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So today, in celebration of the 80th anniversary of Black Tuesday, the Speculative Debauch is pleased to unveil its official new home at speculativedebauch.com Please adjust your bookmarks and, etc.
If you're hep to that internet jive and use one of the new-fangled technologies below, please click to:
When I was a reference librarian, I would, pretty regularly, get a request for information about "The Black-Scholes Model" (Black-Scholes). Black-Scholes is a mathematical equation that uses the price of stock (and other known variables) to determine the value of an option to buy the stock. Building on work done by Robert Merton, Black and Scholes first laid out their theory in a 1973 paper titled "The Pricing of Options and Coporate Liabilites."
The utility of Black-Scholes turned out to be far broader than just pricing options. As John Lancaster pointed out in the the most erudite goof you'll ever read, Black-Scholes "enabled people to calculate the price of financial derivatives based on the value of the underlying asset."
That's right - when Black & Scholes adapted the heat equation to finance they enabled the creation of much more accurate financial derivatives. This was considered sufficiently important that Merton and Scholes won the Nobel Prize in economics in 1997.
I don't pretend to understand any of this - reading the 1973 article is like trying to understand philosopy by starting with Spinoza. I found a purported simple explanation in the Norton Bankruptcy Reporter - maybe it'll help you? (Ayer, GOOD NEWS FOR BLACK SCHOLES SUFFERERS, 1999 No. 1 Norton Bankr. L. Adviser 7)
If you need to price your options, there are online engines that will Black-Scholes your numbers. What'll they think of next? No - don't tell me.
And don't forget - we're moving.
Was the day before "Black Thursday" the first of the four horsemen of the crash of 1929 (the others being Black Friday, Black Monday, and Black Tuesday - presumably the weekend wasn't a picnic, either).
In commemoration of these four, or possibly six, days of horror we're throwing ourselves, not off a building, but into a new website. Starting on Black Tuesday (October 29th), we'll be all moved out of this blog and into our new digs.
Although October 24th is the official first day of the crash, the erosion had begun more than a month before. The market hit its high (381!) on September 3rd and it was mostly downhill from there.
Roger Babson gets blamed for sending the market into its death spiral by, on September 5th, predicting a "terrific" crash. It is hard to imagine that one person, no matter how smart or respected, could wield that kind of power over a confident market.
In the days between the high and Black Thursday, as the market went down, investment companies started to get out and small investors booby-trapped the market by setting stop-loss orders and buying on margin.
The week beginning Monday, October 21st started with a loss and just got worse. At the end of the day on October 23rd, the NYSE was down 13%.
I just noticed that I have posted more than three hundred and fifty times on this blog. If posts were basis points, that'd be 3.5% - way better than today's LIBOR of .57%
Is it weird that that's the first thing I thought?
That pretty much says it. Click to follow. Why is this weirder than the SEC or Westlaw taking advantage of what is now called "social media?" The Bank of England and the Federal Reserve do not tweet (although HM Treasury does).
Also, am I the only one who thinks "social disease" when they hear that polite descriptor? Oh. I am?
Next week I shall be in Chicago presenting securities research master class part 2 (enforcement). I'm also hoping to throw in a sneak peek at part 3 (asset-backed securities and derivatives). If you're in town, and you have time, please join us:
West Librarian Relations Invites You
Securities Master Class 2 - Securities Enforcement
The current financial crisis has put the spotlight on securities regulation. Please join us and our guest speaker, Craig Eastland, Librarian Relations Practice Area Specialist, for the second of three Master Classes on Securities Research.
The West Securities Law Master Classes are designed to provide librarians with an overview of securities laws, a discussion of securities law practice areas and an exploration of West's securities research tools.
Part two will cover how securities laws are enforced. Using the story of the collapse of Enron as a starting point, the class will discuss the shareholder class actions, administrative enforcement proceedings and criminal prosecutions that can flow from violations of the securities laws. The discussion will also feature several research examples.
Tuesday, October 20th, 2009
Noon – 1:30 p.m.
The West InfoCenter
One North Dearborn - Suite 500
Columbus Room
Chicago, IL 60602
Yesterday, I spent some time researching the directors of Enron. What I discovered made wonder whether the post-Enron reforms, particularly the Sarbanes-Oxley Act, are capable of doing what they were designed to do. It even made me think that the laws might be grounded on faulty reasoning.
The most significant product of the corporate scandals of the late 1990’s was the Sarbanes-Oxley Act of 2002 (“SOX”, PL 107-204). SOX, of course, apotheosized the idea of the independent director as watchdog. SOX section 301 requires a public corporation’s audit committee (SOX is only concerned with audit committees – broader requirements for director independence actually come from NYSE and NASDAQ rules) be composed entirely of “independent” directors. Independence means no extra payola and no affiliation with the issuer or its subsidiaries. Affiliation is a two-way street and it comes down to control. An affiliate is someone who controls or is controlled by the issuer. Control is the power to direct via ownership of stock or by contract (see: Bostelman, The Sarbanes-Oxley Deskbook, PLIREF-SAROX s 11:3-3).
In the SOX cosmology corporate officers are compromised by their emotional and financial investment in a corporation’s fate, and must be isolated from other management players like auditors and lawyers. In the words of Byron Dorgan, “There is something rotten going on inside some of these corporations,” (Cong. Rec. pp S5249 – 5251, 2002 WL 32054458). For instance, section 203 of SOX requires auditors be rotated to ensure that they don’t lose their objectivity by getting too friendly with management.
But, according to Woodrow Wilson scholar (and Enron board member) Herbert Winokur, Enron’s board *was* independent. As he told the Senate’s Permanent Subcommittee on Investigation, “Enron’s board was composed of 12 independent directors and 2 inside directors.” And, he’s right – according to Enron’s 2000 proxy statement (Def 14A, 5/2/00), of the 17 directors listed, only three are Enron employees (Lay, Skilling, and John Urquhart who is Lay’s “Senior Advisor”). If we expand the group to include anyone who’d lose their “independent” status under SOX 301 we get five more names (for a total of 8): Robert Belfer, Lay’s business partner and CEO of Belco, an Enron sub, John Duncan, director of Enron sub Azurix, Ken Harrison, CEO of Enron sub Portland Gas & Electric, Rebecca Mark-Jusbasche, CEO of Azurix, and Winokur himself, a director of Azurix.
Pretty cozy, right? You can just imagine the plotting of nefarious doings. But to assess whether SOX 301 can really improve corporate governance ask yourself this (or, allow me to ask it for you): if management’s financial and emotional investment is the problem and an independent board is the solution, does this law really make an independent board possible?
To answer that question, let’s look at the other people on the Enron board, circa 2000. Wendy Gramm and John Wakeham may not have been personally invested in Enron, but both staked their professional careers on the wisdom of deregulating the energy business. Gramm, an economist and wife of Senator Phil Gramm, was head of the CFTC under the first President Bush. Responding to an Enron petition, she, in the waning days of her tenure, exempted energy commodities and swaps from CFTC regulation (CFTC 3620-93, 1993 WL 13822). As Margaret Thatcher’s Secretary of State for Energy, Lord Wakeham was the man in charge of privatizing England’s electricity industry, and as the Independent observed, “Enron was the first US company to benefit from his work.” Gramm and Wakeham are independent by the SOX standard, but Enron’s success would prove the wisdom of their professional decisions.
Also on Enron’s 2000 slate are Charles Lemaistre and John Mendelsohn, respectively, the former and current directors of the MD Anderson Cancer Center in Houston. Enron was based in Houston, and it is certainly a possibility that Lay and Skilling knew Lemaistre and Mendelsohn socially.
I don’t mean to imply that Lemaistre, Mendelsohn, Gramm or Wakeham were in on the scam - quite the opposite. The officers of Enron were running a criminal enterprise and they cleverly populated the board with people who had built-in reasons for wanting Enron to succeed. They capitalized on personal connections and political agendas alike to create a passive overseer.
So, that’s my point – distinctions between inside and outside mean nothing when you’re dealing with a con. Con artists draw people in and then they use them - for money or just for their good name - and that’s already illegal.
As I've mentioned in the past, one of the hazards of derivatives transactions not executed through a clearinghouse is that the parties are responsible for policing each others credit. Each party must satisfy itself that its counterparty will be able to execute the transaction without defaulting.
In the 1980's parties began trying to control credit risk by taking collateral from each other. Basically, when one party is in a more tenuous financial position than the other, the shakier counterparty will pass some collateral (usually cash) to the stronger party as a guarantee. In its 1996 report, the ISDA Collateral Working Group identified three ways that collateral makes derivatives more attractive: it equalizes disparities in creditworthiness thus opening up a wider range of potential counterparties, it can reduce the interest charged to less creditworthy counterparties, and it may help regulated financial institutions reduce their capital requirements by lowering the risk weighting associated with the transaction.
OTC derivatives executed via the ISDA Master Agreement are structured using one of three ISDA credit support annexes to the Master Agreement schedule. All three establish the same framework for the operation of the collateral transfer - how collateral calls are calculated, when collateral can be substituted or exchanged, how disputes will be resolved, etc.
There are three of them because each is governed by the law of a different jurisdiction. The 1994 Credit Support Annex (security interest - New York Law) and the 2008 Credit Support Annex (Loan/Japanese pledge) create a lien on the collateral while the 1995 Credit Support Annex (Transfer - English Law) actually transfers ownership of the collateral to the other party. Each of the annexes has an explanatory "users guide" and the 1994 and 1995 annexes have standard conforming amendments to bring them out of the dark ages of the 1992 Master Agreement.
These collateral support agreements, of course, are what got AIG in trouble. Each time their rating was downgraded they found themselves facing many CDS-related collateral calls.
Subtitle C is the weirdest piece of the administration's proposed Investor Protection Act of 2009 because a lot of it is a spanking for the SEC.
It has been nearly 5 years since Congress gave the SEC explicit regulatory oversight of credit rating agencies, but the agency has had trouble imposing any control. Despite being implicated in the Enron collapse and, of course, in the current financial unpleasantness, credit rating agencies have managed to avoid any substantive oversight. They have evaded regulation of the content of their ratings by arguing that ratings are opinions and therefore protected speech under the First Amendment. They are free from public disclosure obligations, beyond form NRSRO, because they have convinced regulators that secrecy is essential to their business.
This then, is why section 932 of Subtitle C requires that, "The Commission shall establish an office that administers the rules ... with respect to the practices of nationally recognized statistical rating organizations," and why the Commission is directed to "conduct reviews required by this paragraph no less frequently than annually," and to make "[a] report summarizing the key findings of the reviews ... available to the public in a widely discernible format." Most embarrassingly, section 936 orders the Comptroller General to write a report assessing "the extent to which the rulemaking of the Securities and Exchange Commission has carried out the provisions of this Act." Ouch.
Subtitle C also imposes new obligations on credit rating agencies. For starters, they must promulgate a written conflict-of-interest policy and elect a Chief Compliance Officer to police same. For more see this one-page summary from Morrison & Forester.
The SEC has a slew of rules out that cover much of the same territory. It isn't clear whether Subtitle C and the SEC's proposal are coordinated. The SEC has "deferred" its plan to reduce the reliance placed on the NRSRO classification. Subtitle C would put this program where it belongs - with the President's Working Group.
Today, I'm going to start looking at a neglected piece of the administration's reform proposal: title IX, the vast Investor Protection Act of 2009. The IPA is a grabbag of regulatory off-cuts ranging from asset-backed securitization reform to credit rating agency reform.
The centerpiece of Subtitle E, called "Improvements to the Asset-Backed Securitization Process," is the so-called "skin-in-the-game" regulatory fix. The idea is that the present securitization process provides no incentive for deal sponsors to create good-quality securities. The way sponsors make money is by getting fees. They pay themselves a fee for putting together the pool, for underwriting, and even for servicing the underlying debt. They don't invest. The sponsor is like a chef who won't eat at his own restaurant. The thinking is that if he has to eat what he peddles, his restaurant will improve.
So, section 952 of the IPA would require "securitizers" of ABS deals to retain 5% of the "risk." Securitizers would not be allowed to hedge this retained risk and the SEC would establish standards for the risk's "permissable forms" and "minimum duration."
The new law defines "securitizer" as an issuer or an underwriter. It cleverly hops right over the amorphous matter of trying to define "sponsor" and lands right where the sponsor gets its money - underwriting.
Of course, the ABS packagers, especially the residential mortgage monsters like Lehman and Bear Stearns *were* eating in their own restaurant. In fact, they were eating the leftovers (in the form of the lowest tranches of their offerings), and so, there's a funny sort of conversation that's been going on about whether the ABS sponsors were really avoiding the securities they created. What this argument boils down to is a disagreement about how stupid they were. Were they smart enough to know their ABS deals were crappy, but too stupid to get out in time, or were they completely oblivious to how risky these deals were? Skin-in-the-Game is only an effective deterrent if the ABS packagers are just a little stupid.
Subtitle E also gives the SEC power to create a disclosure obligation for ABS issuers that could not be extinguished by de-registering under section 15 and presumably would continue until the breaking of the world.
For a complete overview, see this Cadwalader memo and wonder along with them (and me) about why the law repeals s. 4(5) of the '33 Act.
I admit that I am still agog when I look at the residential mortgage-backed securities transactions from right before the crash. I know it sounds like I am, once again, excavating things best left interred, but that is not the case. Last week, Fitch gave a triple A rating to a new security called "JP Morgan Re-securitization Trust 2009-R10." The Fitch news release mentions that among the securities being "re-securitized" is "a 25% interest in Lehman Mortgage Trust 2007-7, class 6-A-4." "And what's that?" I wondered, you know, to myself (I'm a blogger so, I am alone).
Then, I went on Westlaw Business and found the prospectus. LMT 2007-7 was an $800 million pool of about 2,000 residential mortgages. It issued 19 different classes of securities. The securities were narrowly sliced to reflect specific parts of the large pool. First,the big pool was subdivided into three smaller pools based on the quality of the underwriting standards. 77% of the mortgages in Pool 3, composed mostly of mortgages originated by Lehman's banking sub Lehman Brothers Bank, were "no-doc" loans.
The Pools were further subdivided into "collateral groups" by interest rate. Series 6-A4 was paid out of collateral group 6, a collection of 700-or-so mortgages with a weighted average interest rate of 7.5%. The "A" and the "4" indicate payment priority - "A" securities got paid first, but within "A" 1 got paid before 2, or 4. Further confusing the payment priority picture, the 6-A4 securities are also described as "super senior."
LMT 2007-7 paid right on schedule until December of 2007-7 when it filed a form 15 to withdraw its registration on the grounds that it was held by fewer then 40 people.
Virtually all the LMT 2007-7 securities were initially rated triple A by S&P. When I checked their rating last week, they were all rated B+ or lower. When I checked today, the ratings were gone.
Is this what we're going to get instead of PPIP?
Please read the gloriously deadpan Death Plays in Barron's about my favorite new securitization. "We admit" says Alan Abelson "to a nagging concern or two."
As I mentioned in the last post in this series, in 2002 ISDA revised its Master Agreement to create a better way of determining who owes what to whom when an agreement goes into default. The 1992 Master Agreement provided two methods (with the creative monikers "First Method" and "Second Method") both of which proved unsatisfactory during bad market conditions. The 2002 Master Agreement replaced these mechanisms with a much more flexible method called "close-out amount."
Unfortunately, the 2002 Master Agreement was adopted only gradually. In a March memo, Manuel Frey and Jordan Yarett of Paul Weiss observed that, "since its introduction, the 2002 ISDA Master Agreement has become increasingly common in the market place, although the 1992 ISDA Agreement continues to be widely used." In a January article in Butterworths Journal of International Banking and Finance Law, Edmund Parker and Aaron McGarry second that: "Many Master Agreements still in use are based on the 1992 version, which contains the greatest weaknesses."
In addition to an understandable unwillingness to spend money amending thousands of contracts, reluctance to adopt the new Master Agreement also stems from the need to very closely match a hedge to the transaction being hedged. The fear is that hedging a transaction written on 1992 Master Agreement with a transaction written on the 2002 Master Agreement might cancel the value of the hedge.
The collapse of Lehman Brothers, with its 8,000 Master Agreements and 67,000 outstanding transactions, pointed out the folly of being so conservative (or lazy) and since then, there as been a concerted effort to ditch the 1992 settlement procedures. In August of 2008, most of the large OTC derivatives dealers signed the Close-out Multiparty Agreement which bulk-updated their existing 1992 Agreements to conform with the 2002 Agreement's close-out protocol. In February of 2009, ISDA published the Close-Out Amount Protocol, a standard-form version of the Multiparty Agreement. ISDA maintains a list of adherents to the Protocol.
Corporate Counsel blog on the SEC Inspector General's report on La Madoff. *sigh*
From Forbes (via CompliancEx) a call for securities arbitrators to explain their decisions. Here, here!
From the New Brunswick Business Journal (with thanks to Compliance Week for pointing it out) - a Canadian SEC? Egad.
At the center of the ISDA documentation architecture is the Master Agreement. The Master Agreement began life in 1985 as the Code of Standard Wording, Assumptions and Provisions for Swaps (it spells SWAPS - how cute is that?) and matured into its present acronym-free iteration as the 1993 ISDA Master Agreement.
The Master Agreement is made up of three discrete pieces - the printed form, the schedule, and any subsequent confirmations. The printed form and the schedule lay out the mechanics of the transaction. The printed form is a standard recitation of parties, addresses and other routine information - it is not generally amended. The schedule is a mechanism for customizing the printed form. It gives the parties the option of adding customized langauge and turning on or off some of the printed form's provisions.
The confirmation is a standard practice that predates the Master Agreement. The Master Agreement sets out general operating principles for a proposed derivatives transactions, but the transactions don't actually occur until a confirmation is sent. The confirmation contains the specific monetary terms of the transaction.
The 1993 Master Agreement provides two methods for determining payment in the event of default. Parties must choose one. During the Japanese banking crisis in the 1990's both mechanisms failed to provide equitable settlements. As a result, the ISDA revised the Master Agreement to provide a broader settlement mechanism. The new mechanism is the primary difference between the 1993 Master Agreement and the 2002 Master Agreement.
For a very thorough discussion of both Master Agreements, see 1397 PLI/Corp 51, Klein, Overview of the ISDA Master Agreement Forms.
Part 3: LEHMAN
Part 1
When he planned to steal our sunlight, he crossed that line between everyday villainy and cartoonish super-villainy.
- Smithers
Before I read today's New York Times, I felt slightly superior to people who ascribed evil motives to, for instance, Goldman Sachs. Business cares about making money - it doesn't make moral judgments. But, as today's Times article proves, there's no practical difference between being amoral and being immoral.
Some Wall Street banks, apparently, are planning to securitize viatical settlements thereby creating a way to invest in the probability that other people will die. Presumably, you could even speculate on the likelihood of your own death.
What if your pension fund were to invest? The risk factors should be a hoot, too - "in the event that AIDS is cured, you could lose your entire investment."
1995 ISDA Credit Support Annex
1995 ISDA Credit Support Deed (Security Interest – English Law)
2008 ISDA Credit Support Annex (Loan/Japanese Pledge)
1994 ISDA Credit Support Annex (Security Interest - New York Law)
The first time I was asked to pull one of the components of the International Swaps and Derivatives Association's "documentation architecture" I was pretty intimidated. I spent a few minutes in that forest of teensy, similarly-named pamphlets, chose what I thought was the right one and then, shortly, found myself back at the shelf taking a closer look because I'd pulled the wrong document. Eventually, I became more adept at navigating the ISDA waters, but I always felt a little at sea.
To understand why the ISDA documentation architecture is confusing (aside from the irritatingly similar names), I think it is helpful to remember that derivatives were devised as a hedging tool. A hedge is a way of protecting an investment against a worst-case scenario. For instance, if you owned a store in a seaside town and anticipated a hot, sunny summer you might buy more sunglasses than usual. If you're wrong and it rains, you won't make any money from your investment in shades. So, to hedge against that possibility you might buy umbrellas. If the summer is as you expect, you'll make lots of money, but if it rains every day, you can limp along selling umbrellas.
To be useful as a hedge your umbrella purchase must be precisely related to your investment in sunglasses. Hedging transactions are always associated with a primary investment and must be narrowly tailored to protect against a disaster without negating the primary investment's value. Thus, hedging transactions are always customized to accommodate the needs of both counter-parties.
If you are reluctant to get into the umbrella business, there are other ways to hedge your risky sunglasses play - you could invest in an umbrella company, short a sunglasses manufacturer, or you might want to try something more exotic: like investing in the price of umbrellas. That's where derivatives come in - they were developed as a way to hedge by investing in intangibles, like the price of wheat.
The ISDA documentation architecture was developed to institutionalize and standardize the process of writing these highly customized contracts. So when, in 1980's, the ISDA started working on a set of standard forms for derivatives transactions, they were faced with a daunting task: how do you create a standard agreement for an industry where every agreement is different?
Part 2: THE ISDA MASTER AGREEMENT
Last week, the CFTC withdrew two no-action letters which gave DB Commodity Services LLC (CFTC Ltr. No. 06-09, 2006 WL 1419398) and something known only as "Client X" (CFTC Ltr. No. 06-19, 2006 WL 2682362), exemptions from the position limits in Regulation 150.2 (17 C.F.R §150.2). These entities sought exemptions because they were buying small numbers of futures to create a virtual commodity index. The commodity index was a tool used to price their real product: commodity-linked notes.
The withdrawl of no-action protection from this apparently inocuous activity appears to be part of a general CFTC blitz on speculation. The CFTC limits the size of transactions which are not bona fide hedging (see this CFTC Backgrounder for more). The CFTC news release finds that transactions undertaken by DB Commodity Services and X do "not qualify for a bona fide hedge exemption under the Commission’s regulations," and given CFTC Chair Gary Gensler's belief that "position limits should be consistently applied and vigorously enforced," this seems like something of which we'll be seeing more.
Only two more days until the SEC and the CFTC begin their "harmonization" meetings. Okay, again from the top - and Mary, in E this time.
Today brings a wealth of interesting items (and lots of video) from around the interweb. To wit:
From Advertising Age: Pfizer's PR chief wishes that government regulators would come up with some kind of Twitter policy, already.
From The Compliance Exchange: Ron Paul says that Barney Frank is going to allow a vote on a bill that would let the GAO audit the Fed's monetary policy! Also, YouTube video of Mary Schapiro talking about restoring the SEC's reputation.
From Compliance Week: a podcast (subscription required) about the SEC's proposal, in release 33-9052, to change the proxy rules with an eye to getting better disclosure about the "relationship of a company's overall compensation policies to risk." The proposal would seek to illuminate compensation policies that "can create inadvertent incentives for management ... to make decisions that significantly, and inappropriately, increase the company's risk."
Finally, from the Corporate Counsel Blog: a roundup of all the commentary on the Rakoff / Merrill / B of A proceedings.
In May, the SEC proposed an amendment to the process that gives shareholders the right to insert proposals, and alternative director slates, onto corporate proxies (more here). Last weekend John Coates hepped me to the onslaught of comment letters that followed. He told me he'd signed a letter suggesting a slightly higher threshold than the 1% proposed by the SEC (Jay W. Lorsch et al, 8/13/09). He also told me that there was another letter from another group of law professors saying they thought 1% was just fine (Lucien Bebchuk et al, 8/17/09).
My first thought was that this sounded like a lot of fighting over pretty small numbers. The difference between the current 10% fee and 1% probably adds up, but the difference between 1% and 3%, or 5%? So, I went to Google Finance to see how much money 1% really is. I picked a couple of very large companies to start: Google, IBM, and AT&T, and I did the math. IBM has a market cap of $157 billion so 1% of that is $157 million. That's the minimum price to get one's proposal before the eyes of IBM shareholders. To me, that sounds like a shitload of money - maybe even a couple of shitloads - more than your average crazy has laying around his bunker. The numbers for Google and AT&T are similarly large - they won't have to worry about a flood of alternative director slates.
Smaller companies, however, probably will - a company with a market cap of $250 million would have an entry fee of $250,000. Not exactly spare change to the American Nazi Party, or the Black Bloc, but certainly low enough so that every hedge fund in town could float its own slate. So this is maybe a receipe for chaos, but what the hey ... how else do we find out what happens?
On the 11th, the administration sent to Congress its Solomonic resolution for the lingering over-the-counter derivatives problem (does no one remember that the point in the story of Solomon's proposed baby-hacking is that when you cut a baby in half, it dies?)
The 115-page proposal creates a very broad definition of "swaps" and then carves out a subset of "security-based swaps." Regular swaps are to be regulated by the CFTC and security-based swaps by the SEC. Both agencies are instructed to play nice and write joint rules and joint interpretations or the big, bad Treasury will do it for them.
Standard swaps will be cleared by central clearing agencies and traded on exchanges. Non-standard swaps must be reported. In a nice piece of circular reasoning, the proposal creates an assumption that swaps traded on an exchange are standardized.
For a detailed discussion of the proposal see Sullivan & Cromwell's section-by-section analysis on their Financial Markets Resource Center (a great resource in any event).
On August 5th, Robert Khuzami, the new Director of the SEC's Division of Enforcement, gave a wide ranging speech about the "top-to-bottom scrub" that the Division has gone through post-Madoff. For a scrub overview see this memo from Edwards Angell Palmer & Dodge.
One of the things Khuzami promised is a faster investigative process. He has removed at least one procedural roadblock by convincing the Commission to delegate to him the power to issue Formal Orders of Investigation. He plans to delegate this power to "senior officers" of the Division. To encourage SEC investigators to move with a will, he is taking away thier tolling agreements. Tolling agreements, he said, would become the "exception, not the rule. (I, for one, had no idea that tolling agreements were the rule!)"
A tolling agreement is a contract between litigants where both parties agree not to use the statute of limitations as a defense. Section 3.1.2 of the SEC Enforcement Manual says that "[s]uch requests are often made in the course of settlement negotiations to allow time for sharing of information in furtherance of reaching a settlement." Khuzami appears to believe they were also used to maintain a leisurely investigative pace.
The SEC Enforcement Manual appears to back Khuzami's interpretation - it notes laconically that investigators should "[t]ry to avoid multiple requests for tolling agreements by asking for a suitable period of time [...] it is ultimately more efficient to overestimate rather than underestimate the time need to complete the investigation."
*yawn*
Last week, Jed Rakoff, a District Court Judge in the Southern District of New York, refused to approve a settlement between the SEC and Bank of America. Rakoff was widely praised for taking a principled stand against shoddy disclosure and the SEC's tacit approval of same.
But that's not what I want to talk about. I want to make the case that Jed Rakoff is the Kevin Bacon of the securities bar. Before Rakoff was a judge he was a federal prosecutor, and eventually, the Chief of Business Fraud for the US Attorney's Office, SDNY. He succeeded John R. Wing who would become Peter Madoff's lawyer (his boss at the SDNY was future Whitewater Indepedent Counsel Robert Fiske). Upon leaving the US Attorney's Office in 1980 he became a partner at Mudge Rose (Richard Nixon's law firm). Among his clients was Kidder Peabody M&A specialist-turned-government-informer Martin Siegel. Siegel testified against Ivan Boesky who was defended by short-lived SEC chair Harvey Pitt. In 1990, Rakoff left Mudge Rose and joined Pitt's firm, Fried Frank. In 1995, when President Clinton appointed him to be a District Court Judge (replacing David Edelstein who heard some of the Kidder Peabody civil suits, 686 F Supp 413, 752 F Supp 624) he completed the triangle - he'd been a prosecutor, a defense attorney, and now a judge.
If you know me, you are only two degrees away from Rakoff - he taught a class on Federal Criminal Law I took in law school (I got a C) and I used to work at Fried Frank, too.
Is it a small world, or is it just me?
Perhaps it has come to your attention that Annie Leibovitz is having financial troubles. I spent a couple hours looking into this expecting to find a story about predatory lending, but instead I discovered that the art market is, well, totally sleazy!
Leibovitz, apparently suffering from an advanced case of the New York City disease (real estate), had embarked on a renovation project so vast even her substantial income could not cover it.
Enter Art Capital Group, an art financing business run by a former gallery dealer named Ian Peck. Art Capital, basically acting as a glorified pawn shop, made Leibovitz an offer: her life's work, all her houses (she has five) and two years of her time in exchange for $15 million. On the face of it, this sounds like a pretty bad deal - but only if you're entering into it in good faith ...
In December, Art Capital started negotiating to sell the Leibovitz pictures to The Getty. After extended negotiations, The Getty offered $15 million which Art Capital found insultingly insufficient. Then the Getty broke off negotiations and announced it had made a deal directly with Leibovitz. Art Capital sued them both (602334/09 & 601136/09 - NY Cty Court). In late July a New York court denied some of the Getty's motion to dismiss (2009 WL 2440303).
Felix Salmon, who has been following this ado pretty closely, notes Goldman Sachs, which underwrote part of the Leibovitz loan, has become uncomfortable with Art Capital's methods, but isn't it kind of hard to find a hero, or a victim in this story?
In 2005, Art Capital was itself victimized by an employee who was alleged to have, among other things, colluded to fix the auctions at Christies (see ART CAPITAL GROUP LLC v. ROSE ANDREW, 601389/2005). That employee, Andrew Rose, denied any wrongdoing and now runs his own art financing business.
About twice a year I have a fit of ambition and sign up for listserves. Then, a few weeks later, I start getting those "your mailbox is over size limit" warnings and I unsubscribe. But I never give up, because I'm convinced listeserves are bursting with useful information that will make my job easier. It's just that when I spend time sorting through all that information I don't have time to do the job with which they ostensibly help.
Through it all, I have kept my subscription to the listserve from the Business & Finance Division of SLA, and last week it paid off again with a very useful discussion about intraday trading data.
A typical stock chart, whether acquired from Google Finance or Bloomberg, records the high, low, and closing price for one day's trading. If you need more detailed information about what went on during the trading day (bid, ask, individual trade size, etc.) you must use a more specialized source.
Intraday, of course, means during the course of one day. Intraday pricing is also known as tick-by-tick pricing. A tick is the minimum amount a stock exchange will let a security's price change. From 1792 until 1997 a tick was 1/8 of a dollar on every US stock exchange. In the 1990's that changed when the AMEX, and then the NYSE and the NASDAQ changed their minimum tick to 1/16 (also known as "a teeny"). This radical change lasted all of four years until the SEC blew it away by making the exchanges "decimalize" their trading - thus changing the minimum tick to one cent.
The collected wisdom of the SLA B&F list recommended the following sources (and I know of no others): NASDAQ Report Source, Francis Emory Fitch (which I always called plain old "Fitch"), and NYXdata. Fitch has the largest and deepest data. NYXdata is owned by the NYSE, but it covers NASDAQ otc, and the regional exchanges, NASDAQ Report Source only covers NASDAQ, but its cheaper than the others and you don't have to subscribe.
This afternoon, the SEC and CFTC factions settled their feud over derivatives regulation. The "concept paper" developed jointly by Barney Frank and Collin Peterson would divide regulation "depending on the underlying asset" between "either the SEC or the CFTC, or potentially both."
Playing Solomon over this arrangement would be the still-non-existent Financial Services Oversight Council which will have 180 days to "resolve disputes ... over new products."
How could this not work?
For a summary see this Reuters Fact Box.
In virtually every other country in the world, financial statements are prepared according to the International Financial Reporting Standards (IFRS) set by the London-based International Accounting Standards Board (IASB). The IFRS is, if you will, the metric system of accounting.
In mid-July, the IASB proposed a simple new way of apportioning financial instrument valuation methods. The new standard establishes only two security catergories: loans, and instruments that act like loans (valued at cost), and everything else (marked to the market) The Economist called the compromise “a superior sort of fudge.”
We should probably be paying attention to what IASB does because, at least pre-crisis, everyone agreed that their system should replace GAAP. Canada shed GAAP last year and in February the SEC announced a framework (which they called a “road map” – release no. 33-8982) for full IFRS adoption in the United States by 2014.
FASB and the IASB have been working on joint projects since at least 2002 and in October they created a joint Financial Crisis Advisory Group.
If you’d like to get a jump on the IFRS-ification of US accounting (never too early!) this AICPA website has a guide to IFRS and the creepily-named “convergence” of GAAP and IFRS. If you’d like a head-to-head comparison, Warren Gorham & Lamont’s treatise International Accounting, Financial Reporting, and Analysis is available on Westlaw (WGL-INTLACCT).
Over the course of the last week, Treasury has become a virtual proposed-legislation factory – cranking out a new draft bill every few days. I haven’t spent a lot of time processing this legislative incontinence because their previous attempt at legislation-proposing, the Resolution Authority for Systemically Significant Financial Companies Act of 2009, sank without a trace. Treasury and the White House agree on what regulatory reforms we need, but standing between them is Congress. Without a congressional sponsor, Treasury’s reform agenda can’t move forward.
Prospects look brighter for the current crop of proposals. Of the four, two have already made the leap from suggestion to proposed legislation. The difference appears to be Barney Frank. Frank’s sponsorship transformed the Consumer Financial Protection Agency Act of 2009 into HR 3126. Frank has also elevated the administration’s say-on-pay proposal to bill status (HR 3269). Both bills have been referred to the House Committee on Financial Services, which Frank chairs. Rumor has it that Frank also doomed the resolution authority bill when he changed his mind about giving it support. Now that he’s on board, I assume we can expect the Private Fund Investment Advisers Registration Act of 2009 and the as-yet-unnamed credit rating agency bill to move forward, too.
A few days ago, the investigative panel was finalized for the bipartisan committee charged with investigating the causes of the financial collapse. Expectations are high. The new panel has already been compared to the Senate subcommittee that investigated the 1929 crash. That celebrated investigative body, known as the Pecora Committee after its magnetic investigating attorney, exposed all kinds of legal, but damned sneaky, goings-on and gettings-up-to on Wall Street.
Is our new commission, composed mainly of politicians and chaired by *choke* the former Treasurer of California (Phil Angelides), up to the job? Can a panel with only two people who know anything about derivatives (Brooksley Born and Heather Murren) really untangle what happened to AIG? Can a committee that features Bill Thomas twice voted meanest Senator in Washington ever agree on anything?
The answer, in my opinion, is that it doesn't matter. The much-lauded Pecora Committee wasn't a serious investigation - it was a circus (complete with little people). It was representative democrary in action: the subcommittee, chaired by a guy who was born in a "dug out" in the Dakota Territory, allowed representative ordinary people a forum to humiliate Wall Street bankers.
The '33 Act and the '34 Act were written by legal scholars, but the scholars got the opportuntity to write the law they wanted because the Pecora Committee kept Wall Street notorious. A string of headlines about bank presidents not paying taxes, or giving out plum stock offerings for free to their pals, kept people mad enough to support the strong regulation that resulted.
We need better reform than has been proposed by the administration. The new commission can help us get there by keeping up the parade of shifty bankers and little old ladies who've lost everything.
Matt Taibbi’s article about Goldman Sachs is a refreshing return to form for Rolling Stone, the magazine that was once home to Hunter S. Thompson. Gonzo journalism, a term coined by Thompson when he worked for Rolling Stone, is a journalistic form that puts a cantankerous writer and his sainted opinions right at the center of the story. If you ask me, the way we talk about the financial crisis could benefit from this kind of humanizing touch. Taibbi is pissed off. Aren’t you?
Since the article came out, Taibbi has spent much of his time defending himself. He’s been called sloppy (Business Insider), dumb (Megan McCardle), and intemperate (Felix Salmon to be fair, Salmon likes the article).
His critics are at a disadvantage – Taibbi is cooler than they are and he writes better. Megan McCardle takes an unfortunate stab at sounding hep and titles her article “Matt Taibbi Gets His Sarah Palin On.“ The Business Insider is shocked to find it isn’t reading the Economist: “The story is really not meant,” they sniff, “for an audience interested in a discussion of financial markets, as evidenced by his rhetorical style.” I laugh every time I read that.
As an expansion on yesterday's discussion of SEC accounting and FASB, I offer a quick research guide to GAAP materials for public companies.
Because of the variety of sources, I have found it useful to start with an accounting treatise. There are two Warren Gorham & Lamont treatises on Westlaw that cover accounting for public companies. Both treatises discuss the entire GAAP hierarchy from Regulation S-X to the FASB Emerging Issues Task Force. The SEC Accounting and Reporting Manual (WGL-SECMAN) is organized by disclosure type. There are sections on registering securities and filling out form 10-K. The Handbook of SEC Accounting and Disclosure (WGL-SECHDBK), on the other hand, is organized, like a convential auditors handbook, by financial statement type (the first chapter is "Balance Sheets.")
Reasearching primary FASB materials is about to change dramatically. In June, FASB published SFAS No. 168: The FASB Accounting Standards Codification (FASB ASC). The FASB ASC, which comes into force in the third quarter of this year, replaces pretty much every existing GAAP document and flattens the GAAP hierarchy to two levels (in FASB ASC, and not). Basic level access to a database containing FASB ASC is free.
GAAP stands for "Generally Accepted Accounting Principles." The loose, easy sound of this belies the fact that GAAP is mandatory. The Code of Conduct of the American Institute of Certified Public Accountants forbids accountants from departing from "principles promulgated by a body designated by the AICPA Council to establish such principles." The AICPA's promulgator of principles is the Financial Accounting Standards Board (FASB) an accounting think tank organized in 1973. FASB, based in Norwalk, Connecticut, is controlled by a trust called the Financial Accounting Foundation.
GAAP isn't one document - it is a dizzying array of more than 2000 accounting "pronouncements" issued by a variety of authorities. The pronouncements are arranged in a strict hierarchy laid out in FASB Statement No. 162, The Hierarchy of Generally Accepted Accounting Principles. At the top of the heap are FASB's Statements of Financial Accounting Standards (SFAS).
The securities laws (e.g. '33 Act sections 7 & 19(a)) give the SEC control over accounting standards for public companies, but the SEC has always delegated this power to private organizations. Upon FASB's organization the SEC transferred to it power to set accounting standards. Before the organization of FASB, the AICPA had SEC approval to set standards (thus, AICPA "Accounting Principles Board Opinions" from before 1973 carry the same weight as SFAS). The SEC also describes FASB pronouncements as "generally accepted," but to the SEC the phrase has a very different meaning - the SEC is indicating that it has provisionally agreed to use FASB standards, but reserves the right to set them aside. In the words of the SEC, they are "recognized as authoritative in absence of any contrary determination by the Commission."
The SEC's control over public company accounting standards was recently reinforced by the Sarbanes-Oxley Act which required reaffirmation that FASB was sufficiently independent to act as the financial accounting designee of choice (release no 33-8221).
Speculation has moved to the front of the agenda at the Commodity Futures Trading Commission. The CFTC has embarked on two regulatory excursions that will examine areas where speculation has been overlooked, or even sanctioned.
The Commodity Exchange Act is an anti-speculation law. Section 4a(a) declares that excessive speculation in commodity futures may "cause sudden or unreasonable fluctuations" in the prices of the underlying commodities. The CEA gives the CFTC express power to control speculation. The CFTC has enacted rules controlling speculation in agricultural commodity futures (see this CFTC guide) but not in futures for other commodities. Yesterday, the CFTC announced that it would begin hearings on the possiblity of controlling speculation in energy commodities by developing similar position limits for those futures. According to Bloomberg News, this may mean trouble for the energy trading departments at Goldman Sachs and Morgan Stanley.
Bona fide hedging transactions, "economically appropriate to the reduction of risk," are exempt from the agricultural commodity position limits. In March, the CFTC issued a concept release announcing plans to review the way bona fide hedging exemptions are granted. For more on that release see this Fried Frank memo.
Yesterday, Thomson Reuters released a report on global M&A activity since the beginning of the year. Most of the numbers were predictably gloomy: global M&A is down 40% and US M&A is down nearly 50%. In Canada, on the other hand, M&A is up 25% from last year. Pretty much the entire increase can be accounted for by the merger of Petro-Canada and Suncor. This $20 billion deal made up nearly 30% of 2009's Canadian M&A of $61 billion, but that still means Canadian M&A is flat while the rest of the world is off 40%.
My sources in Canada tell me that the M&A boom has been fueled (sorry) by a scramble to grab Canada's natural resources. The numbers bear this out. A search of the M&A database in Westlaw Business found 88 deals announced since the beginning of the year where a Canadian company was the target. 36 of those 88 were acquisitions of mining or oil & gas companies.
In 16 of those 36 deals, the acquiror was a non-Canadian entity. It has been reported that the Chinese government is implementing a "go abroad" investment strategy and in the last few days, they appear to have taken a special interest in Canada. On June 29th the Swiss-Canadian oil company Addax was acquired by Sinopec for a 47% premium over its share price. Denison Mines, meanwhile, has been fighting off rumors that it sold a control stake to Sinosteel and today CIC, the Chinese sovereign wealth fund, announced it was buying 17% of Teck Resources.
In previous posts, I've talked about derivatives in general terms, but today I'd like to focus on the most widely used type of derivative - the swap. I'm going to use the example of a simple interest rate swap in a single currency (although, be warned - there are no simple swaps). For purposes of this discussion, let's pretend it is January of 2008 and you are the CFO of a medium-sized company.
You need to borrow $20 million from the bank. Your banker offers you a very good, fixed interest rate of 3.5% (50 basis points less than the current LIBOR rate of 4%) and you say yes. Your monthly interest payment is $70,000. Because you are a saavy user of the credit markets, you decide to enter into an interest rate swap to hedge your exposure in the event interest rates fall.
An interest rate swap is a fake transaction where two parties pretend to borrow money from each other. The only thing that prevents the transactions from being a wash is that one phony borrowing is at a fixed rate and the other is at a floating rate. The amount of the phony loan is called the "notional amount." Once a month, you and the other party get together and compare interest rate payments. The party with the higher payment turns over the difference.
Your swap is structured like this - you "borrow" $20 million from a third party (let's call them "Wasp") at the LIBOR rate and Wasp "borrows" $20 million from you at 3%. Therefore, Wasp's payment to you will always be $60,000, but your payment to WASP will vary with the LIBOR rate. At your initial settlement, you owe Wasp money. Your imaginary LIBOR-pegged payment would be $80,000. $80,000 minus Wasp's pretend payment of $60,000 = $20,000. You pay Wasp $20,000. In total, you end up handing over (to Wasp and the bank) $90,000. Not such a good deal for you, yet.
Then, the credit markets collapse and interest rates go down with them. Your 3.5% loan becomes a bad bargain, but your interest rate swap begins to bear fruit. At your next settlement, your LIBOR-pegged payment is down to 2% so Wasp owes you $40,000. If you apply this money to your bank loan, your reduce your interest payment to $30,000.
See how simple that is?
FASB has also been very busy of late. While I was on vacation, they released FAS 166 and 167 about accounting for off balance-sheet entities (more from FEI Blog) and today they began a five-city "listening tour." Presumably, this means they won't talk? The listening tour is Hillary Clinton's invention. Is FASB going to run for the Senate?
It has been a big day. Yikes. Adding to the big-ness: the administration sent to the Hill the proposed text for a law creating the Consumer Protection Agency. This brand-new agency would wield tremendously broad power. A look at the definitions section of the 150-page bill uncovers a definition for consumer: "an individual." Also "defined," is "consumer financial product or service." Guess what that means - "a financial product or service used by a consumer."
Since writing about resolution authority for WB, I have followed with interest the continued unraveling of Northern Rock which the UK government nationalized back in 2008. Today, FT Alphaville reports that NR's financial health has declined to the point that it can't meet its capital adequacy requirements. So, HM Treasury is planning to split it into two pieces. Northern Rock Bank Co will be the deposit-taking (healthy) bank and all the toxic (or "legacy") assets will be transferred to Northern Rock Asset Co.
Is this the kind of disaster we can expect if the administration gets the power to resolve failing financial institutiuons?
JD Supra has a new memo from Edwards Angell Palmer & Dodge about the SEC's proposed revivification of surprise raids on brokers who have custody of client assets. This should be some comfort to John Coffee who recently laid blame for the longevity of the Madoff fraud on the rule that allows broker-dealers to have custody of assets.
Apparently, there was much excitement at today's SEC open meeting. Compliance Week reports that the Commission voted to approve the NYSE's proposed ban on discretionary voting by brokers (see this post for more on discretionary voting). The vote was 3-2 along party lines.
FT Alphaville notes that the Commission also agreed to institute a say-on-pay requirement for TARP-recipient institutions.
Lately, it seems that everywhere I go, people are talking about PIPEs (that doesn't happen to you? You need to get out more!) I was getting ready to post something about those private investments in public equity until I found a post on the Harvard Corporate Governance Blog that covers all the ground I was thinking of covering and then some.
For a more detailed discussion of PIPE terms, have a look at this Stroock Stroock and Levan memo from 2002.
The agreements mentioned in the HCGB post can be found:
Goldman Sachs / Berkshire Hathaway Securities Purchase Agreement, exhibit 10.1 to 10-Q filed by GS on 10/8/08
General Electric / Berkshire Hathaway Securities Purchase Agreement, exhibit 10(a) to an 8-K filed by GE on 10/20/08
The administration's new regulatory plan eliminates the Office of Thrift Supervision. Considering that whenever another agency was threatened with extinction a member of Congress made a stink, what, I wondered had the Office of Thrift Supervision done? How did the OTS end up without a single friend in Washington? There must be a story there! It turns out there is a story, and it appeared in the Washington Post. Like the SEC, OTS was the primary regulator of a number of the large financial institutions that failed (OTS regulated IndyMAc, Washington Mutual and Countrywide Financial). Unlike the SEC, OTS colluded with these institutions to make them look healthier than they actually were.
Countrywide Financial Corporation (CFC) migrated to the more lenient OTS regulatory regime to avoid scrutiny and possible FDIC resolution. CFC did most of its business (60% of pre-tax earnings in 2006), through a bank subsidiary called Countrywide Bank, NA (Bank). Bank was a national bank, regulated by the Office of the Comptroller of the Currency, and therefore, CFC was a bank holding company. In December of 2006, Bank applied to become an OTS-regulated savings and loan. When the application was granted in March of 2007 CFC became a savings and loan holding company.
CFC didn't file an 8-K in December when the application was made and it didn't file an 8-K in March when the application was granted. Investors first got word in the 2006 10-K. "On December 6, 2006 we applied to the OTS to convert Countrywide Bank to a federally chartered savings bank." Later in the filing readers are assured that "Countrywide will remain subject to capital requirements that are substantially similar to national banks." The kicker comes in the 10-Q for the second quarter of 2007. After announcing that the OTS had granted Bank's petition CFC allows that because it is no longer a bank holding company it is "no longer subject to specific statutory capital requirements." That doesn't sound like a big deal, does it?
A couple of weeks ago, I was attempting to help a librarian research the history of an NASD rule. I was attempting to help because I couldn't actually help. While some of this may be chalked up to my own research skills, some blame must be laid at the door of the NASD. Researching rules promulgated by self-regulatory organizations is monumentally unpleasant. While I'm not able to offer a research panacea, I offer the following information to either (a) make such research easier or (b) help manage the expectations of your customers.
The first US stock exchange was organized in Philadelphia in 1790. The early exchanges were organized as private associations and were not subject to government regulation. So, when Congress was debating the Securities Exchange Act of 1934, the exchanges lobbied hard to keep their self-regulatory status. A compromise was reached. The exchanges had to register with the SEC, but their self-regulatory powers were enshrined in law. They became quasi-governmental actors and custodians of the goals of the Exchange Act.
Section 19(b) of the Exchange Act also gave the SEC the power to abrogate SRO rules when necessary to further the Act's goals, but the SROs were not required to submit their rules for SEC approval. In the early days, the SEC took a "collaborative" approach to SRO regulation - they raised questions and conducted negotiations in secret. But, starting in the 1960's pressure began building to give the SEC more power to control exchange activities.
The Securities Act Amendments of 1975 required SROs to get SEC approval for any proposed rule change. It articulated the somewhat contradictory goals of "preserving" self-regulation while "the SEC ... play(ed) a much larger role ... to ensure there is no gap between self-regulatory preference and regulatory need."
What this means in practice is that any pre-1976 rule change is lost in the mists of time, but from 1976 forward, all SRO rules had to pass under the eyes of the SEC before taking effect.
There are two SRO rule approval processes - rules that articulate stated policies, fee changes, or SRO administrative procedures become effective immediately under section 19(b)(3)(A) of the Exchange Act. Other rules are reviewed by the SEC, usually by the Division of Trading and Markets, but in the case of "controversial" rules, by the full Commission. This second process, under section 19(b)(2) of the Exchange Act, requires publication, a comment period, and a notice of adoption in accordance with the Administrative Procedure Act.
That's the good news. The bad news is that the SEC often publishes a summary of the amendment in lieu of the full text. So, even though that rule change you're looking for is probably somewhere in the Federal Register there is no guarantee it uses any of the key words in your search.
The SRO's themselves have made no attempt to create an historical record of rulemaking. Their idea of an annotation often starts with "amended by." They also have a tendency to reformat their rules without warning. For instance, the NASD rule I was "helping" with began its life as a "policy statement." In my experience, the only source for the history of an SRO rule is often an out-dated copy of the SRO's manual. If you haven't held on to those, its too late to start.
I'm talking about the past, of course, these days, SRO rulemaking looks much more like other kinds of administrative rulemaking. Also, much SRO rulemaking is now done by a new, joint NYSE-NASD regulatory body called FINRA.
Today, all my energy has gone into writing an article for Westlaw Business Legal Currents about the Treasury's resolution authority proposal.
As you've probably heard, a piece of Manhattan real estate is changing hands for the second time since 1932. The building, at number 70 Pine Street, is owned by American International Realty and will be acquired by two Korean companies, Young Woo & Associates and Kumho Investment Bank. 70 Pine was the third-tallest building in the world when it was completed in 1932. From that time until 1974 it was the headquarters of Cities Service Corporation, an oil and gas company founded by the monumentally pugnacious Henry L. Doherty. Cities Service moved to Tulsa in 1974 and sold 70 Pine to AIG in 1976. According the the New York Times, the building cost about $15 million to build. I couldn't find any record of what AIG paid for it, but it was probably a pretty good investment. It was recently assessed at 97.2 million.
The Wall Street Journal reports that now that Treasury has given permission TARP money will soon start coming back. JP Morgan Chase, Morgan Stanley and American Express will pay off first.
My colleague Erika Beck is hosting a tax law roundtable at SLA.
Footnoted.org is live blogging the House Financial Service Committee hearing on systemic risk.
The lawyers for Monday's trial involving Maurice Greenberg's alleged misappropriation of a block of AIG shares are generating as much ink as the suit itself. (SDNY, 1:05CV06283, order re motion for summary judgment at 2009 WL 614752)
Reuters DealZone has a chart quickly outlining the numbers regarding Black Rock's acquisition of BGI, the investment arm of Barclay's Bank.
It has been widely reported that within the next few weeks the administration will unveil a new, comprehensive financial markets regulatory scheme. Speculation about the scope of the proposal has been intense. In last week's New York Times, Stephen Labaton reported that the administration probably wouldn’t recommend rolling all four bank regulators up into one agency, but that a new agency for credit card and mortgage regulation was still a possibility. In the background, administration officials have been meeting with a constellation of experts to hammer out details. In one recent meeting, a group of academics, policy analysts and researchers was asked questions that provide some insight into the administration’s general approach. The questions, combined with recent news reports also suggest that the regulatory agenda has been finalized, but they’re still fighting about money and political turf.
The Treasury Department has previously aired two pieces of the puzzle: resolution authority and regulation of the over-the-counter derivatives market. The resolution authority proposal was outlined in a March 26th press release (TG-72). The press release asked Congress for an FDIC-like power to seize and dismember institutions deemed a risk to the entire financial system. Left unresolved was which agency would be the resolver. Resolution authority appears still to be on the table: the experts were asked where the administration could obtain the money to carry out resolutions of institutions that aren’t banks. The FDIC’s resolution process is paid for out of a fund derived from payments made by FDIC-insured institutions.
Secretary Geithner has carefully avoided answering questions about who would swing the sword of resolution, but he has stressed, on several occasions, the need for a new regulatory entity that could police institutions that pose a risk to the financial system generally. He has not, however, been specific about this new agency’s power or role. A number of players have leaped into that void. In late March, a bipartisan bill was introduced in the House and Senate (HR 1754, S 664) that would create a council composed of the heads of all the financial regulatory agencies. This group (called the Financial Stability Council) would be in charge of assessing systemic risk. This bill framed the terms of the debate – should systemic risk be overseen by a loose collection of regulators, or should there be a new agency? Sheila Baer at the FDIC and Mary Schapiro at the SEC (who would be members of a financial risk council, but would lose turf if a new agency were created) have, unsurprisingly, expressed approval of the council idea. The experts were also asked to weigh in on this question. Is a systemic risk council an acceptable compromise, they were asked, or do we need a new regulatory agency?
Over-the-counter derivatives regulation, on the other hand, seems squared away. On May 13th, Secretary Geithner sent a letter to Senator Harry Reid outlining the administration’s proposal for OTC derivatives regulation. According to a source with knowledge of the meeting, the experts were not asked about OTC derivatives regulation.
The US financial regulatory system was constructed piecemeal in response to a variety of historical events. The result of this ad hoc approach is a patchwork of jurisdictions that overlap in some areas but don’t cover other areas at all in others – a problem is known as “regulatory fragmentation.” On the evidence of the last few questions, regulatory fragmentation is still on the agenda. The experts were asked how much they thought regulatory fragmentation contributed to the current crisis. They were also asked to describe how well the existing system protects consumers and investors. Last week, a report from the Associated Press (“Fed Would Serve as Risk Regulator under Obama Plan,” AP Datastream, 5/28/09) described a draft regulatory scheme that would create two major regulatory agencies – one protecting consumers and one protecting investors. The investor protection agency would be created by merging the SEC and the CFTC. Merging or eliminating regulatory agencies has proved to be a reasonably hot political potato. Every agency, it seems, has a champion in Congress. These champions stand to lose power if their pet agency is curtailed. The New York Times article spent several paragraphs addressing the “political cost” of correcting regulatory fragmentation.
If I said "section 10(b) of the '34 Act," you'd know what I was talking about, but if I mentioned section 78j you probably wouldn't be sure, right? They're the same section, of course, but when securities law professionals talk about the '34 Act's anti-fraud provision they say 10(b), a designation that comes from chapter 404 of the laws of 1934 (48 Stat 881), and not 15 USCA 78j. The reason no one uses the United States Code citations for the securities laws is because they are so damned convoluted (the Trust Indenture Act, for example, is 15 U.S.C. § 77aaa – 77bbbb). Unfortunately, 10(b) isn't good enough for the Blue Book so sometimes we need to find the full citation.
The "find a securities document" tool on the Westlaw Securities Practitioner page will translate for you, but this post isn't about how to find the right citation, its about how this mess happened in the first place.
The United States Code is maintained and updated by a House department called the Office of the Law Revision Counsel (OLRC). They are also responsible for enacting the Code into positive law. The OLRC originated during what I like to call the “codification wars” of the nineteen-twenties. In 1919 Colonel E. C. Little, Chairman of the House Committee on the Revision of Laws, embarked on a project to codify federal statutes and enact them into positive law. Col. Little’s completed codification, organized into 60 titles, was passed by the House in 1920. It went on to the Senate and was killed. Why, the Senators wondered, would Little want to repeat the disaster of 1873? In 1873 Congress repealed all existing federal statutes and replaced them with a codification. The Revised Statutes of 1873 contained so many errors and that it had to be amended immediately in 1875 and again in 1877. The House was undeterred by the Senate’s qualms. It re-proposed and passed Col. Little’s codification twice more. Upon its second presentation, the Senate Committee on the Revision of Laws reported that the bill had 600 errors, omissions, and inaccuracies. The Senate Committee proposed a compromise in the form of a joint commission to revise the laws.
In the period between the 1873 codification and the 1919 attempt, commercial publishers had filled the gap. Both West and Thomson produced useful and frequently-updated codifications. The Senate asked these publishers to assist in producing an official codification. The resulting document, shortened to 50 titles, passed the House in 1926. The Senate remained unconvinced and refused to enact the bill. In the end, the Senate couldn't be convinced to replace existing statutes with a potentially error-filled codification. Instead, the Senate amended the bill to provide that the codification was “prima facie” evidence of the law and that existing statutes remained in force.
According to Peter LeFevre, the present Law Revision Counsel, this situation was meant to be a temporary fix giving the House Committee on the Revision of Laws (now charged with upkeep of the codification) time to rectify errors and begin piecemeal enactment of the United States Code as positive law. This temporary fix slowly calcified. In 1946 the committee was demoted to subcommittee. In 1974 it became a government agency of sorts. A 1974 law elevated the Law Revision Counsel from an officer of the House Judiciary Committee to the head of a separate office reporting to, and appointed by, the Speaker of the House. Three men have held the post since 1974: Edward Willet, Jr. (1975 – 1996), John R. Miller (1997 – 2004), and Peter LeFevre (2004 – present).
When Congress enacts a new law, lawmakers don’t normally consider where the law will fit in the Code. In its role as the Code’s custodian, the OLRC decides where laws go. Organizing and maintaining the Code is an enormous job that occupies most of the OLRC staff. Charles Zinn, Law Revision Counsel in the 1950’s, described the process as “a matter of opinion and judgment” driven by “where we think the average user will look.” LeFevre agrees that although the OLRC follows policies and precedent, the driving force behind placing a law in the Code is where people “will expect to find it.”
I asked LeFevre why the securities laws have such difficult citations. He didn’t know, but he told me that laws are added to titles in chronological order, unless they are related to laws that have already been enacted. The securities laws are squeezed into Title 15 of the US Code between Chapter 2 and Chapter 3. Chapter 1 contains antitrust laws: the Sherman Act of 1890, followed by the Clayton Act of 1914. Chapter 2 contains the Federal Trade Commission Act of 1914 and Chapter 3 contains the Trade-Mark Act of 1905.
Why are the securities laws of 1933 – 1940 jammed in between the FTC Act and the Trade-Mark Act? The answer lies in the Securities Act of 1933. When Congress enacted the ’33 Act, the first of a series of planned securities laws, it charged the Federal Trade Commission with enforcing the Act. A year later Congress enacted the Securities Exchange Act of 1934, which created the Securities and Exchange Commission. The ’34 Act removed the securities laws, including the ’33 Act, from the jurisdiction of the FTC and placed them within the oversight of the SEC. Unfortunately, the ’33 Act had already been placed in the Code, right next to the FTC Act. Instead of moving the ’33 Act, the Law Revision Counsel decided to let things stand and proceeded to cram all of the securities laws in the space between the FTC Act and the Trade-Mark Act. To add insult to injury, in 1946 Congress enacted the Lanham Act and repealed Chapter 3.
To learn more about the Office of Law Revision Counsel, visit its website. The legislation governing the OLRC may be found at 2 U.S.C. 285 – 285g. Those interested in the positive codification process should read Charles Zinn’s address to the Law Librarians’ Society of Washington, D.C. at, 45 Law Libr. J. 2 (1952) and Richard J. McKinney’s excellent “United States Code: Historical Outline and Explanatory Notes."
Bruce Carton's all-too-brief notes on a speech by linguist William Lutz about the usefulness of SEC disclosure.
The Harvard Corporate Governance Blog has a post about PIPEs transactions that includes a discussion of what a PIPEs transaction is.
This almost never happens, but today Citibank reminded me of my grandfather. My grandfather had a silver ladle he claimed was made from silver once in the possession of General Santa Ana. Like my grandfather, Citibank (and a whole lot of other banks) have a bunch of mortgages-related securities that are worth a whole lot of money as long as no one asks too many questions. Thus, the New York Times reports that the FDIC has canceled the "legacy assets" part of the PPIP program because banks don't want a bunch of investors asking nosy questions about grandpa's silver.
Battle lines are being drawn and medieval siege works constructed for the Battle of OTC Derivatives. The New York Times reports that CFTC-big wig Gary Gensler has a plan, but as Jim Hamilton reports, so does the derivatives industry.
The National Association of State Securities Administrators joins the FDIC and the SEC in calling for a financial stability council.
Securities Prof Blog talks about Mary Schapiro's Senate testimony.
The Corporate Counsel Blog has good coverage of the SEC's revamped Compliance and Disclosure Interpretations.
This morning Time Warner (TWX) announced it would spinoff AOL. So ends a drawing-room farce that began during our last boom-bust. Those who remember the tech bubble probably also remember that ownership runs the other way – AOL is supposed to own Time Warner, right?
To get our hands around the story lets journey back to 1992 when a small company called America Online, Inc. made a public offering on Nasdaq (424B, 3/20/92). AOL sold 2 million shares at $11.50 a pop, raising $23 million. By 1995, AOL was trading on the New York Stock Exchange at $58/share (S-3, October 1995). Although the price increase wasn’t gigantic, AOL had been issuing a tremendous volume of shares.
Because market capitalization was the name of the game – that’s what made it possible for a company with 12,100 employees and $4.8 billion in revenue (AOL 1999 10-K, 6/30/99) to buy a company with 67,500 employees and $14.6 billion in revenue (TWX 1998 10-K, 12/31/98). By 1999, AOL had 2.3 billion shares out. At $53/share that gave AOL a market capitalization of $121.5 billion (1999 10-K) – 2500 times larger than 1992’s market cap of $47.7 million (1992 AOL 10-K).
In early 2000, AOL decided to use its new paper wealth to buy a feeble, old-economy company called Time Warner Inc. AOL believed it was in a position to acquire TWX because the market had decided that AOL was the more valuable company. For purposes of the merger, AOL’s shares were valued at a very modest $53/share (in the second quarter of 1999, they went as high as $175/share). Although TWX’s shares traded higher at $83/share, TWX had fewer shares outstanding. So, TWX’s market capitalization, per the merger proxy (S-4, 2/11/00, 333-30184), was $99 billion to AOL’s $132 billion.
The merger was accomplished by organizing a new company called AOL Time Warner (ATW). Shareholders of AOL got one share of ATW for each AOL share they held. TWX shareholders got 1.5 shares. Because there were so many more AOL shareholders, they ended up with 56% of the ATW shares. In 2001, the new holding company, controlled by the former shareholders of AOL, started trading on the NYSE under the ticker AOL.
The trouble started almost immediately. In mid-2002, the Washington Post published a story about AOL’s accounting practices. Soon thereafter, the SEC began an investigation and by 2005 the Department of Justice was involved. During this period, the “AOL” started disappearing from AOL Time Warner. ATW dropped the AOL from its name and became, once again, Time Warner. It also retired the AOL ticker symbol and went back to trading under TWX.
So, AOL wanted to buy Time Warner, but by 2003 the acquisition vehicle had morphed into Time Warner and AOL was reduced to being a division of it. In the coming spinoff, AOL shares are going to be distributed to Time Warner shareholders (many of whom, presumably, were once holders of AOL shares?) for free and will reenter the secondary market – possibly on Nasdaq? We’ll have to wait to see what the opening price will be, but I’m betting on $11.50.
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