Eyes On Wall Street

The Volcker Diet for Mega-Banks

Michael Stocker — Mon, 01 Mar 2010 17:40:09 -0500

The Obama administration has renewed a push to toughen regulations on banks that are “too big to fail.” The proposal, dubbed the “Volcker Rule” after the former Federal Reserve Chairman Paul Volcker, would limit the scope and size of banks and other financial institutions by ensuring that no bank will engage in “proprietary trading” -- that is, trading operations unrelated to serving customers.

Proprietary trading places bank capital at risk through speculation. Although such trading is engaged in by only a handful—probably four or five—of American mega-sized commercial banks, the commercial banking sector could take a dangerous hit if these bets go wrong.

Proponents of the Volcker Rule argue that such a prohibition is essential to ensure the stability of the commercial banking sector and to protect banking customers from undue risk undertaken by corporate management. It would also discourage banks from engaging in insider trading using inside information and data gleaned from their customer relationships.

The proposed Volcker Rule has been met with strong resistance in Congress. Critics argue that the objective of the proposal could be achieved under a provision in the House bill adopted last year which let regulators ban speculative trading by banks if it is deemed too risky. They also contend that it will be hard for regulators to differentiate between transactions that a bank makes for its clients from those made in its own account.

One thing that is clear is that if “too big to fail” banks expect an implicit guarantee of taxpayer support, they should be prepared for much greater regulatory review of the risks they undertake.

SEC Cracks the Whip

Michael Stocker — Thu, 21 Jan 2010 11:41:12 -0500

With newly proposed rules regarding naked access and executive compensation, the SEC is making significant inroads in shoring up investors’ confidence in the markets and in the Commission itself.

One of the Commission’s recent achievements is newly- proposed rules to prohibit broker-dealers from providing customers with “unfiltered” or “naked” access to an exchange or alternative trading system. The proposed rules, which were unanimously approved last week, would require brokers with market access, including those who sponsor customers’ access to an exchange, to put in place risk management controls and supervisory procedures. The proposed procedures would help prevent erroneous orders, ensure compliance with regulatory requirements, and enforce pre-set credit or capital thresholds.

Another notable recent achievement is the new executive compensation disclosure rules that were adopted last December and will take effect with this year’s proxies.

In the past, the executive compensation disclosure rules contained loopholes permitting public companies to hide information regarding equity grants, which is most important part of the package for many executives. Under the new rules, companies will have to disclose this information to investors in a summary table.

Even under this improved regulatory scheme, however, companies may still be able to minimize the awards they disclose when grants are tied to undisclosed performance goals. The amounts disclosed will reflect only what the company asserts that executives are likely to be paid, with little meaningful way for auditors or investors to assess the reliability of these estimates.

Cornerstone Weighs In on 2009

Michael Stocker — Thu, 07 Jan 2010 14:54:41 -0500

Cornerstone Research today released its much-anticipated summary of securities class actions filings for 2009. As expected, the data compiled by Cornerstone reflects an overall decline in the number of securities cases filed compared to the bumper year of 2008. However, the summary highlights the fact that financial firms still make up a lion’s share of new filings—underscoring the key role that the these companies played in the financial sector catastrophes of 2007 and 2008.

Cornerstone’s 2009 summary reveals that 84 suits—roughly half of all filings—named financial sector defendants, well above the consumer non-cyclical sector with 33 filings and the communications sector with only 12 filings.

Although the percentage of S&P 500 index financial firms named as defendants in securities class actions dropped from 32.6 percent in 2008 to 11.5 percent in 2009, the financial firms named as defendants in 2009 still represented 39.1 percent of the sector’s total market capitalization.

The report also pointed out that class action filings continue recent upward trends in the numbers of cases including Section 11 and Section 12(2) allegations, and cases naming underwriters as defendants.

Marking to Magic: Interview with Lynn E. Turner

Michael Stocker — Wed, 16 Dec 2009 15:00:00 -0500

Eyes On Wall Street welcomes Lynn E. Turner, the former Chief Accountant of the U.S. Securities & Exchange Commission. Mr. Turner offers Eyes readers some trenchant insight on controversial new rules for fair value accounting, and their long term implications for investors.

Eyes: Many investors may not be familiar with fair value accounting. Can you give us a thumbnail sketch of what it involves?

Turner: In its simplest form, fair value accounting is nothing more than having a company report its investments in terms of what they are worth today rather than what they paid for them when they bought them in past years or even decades.

Eyes: Why should investors care about the way investments are accounted for?

Turner: Well, as an investor you’re always interested in how management is stewarding the assets that you’ve given them to use. One good measure of how they’ve done with those assets and dollars is looking at the value that management has subsequently created. And looking at the value of those investments today, rather than some time ago, gives you a much clearer indication as to whether management has wisely invested the assets and got a return on the investments or instead has losses that they might like to hide and not be held accountable for.

Eyes: Why did fair value accounting come to be so controversial during the financial crisis of 2007 and 2008?

Turner: You know, I’ve been around for about three decades now and the whole debate over fair value accounting is nothing new. It was a major debate during the first half of the Seventies, when we had the ’72-’73 bear market; it was a major debated item during the savings and loan and banking crisis in the late ‘80s and early 1990s; and again it’s returned as a hot item in the subprime financial crisis. So it’s nothing really new. The arguments are always the same: the bankers say in the down times that they shouldn’t be made to take their losses, or it will destroy their businesses. But in the good times, they always come back and ask to use fair value accounting and take the write-ups.

The reality is that these financial institutions, some of which have been dismally managed, don’t want to have accountability for the poor management decisions that they’ve made when they’ve invested the assets, the money from investors.

Eyes: And that’s why the financial sector now has so much antipathy for fair value accounting?

Turner: Well, the crisis was created when banks made a lot of bad home loans that were never going to be repaid.. We know that for a fact now. When the loans defaulted a lot of homes came on the market that couldn’t be resold, or had to be resold at much lower prices than what they’d been bought for or what people felt they were worth.

As a result, investments in those loans and those mortgages declined in value significantly. The financial industry, which had packaged and sold the loans and had a significant amount of these assets on their own balance sheets, really didn’t want the public to learn about the magnitude of those losses. The public would be upset that they were sold bad investments by the finance companies. In turn the companies didn’t have enough capital to reverse or to sustain those losses and would become financially unstable requiring taxpayer and government support.

Eyes: The financial sector has had some recent success in undermining the fair value accounting rules in both the E.U. and the U.S. Can you describe those changes?

Turner: What the Financial Accounting Standards Board (“FASB”) in the U.S. and International Accounting Standards Board (“IASB”) in the E.U. have done, interestingly enough, is somewhat interconnected. Initially, the European Commission and the President of the E.U., Sarkozy, put tremendous pressure in October of 2008 on the IASB to relax its rules and give greater latitude to financial institutions in how they go about figuring fair value, and in particular what type of assets they’ve got to apply fair value to. In part in response to what the E.U. did, earlier this year, under pressure from the US Congress, the FASB relaxed some of the accounting rules to give greater latitude in how you would calculate those fair values. These changes allow the banks to manipulate what they report as fair values. As one person said, under the new rules it’s really not “mark to market,” it’s “mark to magic.”

under the new rules it’s really not “mark to market,”
it's “mark to magic.”

Eyes: Now, what do you make of the argument that fair value accounting just doesn’t work when there isn’t a market on which you can assess the value of some of these mortgage-backed assets?

Lynn Turner: Well, first of all, the vast majority of these assets do have a market, so it’s not as big an issue as what some people make it out to be. For those where there isn’t a market – that is, those investments aren’t traded day in or day out – you can still make an assessment, and accounting rules allow you to make an assessment, of what the cash flows are going to be coming off those investments, and ultimately what someone else is going to be willing to pay you for that. Smart managers should have made that exact assessment when they initially decided to purchase them in the first place and put them on their balance sheet.

Eyes: There’s certainly been a lot of debate earlier this year, and then maybe ongoing next year, about legislative proposals that might undercut the independence of standards boards like the FASB. How important is it that these boards remain independent?

Turner: It is very important that both the Financial Accounting Standards Board and the International Accounting Standards Board be able to go through a due process that allows them to develop standards that will in fact provide investors with the very high quality information they need to make sound investment decisions. When members of Congress here in the US, or when the European Central Bank or Parliament put tremendous pressure on either of these two bodies to serve special interests like the financial lobby instead of investors, then there’s hundreds of millions of investors that get short changed.

In the long run, good investment decisions can’t be made without good information. And unfortunately both the European Central Bank, the European Parliament and the US Congress throughout this year – and it will continue into next year – will continue to try to break the arms of these standards setters to provide standards that are more favorable to the banks, which will do destructive damage to the US capital markets and investors.

Cleaning Up the Financial Sector

Michael Stocker — Thu, 03 Dec 2009 15:43:04 -0500

Senator Christopher J. Dodd (D-Conn.), Chairman of the Senate Banking Committee, has proposed a bill that would, if enacted, result in a sweeping overhaul of the U.S. financial system. Dodd unveiled a plan that would, among other things, consolidate bank regulators, create a consumer financial protection agency and impose new restraints on exotic financial instruments and credit rating agencies. In unveiling the bill, Dodd said, "I could have tried to draft something that was, sort of, already a compromise… But I think you make a huge mistake by doing that. You're given very few moments in history to make this kind of difference, and we're trying to do that."

If enacted, Dodd’s legislation would:

Create a Consumer Financial Protection Agency which would focus on protecting American consumers from fraud and abuse, and on ensuring that consumers be given clear information on loans and other financial products from credit card companies, mortgage brokers and banks. This proposed agency would consolidate consumer protection responsibilities currently handled by the Office of the Comptroller of the Currency, Office of Thrift Supervision, Federal Deposit Insurance Corporation (FDIC), the Federal Reserve, the National Credit Union Administration and the Federal Trade Commission.
Create a Financial Institutions Regulatory Administration which would eliminate the alphabet soup of multiple bank regulators, and would ensure that the FDIC and the Federal Reserve do their jobs.
Address systemic risks posed by derivatives. Over-the-counter derivatives would be more closely regulated by the SEC and CFTC to close regulatory loopholes. Derivative trading would be required to go through central clearing and exchange trading to encourage transparency and accountability.
Require advisors to hedge funds and other pools of cash worth over $100 million to register with the SEC and to disclose financial data needed to monitor systemic risk and protect investors.
Establish a new Office of Credit Rating Agencies at the SEC which would strengthen regulation of credit rating agencies. This new office would have its own compliance staff and the authority to fine agencies. The bill would also give investors a private right of action against ratings agencies for knowing or reckless misconduct.
Create the Agency for Financial Stability, an independent agency responsible for identifying, monitoring, and addressing systemic risks posed by large, complex companies as well as products and activities that can spread risk across firms. The Agency would draft strict rules for capital, leverage, liquidity, risk management and other requirements as companies grow in size and complexity.

The Dodd proposal faces some hurdles. Administration officials, House leaders and some Republicans have criticized parts of the plan as untenable. Edward, L. Yingling, President of the American Bankers Association, said the proposal "would tear apart the existing regulatory structure only to create a new one that would produce conflicts among regulators." However, Treasury Secretary Timothy F. Geithner said that the legislation "moves us one step closer toward comprehensive financial reform." Dodd has said he plans to move the bill through the banking committee quickly.

New Attack on Investor Safety Net

Michael Stocker — Thu, 19 Nov 2009 13:27:29 -0500

In a November 6, 2009 speech at a roundtable conference hosted by the George Washington University Law School and the Institute for Law and Economic Policy (ILEP), SEC Commissioner Luis Aguilar warned that the powerful financial sector lobby has been working overtime to weaken reform initiatives that would benefit shareholders.

Aguilar focused on a potentially disastrous amendment to the pending Investor Protection Act of 2009. A late addition to the bill would sharply limit the reach of the investor protections set out in the Sarbanes-Oxley Act of 2002. Section 404(b) of the existing statute requires that executives of all public companies take responsibility for their internal controls, and that the controls be reviewed by independent auditors. The new addition to the Investor Protection Act of 2009, however, would turn the legislation on its head by repealing these crucial requirements for about 6,000 publicly traded companies with market capitalization under $75 million.

The Commissioner also suggested that the current preoccupation with regulating systemic risk embodied in institutions that are “too big to fail” may not adequately address market protection. Noting that “financial services exist to serve investors,” he emphasized that it is essential that the dialogue be shifted from how best to preserve “too big to fail” institutions to “what is best for investors.”

According to Aguilar, "systemic risk regulation should facilitate an environment where no institution is indispensable, and where other firms can step in to meet the needs of the market."

Say on Pay

Michael Stocker — Thu, 12 Nov 2009 16:40:00 -0500

America is experiencing an extraordinary period of legislative and regulatory executive compensation reform. In fact, executive compensation reform is so much in vogue that many companies are even voluntarily introducing so-called Say on Pay resolutions.

Since Treasury Secretary Geithner first proclaimed that companies in receipt of TARP assistance would have to subject executive compensation to Say on Pay resolutions in February 2009, thirteen publicly-traded companies that did not receive TARP monies—including Verizon, Motorola, and Blockbuster—have willingly adopted the Say on Pay way.

In addition to these thirteen corporate compensation pioneers, eleven other leading publicly-traded companies that did not receive TARP funds—such as Microsoft and Apple—have either willingly scheduled Say on Pay votes for 2010 or have already voted but not yet released results.

These voluntary say on pay resolutions revise compensation disclosure by, among other things, changing the Summary Compensation Table (“SCT”) reporting of stock and option awards and by broadening the scope of the Compensation Discussion and Analysis (“CD&A”) to include a new section that analyzes the link between a company’s overall compensation policies and the company’s risk and management of that risk.

Say on Pay resolutions further require that compensation committees be independent, and that such committees disclose the use of consultants and advisors (who are also required to be independent). In addition, such provisions require disclosure of specific performance targets, and also seek to enhance proxy access for stockholder proposals and director nominations.

Adoption of Say on Pay provisions will result in closer scrutiny of executive pay arrangements by boards and compensation committees. Better-informed and qualified boards and compensation committees, in turn, may help restore investors' faith in corporate governance after the crises of the last two years.

Wall Street Double Whammy

Michael Stocker — Tue, 03 Nov 2009 15:00:00 -0500

On October 22 Wall Street received a double whammy with the release of plans by the Federal Reserve and the Treasury Department to aggressively regulate pay practices at banks. While both approaches capitalize on public wrath erupting over the announcement of record-setting year-end bonuses at top financial firms, they differ significantly in scope and effect.

The Federal Reserve’s new compensation proposal, outlined in its October 22 press release, has the broadest sweep, covering thousands of banks, including U.S. subsidiaries of foreign institutions. While the proposed rules would not directly regulate pay, they would include demands that firms take into account losses incurred by employees, make pay tied to longer-term performance, and pay out over longer stretches of time. The only real teeth in this regulation, however, is the Fed’s right to veto compensation plans it does not like, and to require that management come up with better approaches.

The Treasury plan is more limited in scope, but has a much more immediate impact. The plan, outlined in an October 22 press release titled The Special Master for TARP Executive Compensation Issues First Rulings, applies only to the beneficiaries of bailout funds under the TARP program. It attempts to better align pay with longer-term performance, but takes a more direct approach than the Fed. Treasury official Kenneth Feinberg, the Obama administration’s “pay czar,” slashed cash compensation, increased stock awards, and insisted that stock compensation be held for two to four years. Salaries paid to the highest-earning executives at seven companies getting exceptional federal aid will also be capped at $500K, while the group’s total pay level, annualized, will be 50% lower than last year.

Not surprisingly, the financial services industry is not happy with either approach. Although the sector benefited from last year’s massive infusion of taxpayer capital, banks are bridling at the suggestion that regulators—and the taxpayers they protect—should have any role in reforming the institutions that they helped save.

SEC Announces Proposed Dark Pool Reforms

Michael Stocker — Wed, 28 Oct 2009 09:40:24 -0500

The number of active dark pools transacting in stocks that trade on major U.S. stock markets has tripled since 2002. In the face of the rapid growth of these venues, some commentators worry that their lack of transparency could create a two-tiered market that deprives the public of information about stock prices and liquidity.

On October 21, 2009, the SEC voted unanimously to propose measures intended to increase transparency of dark pools so investors get a clearer view of stock prices and liquidity.

The SEC’s proposals address three specific concerns related to dark pools:

The first proposal would require actionable Indications of Interest (IOIs) — which are similar to a typical buy or sell quote — to be treated like other quotes and subject to the same disclosure rules.

The second proposal would lower the trading volume threshold applicable to alternative trading systems (ATS) for displaying best-priced orders. Currently, if an ATS displays orders to more than one person, it must display its best-priced orders to the public when its trading volume for a stock is 5 percent or more. The SEC’s reform proposal would lower that percentage to 0.25 percent for ATSs.

The third proposal would create the same level of post-trade transparency for dark pools as for registered exchanges. Specifically the proposal would amend existing rules to require real-time disclosure of the identity of the dark pool that executed the trade.

While the SEC’s desire to pursue market transparency is commendable, it should also be wary of moving too quickly in regulating “dark pool” markets. Dark pool trading offers significant benefits to large investors, including a shelter from the share price premiums that result from “flash trading.”

The New Insider Trading

Michael Stocker — Wed, 21 Oct 2009 15:30:00 -0500

Wall Street has a long history of investors profiting on their access to non-public information about the business prospects of publicly traded companies. However, new kinds of “insider” trading, kinds that are still legal, are the subject of increasing regulatory concern.

These technological advantages take several forms. As recently explained by Eyes, in flash trading, select investors pay for access to information about stock purchases and sales fractions of a second before the information becomes public.

Naked access occurs when brokerage firms pay sponsors-- firms approved to trade on particular exchanges-- to execute orders anonymously through the sponsors’ computers, getting tiny but profitable time advantages over the rest of investors. Accounting for more than half of the daily trading volume, “naked” access is currently solely regulated by rules imposed by participating exchanges and brokers. The SEC has threatened to implement rules that would undercut the speed advantage gained through such access.

A “dark pool” is a private exchange over which sophisticated traders can electronically buy and sell large amounts of stock, taking advantage of technology that lets them complete transactions faster than could be achieved in the NYSE. As recently reported in a New York Times article about “dark pools,” these exchanges have caused the daily trading volume of the NYSE to decrease by approximately 39% over a four-year period.

While all of these practices pose complicated problems for regulators, they may also highlight a disturbing trend: that technological advantages may be overtaking investor acumen as the key to profiting on the markets.

Update on Dark Pools Regulation

Concerned about problems posed by “dark pool” markets, on October 21, 2009, the SEC voted to propose new rules that would require more stock quotes in the “dark pool” systems to be publicly displayed. The rule changes may be adopted after a 90-day public comment period. The SEC Chairman, Mary L. Schapiro, discussed the issue in a speech titled “Statement on Dark Pool Regulation Before the Commission Open Meeting.”

For more details on the proposed regulations, please see the October 28, 2009 Eyes post.

Fair is Foul and Foul is Fair: The Attack on Fair Value Accounting

Michael Stocker — Thu, 15 Oct 2009 09:30:00 -0500

In the face of a financial crisis fueled by widespread overvaluation of real estate and mortgage-backed assets, investment banks and other financial sector interests have successfully lobbied to undermine accounting rules that ensure the integrity of asset valuations.

Bowing to intense lobbying efforts, in April of this year the Financial Accounting Standards Board (FASB) altered long-standing rules requiring banks to use “mark to market” accounting—that is, to value assets at what they would fetch in the current market. These changes permit companies to use inflated asset values and allowing companies to avoid having to recognize asset losses in reporting their earnings.

Investors should pay special attention to changes in FASB Staff Position 157-4, called Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly. In FSP 157-4, the FASB states that “[f]air value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction (that is, not a forced liquidation, or distressed sale) between market participants at the measurement date under current market conditions.”

However, amendments to FSP 157-4 contain a loophole permitting companies to disregard an observable market price for assets traded in an “inactive” market—that is, a market in which there is little or no data about current trading values. When markets are inactive, the new rule empowers companies to exercise their own judgment in estimating the fair value of assets traded on inactive markets.

This development is dangerous because companies have the power to ensure that markets are inactive by ceasing to sell or buy risky assets—permitting them to value the assets using their own estimates rather than market prices.

Flash Trading

Michael Stocker — Wed, 07 Oct 2009 09:00:00 -0500

How much of an advantage is it to know about trades three hundredths of second before the investing public? Enough to warrant the concern of the SEC. The issue involves flash trading or high-frequency trading, which gives select traders the ability to see buy and sell orders a fraction of a second before the information becomes public. This tiny time advantage can be highly profitable, because high-speed super computers are able to process the flashed information to help investors capitalize on trading patterns that are not yet public information. Mary L. Schapiro, chairwoman of the SEC commented in a September 17, 2009 speech that, "[f]lash orders may create a two-tiered market by allowing only selected participants to access information about the best available prices for listed securities."

Last month the SEC voted unanimously to propose regulations that would ban flash trading. If the regulations are adopted, they would effectively prohibit all markets, including equity exchanges, options exchanges and alternative trading systems, from displaying marketable flash orders. The Commission is seeking public comment and data on a broad range of issues relating to flash orders, including the costs and benefits associated with the proposal. It is also seeking comment on whether the use of flash orders in the options markets should be evaluated differently than their use in the equity markets.

The proposed ban on flash orders is just one part of a broader effort by the SEC to more effectively regulate the U.S. stock market in the wake of last year’s financial crisis.

G-20 Weighs In on Executive Compensation

Michael Stocker — Tue, 29 Sep 2009 11:00:00 -0500

The G-20 has finally weighed in on the issue of executive compensation. Why should investors care what global financial policy leaders think about performance-related bonuses? Because reforms aimed at ending the financial incentive for executives to bet the house on risky securities will only work if they are adopted uniformly.

There is little mystery about the role that fat-cat compensation packages played in last year’s financial crisis. Top management of investment banks enjoyed bonus packages that rewarded short term bets that could be disastrous for investors, while eliminating any downside risk to executives themselves. It should surprise no one that the result was a vast appetite for dangerous investments that would prove to have tragic long term consequences for investors and taxpayers.

In the Leaders' Statement from the September 24 – 25, 2009 Summit in Pittsburgh, G-20 leaders urged that reforming compensation packages is essential to any effort to increase financial stability. The leaders stated that reforms should ensure that compensation is aligned with long-term value creation for investors, rather than excessive risk-taking. They suggested that this could be accomplished by requiring that a large proportion of performance-related compensation be deferred and be tied to long-term performance. Moreover, they argued that such provisions should have teeth, in the form of claw-back provisions permitting companies to reclaim compensation from executives whose decisions land investors in hot water.

Of course, general statements of policy will be useless unless member countries enact rules enforcing restrictions on pay. A September 5, 2009 address to world leaders by Treasury Secretary Tim Geithner outlines the steps that are being taken in the U.S. to change executive pay structures. Geithner noted that the House has already passed proposals designed to tie compensation to long term performance, and stated that the Federal Reserve would be charged with enforcing the proposed new standards.

It remains to be seen whether any legislative effort to reform compensation can survive powerful lobbying efforts by management interests, but international cooperation on the issue is an encouraging sign.

The Match King (interview with Prof. Frank Partnoy)

Michael Stocker — Wed, 23 Sep 2009 21:00:01 -0500

Eyes welcomes Professor Frank Partnoy of the University of California San Diego, author of The Match King (PublicAffairs April 2009). The Match King is a tautly paced and erudite account of the life and times of Ivar Kreuger, one of the twentieth century's greatest financial innovators—and one of its most notorious scam artists. Partnoy talks to Eyes about lessons investors could learn from Kreuger, and the similarities and profound differences between Kreuger and Bernie Madoff.

Eyes: Why do investors need to know about Kreuger, a man who died nearly eighty years ago?

Partnoy: One of the lessons all of us take away from this financial crisis is that we need to remember history. So many of the financial innovations that recently brought down the banks and AIG are echoed in Kreuger’s story. He was a creator of complex off-balance sheet transactions, he used special purpose entities, he incorporated subsidiaries in regulatory havens. And he manipulated financial statements so that investors wouldn’t understand the truth about what was happening in the bowels of his companies. I think the tragedy is that we should have known about and understood Ivar Kreuger’s story several years ago.

Eyes: In your book you give an account of Kreuger’s key role as an innovator of financial products, and you have a great quote from Keynes, who called Kreuger “the greatest constructive business intelligence” of his age. With that in mind, is it fair to compare Kreuger to Bernie Madoff?

Partnoy: In many ways I think it’s unfair to Kreuger. He, for much longer than Madoff, sustained legitimate businesses. The core of his operations was a compelling idea – the lending of money raised in America to struggling post-World War I European governments in exchange for a match monopoly. He put together these three actors – American investors, European governments, and match producers – in a way that generated gains for all three groups. And he sustained those businesses for many, many years.

Eyes: Despite their reputations as criminal geniuses, one of the things that is striking about both Kreuger and Madoff is that the frauds they perpetrated were in some ways very crude. How did they go undetected for so long?

Partnoy: One of the most perplexing aspects of confidence games is that it’s so hard for the people involved in them to see what is happening. Both schemes basically involved paying out very steady, low double-digit payments to people over time, even when markets were volatile. And once people know that there’s a track record of steady, 10 percent payments, they run screaming to get in. One of the lessons of Ivar Kreuger and of Bernie Madoff is that investors should run when they see steady reported returns from a fund. That's a sign not of a well-run business but of danger lurking in the shadows.

One of the lessons of Ivar Kreuger and of Bernie Madoff is that investors should run when they see steady reported returns from a fund. That’s a sign not of a well-run business but of danger lurking in the shadows.

Eyes: Looking back both at the 1920s and at the decade preceding our current crisis, how large a role do you think market booms played in the success of Kreuger and Madoff’s schemes?

Partnoy: The booms are important because they run parallel with investor psychology. As stocks rise, as companies develop new business models, as financial innovations spread, markets become ripe for financial fraud. Years of stock gains are like the fertilizer that enables fraudulent schemes to flourish and grow. Such gains prime the pump for fraud because they make it easier for companies to come along and tell a believable story about how they can deliver outsized returns.

Eyes: If there’s one silver lining to be found when massive frauds are finally exposed, it’s that briefly there is an appetite for reform. And one of the interesting points that you make in your book is that the Securities Act of 1933 and the Securities Exchange Act of 1934 were directly inspired by Kreuger’s fraud . How likely is it, do you think, that Bernie Madoff will inspire similar kinds of reform?

Partnoy: I’m not especially optimistic. We didn’t get reform immediately after the 1929 crash. We only got reform after the public became very upset about the frauds of Ivar Kreuger and Samuel Insull, and after the federal investigative commission under Ferdinand Pecora started to publicly flog bankers and bring them to their knees. Whether or not we ultimately get reform will turn on whether we experience more scandal and on whether there is someone like Pecora who can galvanize public opinion. It might be the case that Thomas Greene is able to do that with the current version of the financial crisis inquiry commission, but we’ll have to wait and see.

Corporate Governance: There's a New Sheriff in Town

Michael Stocker — Wed, 23 Sep 2009 20:55:56 -0500

In the autopsy of last year’s financial meltdown, one of the principal culprits to have emerged is the extraordinarily lax oversight that the boards of some public corporations have exercised over management. On September 17, 2009, Mary Schapiro, the new Chairman of the Securities Exchange Commission, gave a speech, "Address to Transatlantic Corporate Governance Dialogue--2009 Conference," announcing the SEC’s plan to ensure that this practice would come to an end.

Schapiro lambasted boards of directors for failing to reign in management decisions about risk, and suggested that many boards appear to have misunderstand the gravity of risks taken. The new Chairman stated that “[s]enior management took higher returns at face value without questioning why such higher returns were possible for supposedly safe investments and strategies.”

The new Chairman suggests that regulators should ensure that investors in publicly held companies have the opportunity to remove directors who turn a blind eye to irresponsible management. She outlined a proposal by the SEC to remove obstacles to shareholders' ability to nominate candidates for the boards of directors of the companies that they own.

Under the proposed rules, shareholders who otherwise are provided the opportunity to nominate directors at a shareholder meeting would be — subject to certain eligibility and procedural requirements — able to have their nominees included in the company proxy that is sent to all voters.

You can expect a fight. This comment letter (PDF) in support of the proposal was filed by Labaton Sucharow and other firms representing institutional investors.

The Great White Whale

Michael Stocker — Wed, 23 Sep 2009 17:48:45 -0500

Of all the major players in the mortgage-backed asset debacle of the last two years, credit rating agencies have proven to be the great white whale for injured investors: an attractive target, but difficult to catch. This may be about to change.

The ire directed at the agencies is easy to understand. Only months before the spectacular collapses of Lehman Brothers and AIG, credit rating agencies gave these companies investment grades of A or higher. In email comments uncovered in a recent SEC investigation, one rating analyst suggested that, at her firm, a deal “could be structured by cows and we would rate it.”

Historically, the First Amendment was one of the greatest impediments to suits against the ratings agencies. Ratings agencies argued that a rating is an “opinion” that is entirely protected, or is an assertion about a matter of public interest that is protected by the “actual malice” standard set forth in New York Times Co. v. Sullivan, 376 U.S. 254, 279-83 (1964).

There was a time when such arguments might have made sense. Originally, rating agencies were paid by subscribers to rate most or all of a particular kind of securities for the benefit of the public. However, by the 1970s, they had transitioned to a model where the agencies were paid by the companies whose products they rated, creating insoluble conflicts of interest.

Courts are increasingly unwilling to interpret the First Amendment as giving carte blanche to the agencies. The U.S. District Court for the Southern District of Ohio recently refused to extend the First Amendment defense to a rating agency because its ratings were not published for the benefit of the investing public at large, but rather were distributed only to a select class of institutional investors. In re National Century Financial Enterprises Inc., Inv. Litigation, 580 F. Supp.2d 630, 640 (S.D. Ohio 2008).

Such decisions should give investors some cause for hope that credit ratings agencies may yet be held responsible for their role in the market crisis.