Eyes On Wall Street

Investors Punish Carlyle Group

Michael Stocker — Fri, 11 May 2012 13:49:21 -0500

The market for initial public offerings has been heating up since early this year. But with so much investor interest in newly minted issues, one has to wonder why Carlyle Group, the private equity investment partnership with a well-heeled Rolodex that includes the Bush family, France’s Sarkozy family, and Britain’s John Major, would have to scale back its asking price.

But that is just what happened. Rather than price Carlyle Group’s IPO between $23 and $25 – figures that company executives had for months called conservative – underwriters closed the transaction at $22 per share on the evening of May 2, 2012. One reason that should not be overlooked is the blind faith in management that Carlyle Group demands on the part of its shareholders.

While the last year has seen an erosion in shareholder rights in many corporations, Carlyle Group's governance structure is truly draconian. Shareholders will have no ability to elect members of the governing board and there is no plan for annual shareholder meetings. Carlyle Group board members will bear almost no fiduciary duty to the company, with the board allowed to act in its sole discretion and without even the fig leaf of a “good faith” requirement.

Carlyle Group was forced under intense pressure from investors and the SEC to scrap its most contentious proposal – a term that would have forbidden shareholder class actions and forced all disputes into confidential arbitration. But the reduced IPO price realized by the Company may be an even more effective message that companies that fail to provide for meaningful governance will be punished by the markets.

Contributed by David Erroll

Volcker Rule Delay Means Party Isn't Over for Proprietary Trading

Michael Stocker — Thu, 08 Mar 2012 16:38:34 -0500

Last week Fed Chairman Ben Bernanke announced a delay in the implementation of the Volcker Rule, news that should make investment banks give a big sigh of relief.

Everyone knows the role that risky asset backed securities played in financial crisis. What's less clear to some people is how the collapse of the market for these exotic instruments almost brought down our banking system.

The problem was that banks were trading in these securities for their own benefit. That is, they weren't buying them on behalf of customers, they were acting as investors themselves.

And when enormous banks make really bad investment decisions, they can bring the financial system down with them. Whether or not you liked the idea of taxpayer bailouts of the big banks, they happened because regulators were afraid that the collapse of the big banks would bring the whole system down.

Unfortunately the bailout also taught the investment banks a valuable lesson. They could make massive, risky bets-- and if they were profitable, they could keep the money. If they failed, taxpayers would pick up the tab. That's a recipe for disaster.

The Volcker Rule, part of the Dodd Frank law passed in 2010, was an attempt to prevent investment banks from taking advantage of their taxpayer safety net by engaging in risky trading. It is a simple idea- a ban on proprietary trading by banks that have the backing of taxpayers.

Not surprisingly, the ban is very unpopular with banks, who have been fighting it tooth and nail. Proprietary or "Prop" trading is often their most profitable business. When the Volcker Rule goes into effect, Goldman Sachs and Morgan Stanley, which have already seen a decline in profitability, could take a hard hit.

While the delay puts off the day of reckoning for the investment banks, the story isn't over yet, as the banks and shareholder advocates continue to wrestle over how the rule should be implemented.

New Capital Formation Initiatives: Hidden Danger for Investors

Michael Stocker — Thu, 01 Mar 2012 15:35:00 -0500

While a raft of new "capital formation" proposals are currently enjoying broad bipartisan support in Congress, they are likely to deeply undermine key investor protections at a time when confidence in the integrity of the markets is more important than ever. One set of bills supporting a process called "crowdfunding" would permit high-risk start-up companies to troll for retail investors over the internet with little regulatory oversight -- a recipe for disaster. Another initiative, termed an "IPO on-ramp" would permit companies with revenues of up to a billion dollars a year to avoid basic disclosure and internal control requirements for up to five years after an IPO. While advocates suggest that these efforts to reduce investor protections will increase the number of IPOs, there has been little attention given to whether investors will be bearing a disproportionate share of the risks.

Fed Raises Stakes for Directors with New Governance Rules

Michael Stocker — Fri, 20 Jan 2012 11:13:05 -0500

Surprising new proposals for corporate governance reforms are being issued by an agency not generally associated with investor protection—the Federal Reserve.

On December 20, 2011, the Federal Reserve Board issued proposed rules to strengthen regulation and supervision of large bank holding companies and systemically important non-bank financial firms. The proposal, which applies to U.S. bank holding companies with consolidated assets of $50 billion or more, addresses issues such as capital, liquidity, credit exposure, stress testing, risk management and early remediation requirements.

However, the new rules also provide for a series of significant corporate governance reforms. The new rules would require better oversight of any covered company’s liquidity risk management by its board of directors, who, together with senior management, would be ultimately responsible for the liquidity risk assumed by the company.

Under the proposed rules, senior management of a covered company would be required to establish and implement liquidity risk management strategies, policies and procedures, and the board of directors would be required to review and approve them. In addition, the company would be required to establish and maintain an independent review function to review and evaluate the adequacy and effectiveness of the company’s liquidity risk management processes.

Contributed by Yoko Goto

Stealth Attack on Volcker Rule

Michael Stocker — Thu, 12 Jan 2012 16:37:13 -0500

Investors hoping for strict enforcement of the new Volcker Rule guarding against risky proprietary investing by big banks shouldn't hold their breath.

The Volcker Rule, part of the Dodd Frank reforms inspired by the financial crisis, restricts U .S. banks from making certain kinds of speculative investments that do not benefit their customers. The rule's provisions are scheduled to be implemented on July 21, 2012.

However, Wall Street interests are fighting to weaken the proposed rule through intense lobbying efforts, vastly outgunning investors and their advocates.

A new Duke University study by Professor Kimberly D. Krawiec,based on agency records, determined that 94 percent of meetings between regulators and private interests regarding the Volcker Rule were arranged by financial institutions and their law firms -- while only six percent of such meetings involved public interest groups and unions. The intensity of industry lobbying should make investors everywhere feel nervous about the final product of the rulemaking process.

Contributed by Jodian Davis

EU Takes A Whack at Credit Rating Agencies

Michael Stocker — Tue, 15 Nov 2011 19:04:18 -0500

Today the EU unveiled the most sweeping reforms to date of the troubled credit rating industry. The proposed rules, which will require the approval of the European Parliament and EU member states, represent some significant progress in ongoing efforts to improve ratings.

The reform proposal includes “mandatory rotation provisions” which would force issuers of financial products in Europe to rotate the credit rating agencies they use at least every three years. In addition, the proposal also contains a “cooling off” provision which would compel issuers to wait four years before hiring the same agency. The purpose of these provisions is to increase competition and reduce conflicts of interest.

While US regulators have been reluctant to intervene in rating methodologies, the reform proposals would give ESMA, the European market regulator, the power to develop technical standards and approve specific rating methods. New rating methodologies, or adjustments to existing models, would have to be open to consultation and submitted to ESMA for approval.

Crucially, the proposed rules include a method for private enforcement, in that they would allow investors to sue credit rating agencies for compensation if they break EU regulations "intentionally or with gross negligence.”

Regulators apparently have dropped one of the most controversial proposed rules, which would have permitted ESMA to ban agencies from rating sovereign debt issued by countries in the process of being bailed out—an edict that would have further undermined the confidence of investors in sovereign debt.

Slowing Down High-Frequency Traders

Michael Stocker — Wed, 12 Oct 2011 17:11:23 -0500

Regulators in the United States and abroad have embarked on an effort to crack down on market abuses involving computerized high-frequency trading. High-frequency trading was found responsible for the “flash crash” of May 6, 2010, and regulators suspect that it is contributing to the recent volatility observed in the markets.

High-frequency trading has become very popular, especially among large trading firms, since regulatory reforms encouraged exchanges to shift from floor-based trading to electronics several years ago. This practice now accounts for two-thirds of all trading volume on U.S. exchanges.

Critics warn that high-frequency traders fundamentally undermine the fairness of the financial system, because they make large profits at the expense of retail investors who have no access to such high-frequency trading technology. Long-term investors such as pension funds also complain that some traders may be using high-frequency trading technology to detect large buy or sell orders, and, by trading a fraction of a second ahead of large trades, take advantage of price moves. This concern is driving some large investors to move to venues away from public exchange, called dark-pools.

Domestic and overseas regulators are weighing several ideas for cracking down on manipulation by high-frequency traders. In the U.S., the Securities Exchange Commission approved a “large trader” rule in July that requires high-frequency traders to offer additional information about their activities. Some regulators have called for compulsory registration of high-frequency firms and pre-trade testing of their algorithms. The SEC has also proposed a powerful monitoring system called a consolidated audit trail that would gather data on trades in real time from all U.S. exchanges.

Institutional and retail investors concerned about market volatility should keep a close eye on regulators’ attempt to keep one step ahead in this technological arms race.

Contributed by Yoko Goto

Proposed Legislation Frays Investor Protection

Michael Stocker — Wed, 28 Sep 2011 20:38:21 -0500

A new move by the legislature threatens to increase risk in already dangerously volatile markets.

Section 404(b) of the Sarbanes-Oxley Act sets out detailed internal control reporting requirements intended to better educate investors about the reliability of reported financial results. These protections were weakened by the Dodd-Frank Wall Street Reform and Consumer Protection Act, which created an exemption to this rule for companies with less than $75 million in market capitalization.

A newly introduced bill, “The Startup Expansion and Investment Act” would further erode this check on the reliability of financial filings.

Under the proposed Act, new companies with market capitalizations of up to $1 billion would be allowed to opt out of the requirement under Section 404(b) for the first 10 years after going public – so long as they disclose this opt-out in their annual reports.

In an SEC study released last April, the Commission concluded that, while extending exemptions might result in some decrease in compliance costs for companies, such savings could not “justify the loss of investor protections and benefits to issuers.”

NYSE Tightens Grip on Reverse Mergers

Michael Stocker — Fri, 12 Aug 2011 12:44:24 -0500

On August 4, 2011, the New York Stock Exchange LLC (“NYSE”) and NYSE Amex proposed more stringent rules governing reverse merger companies – companies that became public without having to meet the strict rules covering IPOs. The proposed rules contain a series of “seasoning” requirements that would effectively delay exchange listings for reverse merger companies.

Under the proposed standards that the NYSE submitted to the SEC, reverse merger companies would have to trade for at least a year in the U.S. over-the-counter market, or on another U.S. exchange or a regulated foreign exchange before obtaining an NYSE listing. They would also be required to maintain a minimum $4 stock price for a “sustained” period, and would have to file audited financial statements and an annual report with the SEC. In addition, the NYSE would have the discretion to impose tougher requirements on a particular reverse merger company if the exchange deems warranted.

The NYSE’s move followed an SEC warning to investors about the risks associated with reverse merger companies.

Contributed by Yoko Goto

SEC Sounds Alarm on Reverse Mergers

Michael Stocker — Thu, 16 Jun 2011 14:29:32 -0500

On June 9, the U.S. Securities and Exchange Commission issued a bulletin warning investors about companies that enter U.S. markets through so-called “reverse mergers”—and explaining how they can be detected.

In a reverse merger, a private company merges with an existing public shell company to become listed on a U.S. exchange and gain access to capital markets—a process that avoids the regulatory scrutiny given to IPOs.

The bulletin points out that the lack of transparency in reverse merger companies poses grave risks to investors. However, it can be very difficult to determine whether a public company has undergone this process.

To assist investors, the SEC identifies risk factor disclosures in SEC filings that may serve as red flags signaling a reverse merger. For example, the SEC urges that investors look out for words or phrases such as “lack of public company experience,” “lack of history of compliance with U.S. securities laws and accounting rules,” “inability to comply with federal securities laws” or “inability to attract the attention of major brokerage firms.”

The risks involved in reverse mergers are more than theoretical. The SEC and U.S. exchanges have recently cracked down on many companies that became public through this process. Trading in more than a dozen such companies has been suspended due to a lack of current, accurate information about these firms and their finances. In addition, several reverse merger companies have recently seen their securities registrations revoked because of failures to make required periodic filings.

Submitted by Yoko Goto

Resistance to Tighter Mortage Lending Regulation Makes Strange Bedfellows

Michael Stocker — Tue, 14 Jun 2011 16:00:00 -0500

In the wake of the mortgage meltdown of 2007-2008, regulators have sought to substantially stiffen lending requirements for lower-income homeowners. This regulatory activity, spurred by the suggestion that overly generous lending to consumers with little ability to pay played a key role in the credit crisis, may make have the unintended consequence of discouraging some well-qualified minority applicants from entering the housing market.

This potential downside to overly-stringent new rules has resulted in an unusual alliance.

Mortgage lenders and some non-profit organizations, including the N.A.A.C.P. and La Raza, are cooperating in an effort to protect working class and minority communities from stricter regulations on mortgage packaging that may ultimately discourage some applicants from minority groups from obtaining home loans. Among their targets: a proposal that would exempt mortgage packagers from bearing part of the risk in the loans they package if loan recipients provided a 20 percent down payment.

Submitted by Melanie Boyce

Is "Convergence" Good for Investors?

Michael Stocker — Mon, 06 Jun 2011 18:00:00 -0500

Maybe not, at least according to a new white paper released by the Council of Institutional Investors.

The furor relates to the SEC’s proposal that Generally Accepted Accounting Principles (“GAAP”) issued by the U.S. Financial Accounting Standards Board be replaced with International Financial Reporting Standards (“IFRS”) issued by the International Accounting Standards Board—a process called convergence.

In a paper titled “Criteria for an Independent Accounting Standard Setter,” Professor Donna L. Street of the University of Dayton expresses concern that the international standards suffer from “significant pressures from governmental officials and bodies, particularly those representing the European Union.” In addition, she notes that the IASB has historically subsisted on voluntary contributions—raising serious questions about the its independence. The white paper further points out that only five of the present 20 seats on the IFRS Foundation are held by individuals from the investor community.

Say on Pay Measures Have Teeth

Michael Stocker — Mon, 16 May 2011 14:26:11 -0500

For years, questions have been raised about whether purely advisory “say on pay” initiatives have any teeth. Those doubts are being put to rest in this proxy season, as new say on pay measures are subjecting executive compensation packages to an unprecedented level of scrutiny. This activity will only increase with the roll-out of sweeping new requirements for shareholder votes on executive compensation set out in Section 951 of the Dodd Frank legislation.

Levin-Coburn Report Investigates Causes of the Financial Crisis

Michael Stocker — Tue, 19 Apr 2011 11:36:43 -0500

On April 13, after two years of investigation, Senator Carl Levin and Senator Tom Coburn, Chairman and Ranking Republican on the Senate Permanent Subcommittee on Investigations released a final report on their inquiry into the main causes of the financial crisis. The report presents new facts, findings and recommendations, with more than 700 new documents totaling over 5,800 pages.

The report focuses on the ways that financial firms deliberately took advantage of their clients and investors, on deeply flawed credit ratings, and on federal regulators who apparently cast a blind eye on these unsafe and unsound practices.

The report expands on evidence collected at four Subcommittee hearings in April 2010, examining four aspects of the crisis through a series of detailed case studies: 1) high-risk mortgage lending, using the case of Washington Mutual Bank; 2) regulatory inaction, focusing on the Office of Thrift Supervision’s failed oversight of Washington Mutual; 3) inflated credit ratings, examining the actions of Moody’s and Standard & Poor’s; and 4) the role played by investment banks, principally Goldman Sachs.

The report offers 19 recommendations, including a call for strong implementation of the new restrictions on proprietary trading and conflict of interest. The report also urges, in addition to the reform effected by the Dodd-Frank Act, that the SEC to use its regulatory authority to rank credit ratings agencies according to the accuracy of their ratings.

Contributed by Yoko Goto

Taking Charge of Executive Compensation

Michael Stocker — Fri, 08 Apr 2011 12:15:00 -0500

The SEC has finally issued much-anticipated proposed rules regarding executive compensation.

On March 30, 2011, the SEC unanimously proposed rules directing the national securities exchanges to adopt certain listing standards related to the compensation committee of a company’s board of directors as well as its compensation advisers pursuant to the requirements set forth in the section 952 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

The proposed rules require the exchanges to adopt listing standards that 1) require each member on a compensation committee be a member of the board of directors and be independent; and 2) provide that compensation committee has the authority to retain compensation advisers and is responsible for the appointment, compensation and work of any such adviser.

The proposed rules also require each company to disclose in its proxy material for an annual meeting of shareholders 1) whether its board’s compensation committee retained or obtained the advice of a compensation consultant, and 2) whether the work of the compensation consultant has raised any conflict of interest and, if so, the nature of the conflict and how the conflict is being addressed.

Once an exchange’s new listing standards are in effect, a listed company will be required to meet these standards in order for its shares to continue to be traded on the exchange. Comments to the proposed amendments are due on or before April 29, 2011.

Contributed by Yoko Goto.

Identifying Systemic Risk

Michael Stocker — Wed, 08 Dec 2010 17:00:00 -0500

On November 23, the Financial Stability Oversight Council voted to solicit public input in developing rules for designating financial market utilities as systemically important. A notice seeking comments will published in the Federal Register shortly, triggering a 30-day comment period.

The recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act proposes to categorize the largest or most interconnected financial firms as systemically risky, requiring them to provide advance notice to regulators of any changes to their operations that would materially affect their level of risk, and subjecting them to additional risk management standards and examination and enforcement oversight.

While this goal seems clear-cut, the task of identifying systemically risky firms is proving to be a thorny problem. To begin the process of fleshing out the new rules, the FSOC is soliciting comments on the criteria that should be used to evaluate a financial market utility’s level of systemic risk; how exposure to or interdependency with other financial firms or market utilities should be weighted; and how to measure the significance that a potential failure might have on the broader markets.

Curves Ahead: Mini "Flash Crashes" Continue

Michael Stocker — Mon, 22 Nov 2010 16:00:00 -0500

It’s hard to believe that nearly six months have gone by since the May 6, 2010 “flash crash” that unnerved the financial world. In an attempt to avoid any repeats of this crisis, regulators have implemented “circuit breaker” rules to temporarily halt trading and reset prices in the event stocks plunge suddenly.

In spite of this heightened regulatory interest, similar, albeit smaller, flash crashes continue to occur with alarming frequency. In fact, it has happened to more than a dozen individual stocks in the last six months.

For example, on September 27, 2010, Progress Energy’s share price plunged almost 90% in an instant—dropping from $44.57 to $4.57. In effect, a robust company with 3.1 million customers and 11,000 employees suddenly seemed to be on the precipice of insolvency.

The circuit breaker rule worked on the New York Stock Exchange, but because the trading happened so fast, Progress stock still wound up in free-fall going down to $4.57 before other exchanges could catch up and stop trading. Dozens of trades were declared void, and after a five-minute halt, normal trading resumed. It is speculated that the trigger of this event was an erroneous electronic sell order.

Critics worry that the string of mini flash crashes points to deeper problems in the nation’s stock markets. Some analysts say it is a sign that another big event is possible, if not probable.

Good Times Roll For Finance Industry

Michael Stocker — Mon, 18 Oct 2010 15:00:00 -0500

Despite the economic decline plaguing most U.S. workers, many bankers and traders continue to be sanguine about prospects for their compensation. About half of respondents to a survey of about 2,100 U.S. bankers and traders expect their bonuses to increase this year compared with 2009.

Worse, although regulators and financial executives have repeatedly urged deferring at least part of bonuses to future years to discourage irresponsible corporate risk-taking, most employees expect none of their bonuses to be deferred.

Their optimism is well founded. According to a study by the Wall Street Journal, total Wall Street compensation will reach $144 billion for 2010, marking a record for the second consecutive year. It also appears that increases in compensation will far outpace increases in corporate revenues. The report says that according to a survey of 35 firms, pay in 2010 is expected to increase 4%, while annual revenue is forecasted to increase just 3%.

Contributed by Yoko Goto.

Investment Bank Alibi Doesn't Hold Up

Michael Stocker — Wed, 29 Sep 2010 16:00:00 -0500

Investment banks have long disclaimed their culpability for the subprime crisis by arguing that they had been bamboozled by the AAA ratings that credit rating agencies had bestowed on instruments that were in fact very risky. That alibi is looking increasingly unlikely.

On September 23, 2010, D. Keith Johnson, the former president of Clayton Holdings, testified before the Financial Crisis Inquiry Commission that the rating agencies routinely ignored evidence that the loans they were rating “did not meet lending criteria promised to investors”.

More importantly, he suggested that investment banks were well aware of the infirmity of the ratings. Clayton Holdings was hired by investment banks to analyze the mortgage pools they were bundling into securities. Johnson testified that an analysis of a sampling of the loans revealed that almost half of these mortgages failed to meet the underwriting standards laid out by the banks themselves. These findings were provided to the same investment banks that have been pleading ignorance of the risk associated with the loans they securitized and sold.

Worse, Johnson testified that Wall Street investment firms capitalized on Clayton’s findings. Instead of informing the public about the risky loans, the investment banks used the information provided by Clayton to obtain the bad loans at a lower price from the issuing lenders. And, instead of passing these savings on to the public, the investment banks sold these mortgage pools at the same prices as the loans that actually met underwriting standards.

Contributed by Carol Villegas

Party Over: Basel Group Puts Safety First

Michael Stocker — Tue, 14 Sep 2010 11:00:00 -0500

On Sunday, the Basel Group reached agreement on a controversial new set of banking requirements that will put an end to the heady days when financial institutions could take huge gambles using investors’ cash. The new rules, called Basel III, will ultimately require that banks raise their Tier 1 capital, the kind of funds most important to have in the event of disaster, from 2% to 7%. These higher capital requirements will go a long way towards reining in the risk-taking that fueled the financial collapse of 2007 and 2008.

Not all the news was good for investors, however, as banks have been given until 2019 to reach the 7% level. The new Basel requirements will also force banks to set aside extra cash in times of growth as a buffer for financial crises—a “countercyclical buffer.” These changes will go a long way to helping stem the volatility in the financial sector that has had investors spooked.