A stimulating conference on the performance of financial intermediaries (that's banks and shadow banks) during the crisis reminded me that a number of finance scholars largely agree on some of the basics of what happened.  Legal scholars and bloggers have expressed no such consensus, perhaps because we are focused on institutions and laws, such as was it compensation practices?  Regulators asleep on the job?  Credit rating agencies?  And so on.

All of these institutions probably played a role, of course, but many economists would probably put much of the blame where, it seems to me, it must belong: in the markets.  And in those markets, banks and shadow banks kept risky assets on their books, rather than selling them on to the greater fool.  When the asset values collapsed, there was an old-fashioned run on the shadow banks, and a serious impact on the solvency of the banks.

So I thought I'd do a couple of posts on this, ventriloquizing what I've heard - there's no creativity here - so that the wise readers of this here website can consider these issues. But the market failures raise three questions.  First, why did the banks keep the risky assets?  Second, why was there a bank run in the shadow banking sector?  And third, what should be done to prevent these sorts of market failures from happening again?

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I've been busy with semester-starting, Glom Master-organizing, FAR-form-reading, home remodeling, etc., so the flash-trading ruckus has been lurking on the periphery of my consciousness.  Yesterday's WSJ article intrigued me, though.

What's flash trading?  According to the article it's "a particular variety of high-frequency trading that briefly previews some orders to a few dozen market participants and trading platforms in hopes of finding a match."  Huh? 

Last week flash-trading proponents Chris Hynes and Donald Luskin described it this way:

 ...it is simply a way for one customer to query other customers to see if they will take the other side of a trade.

Let's say that among all the exchanges, the highest bid for stock XYZ is 10, and the lowest offer is 10.5. Bob enters a flash order to buy 500 shares in between, at 10.25. This order exists in Direct Edge's system for mere milliseconds, but in that time the high-speed computers of other participants might decide to sell Bob the 500 shares he wants to buy. So Bob gets a price better than the best offer, and the seller gets a price better than the best bid. If a trade can't be executed, then Bob can try other markets.

In this example, because the flash trade comes in between the best bid and the best offer, it does not contribute to market volatility. Buyer and seller have entered into a trade in which they both feel they have achieved the best possible deal, or they wouldn't have traded. And the flash order created an opportunity for new liquidity to enter the market.

Flash trading is definitely a big deal. A NYT article says:

An explosion of computerized trading has helped drive volume on the New York Stock Exchange alone up by 164 percent since 2005. Stock exchanges say that more than half of all trades are now executed by just a handful of high-frequency traders, who use rapid-fire computers to essentially force slower investors to give up profits, then disappear before anyone knows what happened.

I'm still not quite sure I get exactly how flash trading works.  But I do get the stories. 

N.Y. Sen. Charles Schumer claims these deals create:"a two-tiered system where a privileged group of insiders receives preferential treatment." He wants the SEC to ban them.  Basically the story goes that it's unfair to the rest of us that these insiders get to make these special trades.  It's the "rich people get access we don't" story.

Hynes and Luskin tell a story of Direct Edge as scrappy little guys trying to buck the establishment (NYSE), taking too much market share, and being unfairly picked on.  With Direct Edge accounting for 12% of U.S.-listed stock trading, it's a plausible David-vs.-Goliath story: NYSE sees a threat to its turf, and sics the SEC on the plucky upstart. 

Who's right?  I don't feel like I understand enough of the mechanics to say.  But look for SEC rules on flash trading and "dark pools" this fall.

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Thanks to Gordon for his nice words about my new paper on venture debt, and for his great help whipping it into present form (a new version just went up on SSRN). When I started the paper, I remember a friend warning me that “debt is not sexy.” Worse, the financial crisis has given debt a bad rap. Yes, consumers may take on too much debt, but don’t believe all the naysayers. Debt is awesome. It is extremely important in financial markets. Even in the start-up world my paper explores, where equity from angel investors and venture capitalists dominates, the use of debt makes for a fascinating story. Start-up companies have no track records, no positive cash flows, no tangible collateral, and no personal guarantees from entrepreneurs, yet are able to attract billions of dollars in loans each year. How is that possible? Read the paper to find out. Long live debt!

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An increasing number of British news reports -- such as this one in yesterday's Guardian -- suggest that the roiling Scottish-Libyan kerfuffle over the release of Abdelbaset al-Megrahi is best understood as a story about international business in addition to criminal justice.  Such an evolution might make business law professors generally more interested.  For my part, the particular facts are also coming closer to home.

Evidently, a centerpiece involves details regarding how the Anglo-Dutch oil concern, Shell, bested American Exxon for rights to massive natural gas fields in Libya.  The Guardian claims that high-ranking British ministers met with Libyan officials as many as 26 times to win access and control of "one of the world's key energy terminals": Marsa el-Brega.

Marsa el-Brega was "once a tiny fishing village on the most southerly tip of the Mediterranean" but now features a massive liquefied natural gas facility.  Brega, as it happens, was also once my home.  For the best part of my first eight years of life, I lived in a tiny expatriate compound there.  Then came the "line-of-death" US-Libyan brouhaha and we were all evacuated, with Americans banned for about a quarter of a century.  How profoundly odd it is to see one's puny, sand-strewn childhood village loom large in international intrigue.

By the way, if you're ever visiting, we lived at 1169 Cyrene.  (A fairly grandiose address, I confess, since there were only about 300 houses.)

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Thanks to Gordon and everyone at the Glom for having me back to visit. It’s a real pleasure to be back! With my securities regulation class starting this week, I wanted to begin there. While I really enjoy teaching the course, I can’t help but wonder whether it should be retooled in light of today’s financial markets.

My course is a standard survey of the disclosure process for public offerings and public corporations. As a combined securities regulation and securities litigation course, we spend a good bit of time on the liability provisions that the litigators look to when the transactional lawyers screw up the disclosures. But several important topics that seem to warrant coverage are hard to place within that traditional framework. For example, where does the financial crisis and systemic risk come in? Or the appropriate regulatory balance between the SEC and the Fed? What about Madoff and broker-dealer regulation? And perhaps most troubling of all – and this is a critique of the law as much as the course – we’re still studying retail investor rules in an institutional investor world. If mutual funds are such important financial intermediaries in today’s markets, why does the course not spend some time on them and their regulation? There is really interesting scholarly work in the area (e.g., William Birdthistle’s), but I fear that students leave the basic securities course knowing little to nothing about the vehicle through which most of them will invest, if not counsel as clients.

SEC Commissioner (and former Glom guest) Troy Paredes beat the same drum at this summer’s AALS Mid-Year Conference on Business Associations, so others might share these concerns. Perhaps there’s a market opportunity to write an innovative casebook that shakes up how we think about and teach this material. Any takers?

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Paul Caron has the collected links. This is a great resource for people wanting to make their way into the profession.

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Darian Ibrahim is a familiar name to many Glom readers. He is back for another stint at guest blogging, and will be discussing, among other things, his excellent new paper on venture debt. Welcome back, Darian!

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So, the last two weekends have found us at the movies, and as the blockbuster summer season wanes, we went to see two "small" movies that we liked very much.

500 Days of Summer.  We were going to see the "Time Traveler's Wife," but made a game time decision to see this movie after a neighbor recommended it to us on our way out the door.  It's a really simple movie, but captures what it's like when you are in your 20s and you really think that someone is "the one."  You know, when two people are holding hands at the IKEA and pretending they are married and live in the furniture "serving suggestions," and one person is like "Oh my gosh, they must want to marry me because we're pretending we're married in the IKEA" and the other person is like "The IKEA is such a fun place to joke around.  Let's go get some meatballs."  I've been there.  Anyway, the male lead, Joseph Gordon-Levitt, completely makes the movie.  He was the "boy" alien on 3rd Rock From the Sun and the little boy in Angels in the Outfield, but now he's a male lead, which somehow adds to the affection that you have for this naive young man falling in love so hard, so hard.  Very sweet movie.  It's set in modern day, but it feels sort of retro (the music, the clothes) somehow, which help us old people remember. . . .

Taking Woodstock.  We sort of just wandered into this one at the art theater downtown without knowing what it was going to be.  I think our lack of preconceived notions helped a lot.  Again, it's a really sweet movie about another early 20s male trying to find his way in the world, navigating between his immigrant parents who run a (run-down) motel in the Catskills and his desire to be a designer and go to San Francisco with his New York friends.  And, he's gay, but his parents don't know.  So, with this backdrop, Elliot becomes the driving force for getting the Woodstock music festival to come to his Catskills town when the "hippies" are kicked out of Wallkill, NY.  The movie is based on the memoirs of Elliot Teichberg, now Tiber.  Woodstock is the backdrop -- the real story is Elliot's journey separating from his parents and becoming his own person. 

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According to WaPo, the torture debate just got a lot more complicated:

The case against "harsh interrogation techniques" is easy if they don't work. But as Ann Althouse rightly observes, this story (if true) removes that easy path, "forc[ing] the moralists to get by on moral ideals alone!"

Arguments about corporate social responsibility often follow the same trajectory. Naive commentators often attempt to win points by portraying corporate managers as unenlightened and backward. If they would just act responsibly, the argument often goes, the world would be a better place and corporations would be more profitable to boot! To be sure:

The tough issue isn't whether managers should be "responsible" when responsibility pays, but whether managers should forfeit profits to pursue a "responsible" path. Tellingly, corporate law doesn't have much to say on that issue. Legislatures ban many forms of irresponsible behavior, but the marginal cases -- the morally complex cases -- are left to managerial discretion.

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Michigan cheats ... and goes 3-9?

[Insert gut-busting laughter from a Wisconsin Badger fan.]

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The latest notice by the banking agencies certainly suggests that it is true that accounting standards rule the world.  I'll italicize some of the particularly notable bits:

The agencies are issuing the proposal to better align regulatory capital requirements with the actual risks of certain exposures. Banking organizations affected by the new accounting standards generally will be subject to higher minimum regulatory capital requirements. The agencies' proposal seeks comment and supporting data on whether a phase-in of the increase in regulatory capital requirements is needed. It also seeks comment and supporting data on the features and characteristics of transactions that, although consolidated under the new accounting standards, might merit an alternative capital treatment, as well as on the potential impact of the new accounting standards on lending, provisioning, and other activities.

So, less off-balance sheet action, and higher capital requirements for financial institutions.  One might call it regulatory reform through the Federal Register.  And it is FASB that is to blame!  You can submit your comment in the following manner:

How hard could that be?  The banking agencies await the insights of the intelligent readers of this here website.

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We at the Glom are very pleased to announce a new feature: the Conglomerate Masters.  We have assembled an incredible lineup of distinguished commentators we will call upon to discuss particularly noteworthy business law events in the coming year.  We are particularly grateful that friend and former Glommer Fred Tung will be adding his expertise to the Masters mix.

Our goal is to create a centralized place for timely discussion and commentary.  We plan to call a Masters Forum roughly once a quarter, and Larry Ribstein is already blogging about our first anticipated topic: shareholder access to the proxy.  Look for the first Masters Forum sometime in the next few months.  And Masters, welcome to the Conglomerate fold!

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I'm in Sweden for a conference and a talk, in between which much research is occurring.  To that end, it is a good thing that it is raining today, because boy, this is a beautiful country.  But it is an action-packed week for the Fed, so a brief observation or two:

• The lost FOIA case on its bailout decisions is an example of how exception 4, which lets the government keep proprietary information private, can really implicate public policy (opinion here).  The Fed probably does have proprietary information from regulated companies that said companies don't want to disclose ... and yet the Fed used the information to do all these awesome interventions, which are matters of intense public interest.  In my view, it is an example of how all bright-line rules have linings that turn into balancing tests (proprietary information or no ... into public interest or not).  Anyway, all the banks could jump in with reverse-FOIA suits now, if the Fed doesn't appeal, which I would expect it might, unless overruled by Justice. (edited to correct the bad grammar)
• Simon Johnson is still great reading, and on the re-appointment of Bernanke, he's taking up a new and interesting role - he's becoming a bear, when many of his ilk are abandoning the field to the bulls.
• Should the Fed be doing consumer protection or should it be a new consumer protection agency?  As always, as Kevin Drum notes, it partly turns on how you feel about regulatory competition.
• Are you making causal inferences?  Do you want help?

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Yesterday I found a flyer among my mail for an auction “from a family member whose family was victimized by the Bernie Madoff Scam”—with Bernie Madoff Scam in large bold letters. According to the flyer, the auction is going to feature a “huge portfolio of investment grade art” complete with a “large Salvador Dali collection” and “large carat estate jewelry.” The link to Bernie Madoff is likely to have many different results—some of them positive from the stand point of the auction. Indeed, it may cause some to come who are still curious about the Bernie Madoff scandal, and thus interested in being around a family (or at least their art) that has been caught up in the scandal. And once there, perhaps the curious will be moved to bid and purchase. The link also may increase the likelihood that others will bid and purchase based on their desire to help out those apparently forced to auction their assets as a result of being scammed. Regardless of the result, the flyer—like the USAA ad—caught my eye (and not because I am in the market for estate jewelry or art). But rather because it demonstrates in a personal way how individuals, even in my own neighborhood, have been negatively impacted by the Bernie Madoff scam and are suffering because of it, while showing how those individuals are using that scandal, if only in a small way, and thus trying to turn lemons into lemonade.

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In the coming months, a wave of interconnected mutual fund litigation will wash upon the higher federal courts and very likely reshape the legal and regulatory contours of these investment funds.  The four most prominent cases have a great number of legal issues, lawyers, and schedules in common.  In fact, these cases are really two pairs of nearly identical claims filed in parallel courts of appeals, the Seventh and Eighth Circuits, and now making their way to the Supreme Court.

The Seventh Circuit Cases
Jones v. Harris
  In Jones, the plaintiffs claim that their investment adviser Harris Associates violated the Investment Company Act's Section 36(b) fiduciary duty by charging excessive fees to manage mutual funds.  Representing the plaintiffs now are Kellogg Huber, while Ropes & Gray are representing Harris Associates.  Certiorari was granted earlier this year, and oral argument is scheduled for November 2, 2009.  Other major dates in the coming weeks include Harris Associates' brief on the merits due August 27, amicus briefs in support of Harris Associates due on September 3, the Jones reply brief, if any, due on September 26 and of course oral argument on November 2.

Hecker v. Deere & Co.
  In Hecker, the plaintiffs claim that Deere & Co. violated its ERISA fiduciary duty by assembling an imprudent array of expensive mutual funds as investment options in Deere’s 401(k) plan.  Representing the plaintiffs now are Kellogg Huber, while counsel for respondents aren't yet certain (though O'Melveny & Myers and Covington & Burling represented them below).  The petition for certiorari is due to be filed by September 22.

The Eighth Circuit Cases
Gallus v. Ameriprise
  In Gallus (as in Jones), the plaintiffs claim that their investment adviser Ameriprise violated the Investment Company Act's Section 36(b) fiduciary duty by charging excessive fees to manage mutual funds.  As in Jones, representing the plaintiffs now are Kellogg Huber, while Ropes & Gray are representing Ameriprise.  Ameriprise filed a petition for certiorari on August 6, 2009, and the Gallus brief in opposition is due on September 5, 2009.

Braden v. Wal-Mart
  In Braden (as in Hecker), the plaintiffs claim that Wal-Mart violated its ERISA fiduciary duty by assembling an imprudent array of expensive mutual funds as investment options in Wal-Mart’s 401(k) plan.  Representing the plaintiffs are Keller Rohrback, while Shook, Hardy & Bacon and Steptoe & Johnson represent the defendants.  Wal-Mart recently won in the district court, but the plaintiffs have appealed to the Eighth Circuit.

One senses that the Supreme Court could have a great deal to say about the way in which most Americans save for their retirement in the coming months.

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