Business Law Prof Blog

The Goose That Lays the Golden Eggs

Once the Democrats select a Presidential candidate and focus on running against the Republican candidate, we are going to hear a great deal about tax cuts and the efficacy of "supply side" or "trickle down" economics.  The argument will focus on the effect of higher tax rates on the behavior of the wealthiest one percent of the population.  Democrats will argue that a higher tax on the wealthy will raise more revenue needed to balance the budget.  Republicans will argue that a higher tax on the wealthy will reduce revenue;  the wealthy who are productive will invest less effort and money in American business and there will be fewer jobs (and total income to tax) as a result.  Some of the productive wealthy will put the money they have in tax havens abroad (or find tax favored methods to invest at home) and reduce their efforts in American business  (competitive energy will find outlets in bridge or golf).  We will hear about the age old parable of the goose that lays the golden eggs.  Will higher taxes on the goose kill it? or will the goose continue to lay the eggs?  Democrats assume higher taxes will not kill the goose; Republicans assume that it will.  There will be fights over past data on the effects of the tax cuts of Bush in 2000 and Reagan in 1986 and the Clinton tax increase in 1993, events with much noise in the data.  Politicians will spin the data and people will believe who they want to believe.  Both sides could be right -- it depends where on the trade-off curve (between rates and revenue) we are at the time of any given tax cut and which type of tax is in issue (investment, sales or income taxes) and haw the tax is levied (corporate versus individual).  Me?  I would eliminate the double tax on business earnings (with an individual tax credit for corporate taxes paid on earnings that attaches to any dividends actually paid investors) and increase the progressive tax rate on individuals in the upper brackets.  Never happen.

The Uptick Rule

In July of this year the SEC finally overturned the "uptick" rule on short selling. The rule disables short sellers from shorting stock until after an uptick in the stock price.  Jim Cramer has called the SEC "morons'' for repealing the rule.  As usual, Cramer is wrong.  The market for years has had a vested interest in stock price appreciation and the law was slanted in that direction.  Penalties on short sellers are part of the legal bias.  The bias proves short term comfort at a long term price -- short term prices are artificially high and major asset re-valuations, when they come, are big and painful.  The same argument applies to artificially low interest rates -- we get short term asset bubbles that are very painful when they finally collapse.  Cramer, of course, is also pushing very low interest rates (to allow his buddies at the investment banks to print money).  Cramer is the moron. 

Sovereign Wealth Funds

When the sovereign wealth funds showed up to invest in United States financial institutions, my first response was great -- we enjoyed Japan's sucker money in the 1990s and now we will enjoy this sucker money as well.  Well, how are they doing.  The China Investment Corp has lost gobs on its $3 billion investment in Blackstone and the $5 billion it put in Morgan Stanley.  The Kuwait Investment Authority has lost big on investments in Merrill Lynch, Citigroup.  Bureaucrats care bureaucrats whatever country they come from; they are not astute investment managers.  Our bureaucrats do no better but it does ease the mind some to have other country's bureaucrats in our markets. 

The Clear Channel Deal and the Court

This is choice.  The banks financing the $19 billion privatization of Clear Channel Communications by Bain and Lee Partners want to back out.  The buyout firms, sitting on a $600 million termination fee obligation, want to close.  Clear Channels controlling family, sitting on a promise for cash, want to close.  The result?  Lawsuits.  One in Texas and one in New York.  The Texas judge, in a very very quick opinion, entered a temporary restraining order against the banks.  A renegotiation of the price would benefit all the parties.  Now the banks say they cannot renegotiate the deal without violating the Texas judge's order.  The Texas Judge's order against the banks, has, in essence, helped the banks delay a solution.  Delay favors those who have not yet paid the money.  You gotta love judges. 

James E. Cayne and the Bear Stearns Collapse

The chair of Bear Stearns, James E. Cayne, was a high flier -- brash and self-important.  He held 1$ billion in Bear Stearns stock.  After the collapse of Bear Stearns, his stock, which he sold, was worth $61 million.  Ordinary folks will not cry for him (he still has loads of money) but he did lose $940 million dollars in less than one year.  He also lost his false pride.  His brashness now does not play well on the street.  Recall the stories of how he refused to come off the golf course or the bridge table when problems were brewing. He has been humiliated and is ashamed and should be ashamed and others on Wall Street should note his example.  Rumor has it that he is turning to religion to help himself explain his predicament.  He does not need religion.  He should read Fitzgerald.

Treasury's New Plan

By now most have in the financial community have digested the details of Sec. Paulson's grand plan to reorganize federal financial regulations in the country.  The plan augments the power of the Federal Reserve Board to step in when there is a financial crisis.  The plan establishes three agencies with different task -- one to regulate the stability of the market, another to regulate financial market competition, and yet another to protect investors.  Part of the plan is, for example, a merger of the SEC and CFTC.  Hidden in the plan are proposals to lighten regulation -- for example, a proposal to lighten regulation of securities exchange rules on listings. This plan has no chance of approval -- it is too complex, upsets too many apple-carts, and appears in an election year and a year in which the economy is staggering.  Why propose it then?  Simple.  What makes the knees shake of government officials, even those that favor market based solutions over government based solutions to economic cycles, is getting condemned in the history books as having done "nothing" while the people suffer.  This plan is a CYA for Paulson.  He can claim to have done "something" to solve our economic problems.  The proposal of the plan itself is an illustration as to why government ought not have the power the plan gives the FED.  There is too much pressure on government officials in a downturn to "do something" and that pressure, more often than not, leads to counterproductive actions.  It is well known that Herbert Hoover should not be criticized for doing nothing during the early days of the depression; he should be criticized for doing stupid things in response to pressure -- increasing tariffs and increasing taxes.  The plan, increasing the power of the Fed in crisis times, is likely to lead to more problems than corrections.

Pension Benefit Guaranty Corporation's New Policy

Along with discussion of Bear Stearns, the WSJ's opinion page has a helpful discussion of another moral hazard problem: the Pension Benefit Guaranty Corporation.   The PBGC is a government safeguard against shortfalls by company pensions.  The PBGC is funded by "premiums paid by employers,assets from failed pension plans, recoveries from bankruptcies and returns on invested assets."  The difficulty for the PBGC is that its funding does not meet its obligations, so in order to remedy the problem the PBGC has decided on a new investment policy that will more heavily invest in equities.  Unlike some sovereign wealth funds, the PBGC does not select stocks or bonds or actively manage its own portfolio, relying instead on professional money managers and market index funds.   The PBGC believes its new strategy will both obtain better returns and reduce risk through diversification.  Still, the WSJ warns that the PBGC strategy may create more risk, and in any event it still leaves the PBGC vulnerable, which could potentially mean a government (read: taxpayer) bail-out.  The WSJ asks: If we are even going to have a PBGC, why not demand higher premiums?   The reason is, I suppose, that there would be a great outcry over the burdens placed on small businesses, similar to what has happened with the planned (but not yet realized) imposition of Sarbanes-Oxley's 404 to smaller companies.  However, the important difference between the two scenarios is that in the case of unfunded pension liabilities, taxpayers ultimately bear the risk of failure; in the case of potential losses due to the decision not to apply 404, investors bear the risk of failure (and can price accordingly).

Posted by Paul Rose

The Fed, the Treasury and the Bear Stearns Deal

Two government units, the Treasury and the Fed, are negotiating the JP Morgan buyout of Bear Stearns.  This should give us great pause.  First Paulson has agreed to write a $29 billion credit derivative swap on Bears risky mortgage backed securities for free.  In essence he is granting JP Morgan what would have been the fee on the swap, a sizable amount.  The deal, unless offered to all potential buyers (and we do not know who Paulsen had included in the selective group of offerees), stops any competitive bidding market for Bear Stearns.  The Treasury has, in essence chosen the buyer.  Second, Bernanke is setting the price. With Treasury offering up a cash induced to do the deal at issue is how the inducement is split among the lucky players -- what do the Bear Stearns shareholder get of this largess?  Bernanke apparently did not like the price at $2 a share and negotiated for $10 a share for the Bear Stearns shareholders, giving the shareholders a larger piece of the Treasury's surrogate cash grant..  So, after the Treasury choose the price, the Fed has chosen the price.  Moreover, he delayed telling Bear Stearns about his intent to lower the discount rate on funds that investment banks can now borrow (this also is new) from the Fed until after the contract was initially inked.  Bear Stearns could have used the window to borrow money to keep afloat a bit longer to negoitate a higher price or to encourage other bidders.  This heavy- handed manipulation of a buyout of the country's fifth largest investment bank ought to raise eyebrows all throughout the financial community.  Do we want Treasury and the Fed using such a heavy hand to structure the operating side of the financial markets?  I do not.  What's next, one has to wonder?  The feds had better develop a principle fast for when to get into the business of restructuring financial institutions beyond the caterwauling of "impeding doom" by wall street insiders.   The feds will find that appeals to them to "do something" by anyone facing financial loses will now step up considerably.  What a mess.

Treasury, Abu Dhabi and Singapore Agree to Basic Principles for SWFs

The Treasury Dept. and two of the largest and mosty active SWFs have agreed on some basic principles for sovereign wealth investment.  The press release from Singapore is here.  The principles are essentially the those of the framework set out by Treasury Undersecretary Robert Kimmitt in his recent Foreign Affairs article "Public Footprints in Private Markets".  I think the Treasury has struck the right tone with SWFs thus far, and demonstrates that at least some SWFs are willing to act more like fiduciary investors as long as they are treated like other investors.  The key investor that must come to the table, however, is China.  While Singapore and Abu Dhabi are important SWF investors, China's SWF is the bigger concern because of China's greater economic and political importance.

Posted by: Paul Rose

Two Items on Financial Restatements

The SEC's Advisory Committee on Improvements to Financial Reporting met last week in San Francisco, and discussed a February report from the Committee finding that companies are restating financials "for trivial reasons that have no bearing on their true financial situation," as BNA sums up the report.  Ultimately, the Committee report proposed that:

·       Prior period financial statements should only be restated for errors that are material to those prior periods.

·       The determination of how to correct a material error should be based on the needs of current investors. For example, a material error that has no relevance to a current investor’s assessment of the annual financial statements would not require restatement of the annual financial statements in which the error occurred, but would need to be disclosed in an appropriate document, and, to the extent that the error remains uncorrected in the current period, corrected in the current period.

Although this seems to me to be a sensible position, a number of concerns were raised by consumer and investor advocates and some institutional investors.  Most notably, a representative from the Capital Group, a very large fund manager, argued that a company should restate previously reported amounts for individual income and expense items on the income statement even though the previously reported net income number would not change as a result, stating that "[w]e are very interested in the corrected individual components of the income statement and use the changes in specific income and expense items over time as part of our trend analyses." 

The Capital Group’s position aside, I suppose that the real value in restatements for investor rights advocates is that a restatement is sometimes a prelude to a securities litigation claim—decreasing the number of restatements will probably decrease the number of securities fraud suits, which investor advocates promote as an important check on management. 

In related news, Plumlee (Utah) and Yohn (Indiana) recently posted on SSRN a study entitled An Analysis of the Underlying Causes of Restatements :

Abstract:      

The dramatic increase in the volume of restatements over the past years has been attributed to causes such as the complexity of the accounting standards, internal control reviews, changes in materiality thresholds, the overly conservative nature of auditors, earnings management, increased transaction complexity, and the second guessing of management judgments. While there are many explanations for the increased number of restatements, empirical evidence on the underlying causes of restatements has been lacking. This study provides such evidence by directly addressing the questions of what causes restatements, what characteristics of the accounting standards cause restatements, and whether the materiality threshold for restatements has fallen over the years. We analyze the disclosures related to each restatement filed during 2003 through 2006 and identify and categorize the underlying cause of each. Using these data, we analyze the relationship between the causes and various firm characteristics, including size and auditor type. We also consider the impact of contributing factors (including the clarity of standards and the use of judgment) on restatements caused by characteristics of the standards.

We find that, inconsistent with the notion that increased complexity has caused the rapid increase in the number of restatements, restatements are most often caused by basic internal company errors unrelated to the accounting standards themselves. We also find that for those restatements caused by some characteristic of the accounting standards, the primary contributing factor was the lack of clarity in applying the standards and/or the proliferation of the literature due to the lack of clarity in the original standard. Judgment and the use of bright lines are much less frequently cited as the contributing factors, and the proportion of restatements that they are related to has decreased across our sample period. Finally, we find some evidence that the materiality threshold applied in the decision to restate appears to have decreased over our four year sample period.

Posted by: Paul Rose