery for rating agency violations. The standard for auditors generally is the tougher one of recklessness. In addition, the proposal caps rating agency damages measured in relation to earnings from the botched rating. Despite decades of campaigning by auditor lobbyists for such a cap on their damages, they have not been able to win this victory. Also, alas, auditors continue to be paid by the clients whose financial statements they audit (which I’ve proposed addressing by using financial statement insurance or capital market funding to prevent destroying the auditing industry).

Those interested in preliminary diagnosis of causes and cures for the current crisis should read Manns’ new article. My guess is that everyone who has written or thought about the rating agency’s role in our corporate finance system will consider the piece must reading.


“Interim Final Temporary Rule”?

What should regulated persons make of a federal agency describing a binding regulation as an “interim final temporary rule”? That’s the self-titling the Securities and Exchange Commission gives to two (here and here) of its latest in a series of controversial regulations concerning short selling of securities (selling securities one doesn’t own at a current price to be delivered in the future after buying them at an expected lower price).

The strange nomenclature may be due to difficulties the SEC has faced trying to create a sensible policy on short selling as it struggles with a role to play in addressing the credit crisis. It settled on restricting short selling in the name of trying to prop up prices of equity securities. It adopted emergency measures, and amended and expanded these then allowed them to lapse and is now reviving its effort to play a role. Everything it has done has been subject to criticism and second-guessing, with some evidence indicating that its efforts have exacerbated equity market performance rather than helped.

The SEC now adopts these two “interim final temporary rules,” trying to micro-regulate short selling with greater precision. Separately, it also adopted more traditional forms of regulation more in keeping with its longstanding regulatory philosophy, establishing anti-fraud principles.

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The SEC’s Failed Cover Up

SEC Seal.gif

SEC officials redacted extensive portions of the agency’s internal watchdog’s report exposing its internally documented failures overseeing failed investment bank, Bear Stearns. But an unredacted version is published by Senator Charles Grassley, Senate Banking Committee Member who requested the study.

The failed cover up is ironic for an agency charged with promoting transparency in corporate America. It makes a mockery of todays’s SEC roundtable on how the SEC can help investors by promoting corporate transparency.

Many of the failed deletions refer to internal SEC documents showing that the SEC knew of problems that it left unaddressed. Also deleted are judgments the inspector makes about SEC performance, including one concerning the existence of ignored red flags.

It is not obvious why it is appropriate for SEC officials to delete these materials. Indeed, Senator Grassley obviously believes there is no basis for doing so. Below I highlight differences between the SEC’s redacted version (available in full here) and Senator Grassley’s published version of the original (available in full here).

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