Directors and Officers Liability and Insurance : The D & O Diary : Kevin LaCroix : Securities Laws, Corporate Fraud, D & O Litigation

On May 17, 2007, Treasury Secretary Henry M. Paulson, Jr. announced (here) his latest "initiatives...to enhance U.S. capital market competitiveness." In a Financial Times op-ed piece published the same day (here), Paulson said the purposes of the initiatives were to "ensure we preserve an efficient financial reporting system that provides reliable information, is supported by a sustainable auditing industry, and has enhanced compatibility with foreign reporting requirements."

The most substantial part of the initiatives is the commencement of two studies. One study, to be led by former SEC Chairman Arthur Levitt and former SEC Chief Accountant Donald Nicolaisen will "address auditing industry concentration" and "consider options available to strengthen the industry's financial soundness and its ability to attract and retain qualified personnel." The second study will "analyze the factors driving financial restatements and their impact on investors and financial markets."

The rise in the number of restatements, up from 116 in 1997 to 1,876 in 2006 (or one for every ten public companies), is a point of particular emphasis in Paulson's op-ed piece. Paulson notes that "restatements pose significant costs on our capital markets. They have the potential to confuse investors and erode public confidence in public reporting." The volume of restatements reflects, in part, "the complexity of our financial reporting system." The Treasury' study is intended to complement the SEC's efforts to reduce the complexity.

The Treasury Department also announced its support of the SEC's and the PCAOB's efforts to "improve the application of Section 404" of the Sarbanes Oxley Act. In his op-ed piece, Paulson states that "a more risk-based implementation will be a positive step." Finally, the Treasury Department also expressed its support of SEC effort to effect the convergence of the U.S. GAAP and International Financial Reporting Standards, and eliminating the U.S. GAAP reconciliation requirements by IFRS-reporting foreign companies by 2009.

With their proposal for a couple of studies and their expression of support for SEC proposals, the Treasury initiatives are strikingly modest. (To be sure, the recent announcement took great pains to emphasize that this is only the first salvo; the Treasury announcement specifically notes that "Secretary Paulson will continue to provide follow up steps to other ideas.") But even if the initiatives themselves are modest, it seems fair to ask whether their underlying premise is overstated, or even valid. That is, while Paulson and others (refer here) are fretting loudly about U.S. capital markets' competitiveness, the markets are busy surging ahead.

According to news reports (here), total U.S. capital markets equity underwriting of common and preferred stock during the first quarter of 2007 rose 42.6 percent compared with the prior year period, and raised $61.4 billion in connection with 202 deals. Corporate bond issuance rose during the first quarter to a record $308 billion, up 23.6 percent from the first quarter of 2006. According to a PricewaterhouseCoopers report (here), U.S. IPO activity during the first quarter of 2007 was at its highest first quarter level in 7 years. During the first quarter of 2007, there were 64 IPOs that raised $12.1 billion, compared to 54 deals that raised $11.6 billion during the first quarter of 2006. And as I have noted in prior posts (most recently here), foreign companies continue to be attracted to U.S. capital markets, contrary to the contention of the would-be reformers.

There may or may not be good reasons for the various studies Paulson has launched, and there is no harm at taking a closer look at things. But to the extent reform proposals emerge that are premised on the supposed declining competitiveness of the U.S. capital markets, there is reason to be skeptical, if not concerned. As the CFO Blog noted (here), the "whole argument" for Paulson's Capital Market Plan is "looking kind of shaky." While studies themselves can do no harm, the danger is the possibility of reform proposals that undermine the very things that give the U.S. markets their strength, -- that is, their justified reputation for transparency and integrity.

Whistleblower's Lament: In prior posts (most recently here), I have examined the question whether the whistleblower protection under Sarbanes-Oxley may actually be discouraging fraud detection. Anyone who doubts this concern may want to review the May 18, 2007 CFO.com article entitled "Five Years Out of Work" (here). The article contains an interview with David Welch, the first person to file for whistleblower protection under Sarbanes-Oxley. After five years of unemployment and attorneys'fees of over a half million dollars, his case if far from over and seems likely to have years left to run. His conclusion?: " If you are a whistleblower and you have no money, you have to stop. The deep pockets of corporations can starve out an unemployed whistle-blower."

As I noted in a prior post (here) discussing Welch's case, the Sarbanes-Oxley whistleblower protection may be "more theoretical than real."

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In recent months, several blue ribbon panels, concerned about the competitiveness of the U.S. securities markets, have proposed reforming U.S. securities regulation, on the theory that the regulatory burden that has driven overseas companies to list their shares outside the U.S. As I have discussed at length previously (most recently here), there are a host of reasons why overseas companies have been list their shares on other exchanges. But despite all of these reasons driving the growth of other countries' markets, there nevertheless seems to be a continuing and arguably growing interest among overseas companies, particularly Chinese companies, to list their shares on U.S. exchanges.

According to the May 11, 2007 Financial Times article entitled "Chinese Listing Influx Begins" (here, subsciption required), 35 Chinese companies expect to list on U.S. exchanges this year, as many as listed in the last three years combined. Three Chinese companies - Qiao Xing Mobile, Acorn International and LDK Solar - together expect to raise $1 billion in U.S. listings.

A second May 11, 2007 Financial Times article entitled "New York Proves an Attractive Destination" (here) explains that the reason for the influx of Chinese companies is that "a pipeline of private equity and venture capital investments, mostly made by U.S. based funds...have reached maturity." These companies are drawn to the U.S. markets and are not deterred by U.S. regulations because "despite Sarbox, they can still get better valuations and wider analyst coverage ... than in the resurgent Chinese domestic markets or in other parts of the world." Chinese companies have been drawn to the U.S., according to one commentator, because "they were looking to establish their brand internationally and nothing matches that like a U.S. listing."

As one source quoted in an April 4, 2007 Law.com article entitled "Law Firms Compete for Chinese Companies' IPO Action" (here) put it, "in China, everyone wants to get registered to raise funds in the public markets in the U.S." A U.S. listing, another commentator in the article notes, "provides legitimacy and transparency."

A prior post on the "healthy" U.S. market for foreign IPO market can be found here.

The Chinese companies' perception that they will enjoy a better valuation on the U.S exchanges is supported by recent academic research. According to an April 2007 paper by Craig Doidge of the University of Toronto and George Andrew Karolyi and Rene Stulz of the Ohio State University entitle "Has New York Become Less Competitive Over Time? Evaluating Foreign Listing Choices Over Time" (here), there is a significant valuation premium for U.S. exchange listings, and the premium did not decline after the passage of SOX. The article go on to state that "all of our evidence is consistent with the theory that there is a distinct governance benefit for firms that list on the U.S. exchanges." An April 27, 2007 Wall Street Journal article entitled "Maybe U.S. Markets Are Still Supreme" (here, subscription required) discusses the academics' research.

As I have previously argued (most recently here), the would-be reformers' case for regulatory reform is "weak." But if, as further evidence increasingly seems to substantiate, overseas companies on balance find U.S. markets preferable to other markets, the case for reform goes from weak to nonexistent.

All of this underscores a point I have frequently made, that Wall Street may be attempting to use the effects of the evolving global financial marketplace as a pretext to undermine regulatory requirements that occasionally prove to be uncomfortable because they actually have teeth. The would-be reformers may claim that they seek to advance U.S. competitiveness, but anything that weakens the U.S regulatory structure could remove the greatest advantage the U.S. markets enjoy - that is, the U.S. markets are the most highly regarded precisely because they are the most highly regulated.

Over There, Over Here: As I have also frequently noted, overseas investors are becoming much more accustomed to using litigation as a means to hold management accountable. Further evidence of this can be found in a May 2007 Institutional Investor Services paper entitled "Accountability Goes Global: International Investors and U.S. Securities Class Actions" (here) takes a look at the growing role of overseas institutional investors as lead plaintiffs in U.S. securities class actions.

Among other things, the paper notes that "in every year since 2002, international institutional investors have filed lead plaintiff motions in more than 5% of all securities class actions," including not only suits against companies that are domiciled in their home countries, but also suits against U.S.-based companies. The international institutional investors, drawn from 17 countries, sought to serve as lead counsel in 182 cases between 1996 and March 31, 2007.

The paper was written by Adam Savett, who also maintains the Securities Litigation Watch blog (here).

Hat tip to the 10b-5 Daily (here) for the link to the ISS paper.

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Two of the recent reports of blue ribbon groups looking at the competitiveness of U.S. capital markets recommended among other things that the SEC should consider permitting public companies to amend their charters to provide for arbitration of securities claims. According to an April 16, 2007 Wall Street Journal article entitled, "SEC Explores Opening Door to Arbitration" (here, subscription required), the SEC, as part of a "broader package" of shareholder rights proposals, is now exploring whether or not to allow corporate charter provisions requiring the arbitration of complaints by aggrieved shareholders.

The Interim Report of the Committee on Capital Markets (here, at pages 109 to 112) recommended "that the SEC should permit public companies to contract with their investors to provide for alternative procedures in securities litigations, including providing for arbitration (with or without class action procedures) or non-jury trials." The Interim Report went on to state that "the Commission should not force shareholders to accept the costs that go with class action securities litigation, particularly the substantial and unpredictable risk of large jury verdicts that effectively force settlement of what may well be non-meritorious claims."

The Bloomberg/Schumer Report (here, at pages 100-104) recommended that the SEC reverse "its historical opposition to the arbitration of disputes between investors and publicly traded companies." The Report asserts that "shareholders should have the opportunity before the fact to determine whether submitting the future securities grievances to arbitration is in their own and the company's best interest." The Report also states that arbitration "would benefit all parties involved," by reducing cost and speeding resolution, while permitting SEC enforcement action in appropriate cases.

While the SEC is exploring the possibility of allowing companies to amend their charters to require arbitration of shareholder claims, the Journal reports that SEC Chairman Christopher Cox does not believe that arbitration is a "panacea."

There are several obvious shortcomings for the use of arbitration for shareholder fraud claims. First, there is limited opportunity in an arbitration proceeding for discovery, in a type of dispute that increasingly depends on extensive review of electronic communications and other electronic documents and data. Second, there is limited opportunity for appeal, which could substantially affect the rights of plaintiffs and defendants whose legal rights are determined by the arbitration panel. Third, arbitration hearings typically are conducted in private, rather than in a public forum, which would undercut the deterrent effect of private securities claims. Fourth, even if the company were able to require shareholders to pursue claims against the company and company officials through arbitration, shareholders would still be free to pursue related claims against other defendants (underwriters, accountants, lawyers, for example) in court. An overview of arbitration can be found here.

The Journal article anticipates that the arbitration proposal "is likely to spark fierce opposition from both investor-rights groups and trial lawyers." Another group that might be motivated to object is the states' attorneys general, who have recently discovered the profit and political appeal of class action opt-out cases (refer here) and who recently filed an amicus brief in the Tellabs case in the U.S. Supreme Court arguing against pleading restrictions that would limit their rights to bring shareholder claims (refer here). The Journal article notes that as a result of likely opposition, there is "a good chance" that the idea of permitting companies to require arbitration of shareholder claims "could fall flat."

But even if the SEC were to go ahead, the possibility of a charter amendment requiring arbitration would be optional - that is, companies, would have to affirmatively choose to include the arbitration requirement in their charters. For existing public companies, that would presumably require a shareholder vote approving the charter amendment. To consider what shareholders might be asked to approve, it is worth thinking about what a proposed charter amendment might look like.

A prescient April 10, 2007 article entitled "Compelling Arbitration of Stockholder Class Actions Based on Federal Securities Law" (here), by Joseph Bartlett and Cathy Reese of the Fish & Richardson firm, takes a look at what enabling charter language might look like (including a sample charter amendment). The proposed language has some interesting features, including, for example, a requirement that the SEC be notified of the arbitration and have the opportunity to participate. The sample language brings home some of the limitations as well - for example, should a shareholder be compelled to Wilmington, Delaware to arbitrate? Looking at the proposed charter amendment makes me wonder how many companies' shareholders would approve these kinds of charter amendments?

Interesting blog posts on the arbitration proposal can be found on the FEI Financial Reporting Blog (here), the 10b-5 Daily blog (here), and Ideoblog (here).

D & O Conference: This week, I will be participating in the American Conference Institute event entitled "D & O Liability Insurance" in New York City (refer here). On Wednesday April 18, 2007, I will be speaking on a panel entitled "State of the Market: New Coverages and Developing Exposures," and on Thursday, April 19, 2007, I will be on a panel entitled "Boards of Directors: What are They Worried About and What are They Looking For?" If you attend the Conference, I hope you will greet me and introduce yourself.

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Amidst the current clamor over the competitiveness of the U.S. financial markets, a recurring theme has been the burden on the financial markets of U.S. litigiousness. One variant of this theme that has gotten air time is the idea that private securities lawsuits should be eliminated. The most prominent proponent of this idea is Stanford Law School professor Joseph Grundfest, whose Wall Street Journal op-ed piece on this topic (here, subscription required) was the subject of a prior D & O Diary post (here).

The editorial page editors at the Journal clearly like this particular idea, because on March 20, 2007, they ran a second op-ed piece on this same topic, this one (here, subscription required) entitled "Capital Complaints," by Peter Wallison of the American Enterprise Institute. (Wallison served as White House counsel during the Reagan administration.)

Wallison's article starts with the notion that the "financial pre-eminence of the U.S. is eroding," and if "you listen closely to what foreign and U.S. business and financial people are saying, there's one central cause - private class action enforcement of the SEC's Rule 10b-5." Wallison invokes a parade of horribles weighing on U.S. competitiveness, each component of which "is exacerbated by class action risk." The solution, according to Wallison, "is restoring what Congress originally intended - enforcement of Rule 10b-5 only by the SEC."

I have previously reviewed elsewhere (here) the reasons why an SEC monopoly on enforcement of the securities laws is not necessarily in investors' best interests. Essentially, I believe that private investors ought to have the ability to seek redress of their grievances without having to depend on an over-burdened SEC to enforce their rights. And while Congress may not have originally put an explicit private right of action in the securities laws, during the decades since the courts first implied a private right of action, Congress has revised the securities laws multiple times but has never gone back to legislatively prohibit private lawsuits.

The most significant problem I have with Wallison's article is its very premise, that the most significant cause in the erosion of U.S. financial markets is the existence in the U.S of private securities class action lawsuits. Would foreign companies view the U.S more favorably if they "only" had to worry about the SEC? And as I have discussed at length previously (most recently, here and here), the causes of the increased competitiveness in the global financial marketplace are myriad, diverse, and subtle, and have more to do with the growth overseas capital and the increased sophistication of overseas markets.

The only evidence that Wallison cites for his premise that the existence of private securities lawsuits is undermining U.S. competitiveness is his assertion that the cause is apparent if "you listen closely to what foreign and U.S. finance people are saying." I don't doubt that this particular notion may have a certain currency in certain circles, and that people who talk to each other all the time have persuaded themselves, but that does not make it true. If you look at what companies are doing rather than what "finance people" are saying, the picture looks quite a bit different.

For example, if Wallison's premise were true, you would think there would be evidence that foreign companies were fleeing the U.S. because of the threat of litigation. While the evidence shows that some companies are, indeed, leaving the U.S. securities markets, it is not for the reasons Wallison cites.

A March 19, 2007 CFO.com article entitled "Bluff or Bluster?" (here) takes a look at delistings from U.S. exchanges, and concludes that "predictions of mass delistings have failed to materialize" and the companies "that have delisted rarely cite onerous regulation." Of the 12 European companies that delisted from the NYSE in 2006, "nine were because the company was taken over." Of the remaining three, one (Vivendi) delisted to save costs because its trading volume was virtually nonexistent; one, Tatneft, and energy company controlled by the Russian state of Tatarstan, delisted after failing to submit audited financials; and one, Espirito Santo Financial, a Luxembourg-based company that delisted because its trading volume on Euronext was six times greater than on NYSE.

The CFO.com article also notes another important point that often gets overlooked amidst the hubbub about U.S. competitiveness; that is, while its global equity market share may be declining, its participation in the debt marketplace is booming. According to the article, the number of European companies going to the U.S. to raise debt capital increased by 77 percent between 2000 and 2006, and the annual volume of debt raised during that period grew from $174 billion to $396 billion.

In other words, the global marketplace is dynamic and is changing in many ways, with a variety of effects and from a diversity of causes. To seize a single aspect as the sole or even the most important cause, and to use that as the pretext for radical changes to the enforcement of our securities laws, simply ignores the complexity of the global marketplace. Given the diversity of causes and effects, the elimination of private lawsuits would have only an uncertain impact on U.S. competitiveness, but it would eliminate the means by which private investors can seek redress without depending on the government to take up the cause on their behalf.

None of this should be interpreted to suggest that I think our system of private securities litigation could not be improved. Anyone who watches these cases up close knows that that system can be wasteful and excessive. But while it undoubtedly can (and should) be improved, I do not think it is in the best interests of investors or the markets for private securities lawsuits to be eliminated.

Professor Larry Ribstein has some interesting comments on his Ideoblog (here) about Wallison's column.

One final observation: as I have previously noted (here), differences between the litigation systems in the U.S. and elsewhere may be diminishing over time. A recent interesting post along those lines can be found on the Drug and Device Law blog (here).

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On March 12, 2007, in the latest in the apparently never-ending series of big thick reports on the competitiveness of U.S capital markets, the U.S. Chamber of Commerce released the Report and Recommendations of its Commission on the Regulation of the U.S. Capital Markets in the 21st Century (here). An Executive Summary of the Report can be found here.

The Chamber Commission advertises itself as "an independent bipartisan Commission established by the U.S Chamber of Commerce.' The Commission is co-Chaired by Arthur Culvahouse, who is Chairman of the O'Melveny & Myers law firm and former White House counsel in the Reagan administration, and William Daley, Vice Chairman of JPMorgan Chase and Commerce Secretary in the Clinton administration. The Chamber Commission report will be formally released on March 14, 2007, as part of the Chamber's "First Annual Capital Markets Summit: Securing America's Competitiveness" (here)

Including appendices, the Chamber Commission's Report weighs in at 179 pages, putting it in a competitive position, girth-wise, with the Interim Report of the Committee on Capital Markets Regulation and the Bloomberg/Schumer Report. (The Chamber Commission's Executive Summary even weighs in at 20 pages.) The Chamber Commission did reduce its recommendations to six bulleted points:

* Reform and modernize the federal government's regulatory approach to financial markets and market participants.

* Give the Securities and Exchange Commission (SEC) the flexibility to address issues relating to the implementation of the Sarbanes-Oxley Act of 2002 (SOX) by making it part of the Securities Exchange Act of 1934.

* Convince public companies to stop issuing earnings guidance or, alternatively, move away from quarterly earnings guidance with one earnings per share (EPS) number to annual guidance with a range of EPS numbers.

* Call on domestic and international policy-makers to seriously consider proposals by others to address the significant risks faced by the public audit profession from catastrophic litigation, as well as the Commission's suggestion that national audit firms be allowed to raise capital from private shareholders other than audit partners.

* Increase retirement savings plans by connecting all employers of 21 or more employees without any retirement plan to a financial institution that will offer a retirement arrangement to those employees.

* Encourage employers to sponsor retirement plans and enhance the portability of retirement accounts through the introduction of a simpler, consolidated 401(k)-type program.

The six principal recommendations are discussed further in the March 12, 2007 Wall Street Journal article (here, subscription required). The recommendation regarding the incorporation of SOX into the '34 Act is discussed further on the FEI Financial Reporting Blog (here). The CorporateCounsel.net Blog also has a post on the Report, here.

While not included in the six principal recommendations, the Chamber Commission does also make "a number of specific recommendations designed to enhance the effectiveness of the U.S. legal system." The most significant of these recommendations is based on the Commission's view that there is a "strong need to investigate the accuracy of the widely held global perception that the U.S. securities litigation and regulatory environment makes it dangerous to participate in our capital markets."

But rather than make any specific reform recommendations in that regard, the Commission "recommends that Congress call upon the SEC to undertake a comprehensive study of state and federal securities enforcement mechanisms to assess whether they are enhancing the goal of investor protection and capital formation and whether the PSLRA is achieving the objective set forth by Congress." The Commission specifically recommends that the study analyze:

* civil and criminal cases brought by governmental agencies and regulatory actions brought by [self-regulatory organizations];

* PSLRA's impact on the effectiveness of the federal securities laws; and

* impact of post-PSLRA litigation on the dual objectives of protecting investors and promoting capital formation.

The Chamber Commission notes that "time is of the essence" in the study's completion. (These issues are discussed at pages 28 to 31 of the full Report.)

The Chamber Commission Report also identifies three other "problem areas" in private securities litigation and makes recommendations that "should reduce costs while preserving investor protections":

Fair Funds: The Chamber Commission recommends that "the SEC adopt a forma policy that prohibits duplicative payments from Fair Funds and private litigation on the same claim." (Discussed at page 88-89 of the full Report)

Scope of Professional Liability: The Commission recommends the adoption by the other federal judicial circuits of the Second Circuit's bright-line test for primary liability of secondary actors in securities fraud cases; and the Commission advocates that other circuits follow the Eighth Circuit in rejecting "scheme liability" as "incompatible with the Supreme Court's rejection of aiding and abetting theories under Section 10b and Rule 10b-5." (Discussed at pages 90-92 of the full Report).

Selective Waiver: The Commission recommends that Congress adopt legislation "establishing a selective waiver that would permit corporations to share privileged information with the SEC and continue to assert the privilege against other parties." The Commission also recommends that Congress establish a selective waiver that would "permit a private party to share privileged information or documents with external audit firms or government appointed corporate compliance monitors...without waiving the attorney-client privilege to other third parties." (Discussed at pages 92-95 of the full Report)

The Chamber Commission's Report also has extended discussion (at pages 80-87 of the full Report) of the controversies surrounding the federal prosecution of business organizations. The bulk of this discussion related to concerns regarding prosecutorial ability to seek or require production of attorney-client privileged materials or work-product materials. The Commission expresses its concern that the Department of Justice's (DoJ) McNulty Memorandum "does not adequately address the concern that companies feel pressured to waive attorney-client privilege and work product protection under threat of indictment or other enforcement actions." The Chamber Commission endorses the "ongoing efforts to have the DoJ eliminate as a cooperation credit factor a company's decision to waive the attorney-client privilege or attorney work product protection."

The Chamber Commission also recommends that Congress and the DoJ "reevaluate the standards of corporate criminality" to "place more weight on the proactive efforts of corporations to prevent criminal conduct." The Commission recommends that "corporate criminal conduct should be largely reserved to instances where the corporate form is a mere shell or in which criminal conduct is pervasive within the company's senior executive ranks."

The SEC Actions Blog has a thoughtful discussion (here) of the Chamber Commission's recommendations regarding the McNulty Memo, the attorney client privlege and federal corporate criminal prosecutions.

The Report contains quite of number of other interesting suggestions, as a result of which the Report merits a full review, notwithstanding its daunting length. The sheer number of reform recommendations defies quick summary, but there are several that are particularly worth closer review, including the Report's suggestion (at pages 71-77) that all public companies "eliminate the practice of providing quarterly guidance" because "reducing the pressures to meet precise quarterly earnings targets...is an important first step toward shifting the focus away from quarterly results and toward the long-term performance of U.S. companies." The elimination of qurterly earnings guidance was previously recommended by the Business Roundtable Institute for Corporate Ethics in is July 2006 Report (here). The D & O Diary's prior views regarding the pitfalls of earnings guidance can be found here and here.

The Report also recommends the creation of two federal chartering mechanisms, one for accounting firms and one for insurance companies. In both cases, the objective is to reduce regulatory burdens that add friction costs and impeded competitiveness. The D & O Diary believes the recommendation for an option federal level insurance chartering system is particularly noteworthy and is a concrete suggestion that could in fact actually help U.S. based insurance companies (which are very important participants in the U.S. financial markets) to operate more efficiently and compete more effectively.

The Chamber Commission's Report is merely the latest in a series, and we will be hearing more of the same tomorrow (March 13) when the Treasury Department holds its conference on U.S. Capital Markets (here). But the Chamber Commission deserves credit for not replowing the same ground as the prior reports, and for avoiding the shortcoming of the prior reports of confusing the interests of Wall Street with the interests of the overall economy. The Chamber Commission's Report seems much less concerned than prior reports with simply removing things that Wall Street finds annoying, and more focused on ideas that will aid capital formation and competitiveness of U.S.-based financial enterprises.

As the regulatory reform dialog continues, the process seems to be becoming additive and cumulative. There have unquestionably been a number of interesting and promising ideas that have emerged, and the more the continuing dialog focuses on improving U.S economic prospects and the less it focuses on weakening the integrity of the U.S. regulatory system, the more promising will be the outcome.

The D & O Diary's prior discussion of the Interim Report of the Committee on Capital Markets Regulation can be found here and here. The D & O Diary's prior discussion of the Bloomberg/Schumer Report can be found here. My prior commentary on the weak case for regulatory reform can be found here and here.

Another Damned, Thick, Square Book: According to history (here), when Prince William Henry, Duke of Gloucester and Edinburgh (the younger brother of King George III, and pictured above) was presented in 1781 with Volume II of Edward Gibbon's classic The History of the Decline and Fall of the Roman Empire, the Prince is reported to have said "Another damned, thick, square book! Always scribble, scribble, scribble! Eh, Mr Gibbon?"

Welcome to the Litigation Consulting Blog: The D & O Diary would like to welcome the Litigation Consulting Blog (here), which appears to be a worthy addition to the blogsphere. The blog is relatively new but has already had a number of interesting posts, including today's post (here) about activist investing. D & O Diary readers will undoubtedly find this new blog interesting. Hat tip to Werner Kranenberg of the With Vigour and Zeal blog for the link.

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In a series of recent editorials, the New York Sun has raised some interesting and troubling questions about a New York City's pension fund's involvement as lead plaintff in the Apple Computer options backdating securities litigation.

The first Sun editorial on the topic, entitled "New York Versus Apple "appeared on January 25, 2007 (here). The editorial noted the irony that the same day as the city's Mayor, Michael Bloomberg, and its senior U.S. Senator, Charles Schumer, released a report (here) asserting among other things that meritless securities litigation was undercutting the competitiveness of the city's financial markets, the New York City Employees' Retirement System (NYCERS) was named as lead plaintiff in a class action lawsuit against Apple Computer and its executives and directors. The editorial observed that the city's law firm in the lawsuit, Grant & Eisenhofer, includes on staff as Senior Counsel, Leslie Conason, whose firm website bio reports that prior to joining the law firm, she "was responsible for managing all securities lititgation for the City of New York, where she was in charge of securities litigation for the $100 billion in pension assets held by the workers and retirees of the City of New York."

The editorial also points out that a partner at the Grant & Eisenhofer law firm, Keith Fleischman, had made a $1,000 campaign contribution to the city's Comptroller, William Thompson, Jr., in 2003, when Fleishman was at the Milberg Weiss firm. (As reported on the Comptroller's website, here, among Thompson's duties is the managment of the city's pension funds.) The editorial concludes by saying that:

The notion of a shareholder suit against Apple strikes us, in any event, as a stretch. Whatever shenanigans went on with Steve Jobs' stock options, the company's stock price is up 600% over the past two years, far outpacing the overall gains by the stock market or NYCERS. Any reasonable shareholder should be happy as a clam. New York's economy and streetscape have certainly benefited from the city's Apple Stores in SoHo and at the plaza of the GM building. If there's a bright spot, it's that one of the Apple directors named as a defendant is Albert Gore, Jr. By the time the vice president is done being deposed by the class action lawyers hired by the NYCERS board, he may be ready to line up with Messrs. Schumer and Bloomberg the next time they call for legal reform.

 

In a letter to the editor printed in the February 27, 2007 issue of the Sun (here), Thompson defended himself and the city's process for selecting counsel. His letter explains that after a selection process that included interviews and reference checks, the city executed agreements with nine plaintiffs' firms in mid-2006. His letter also points out that each of the city's pension systems' Board of Trustees makes the final determination as to whether or not to proceed with this type of litigation. Thompson's letter also defended the decision to pursue the Apple litigation, and the city's role in shareholder litigation generally.

In the same February 27, 2007 issue in which Thompson's letter to the editor appeared, the Sun ran a second editorial, this one entitled "Thompson's Trial Lawyers" (here). The paper found that six of the nine firms in New York City's "securities litigation pool," had made a total of $102,491 in donations to Mr. Thompson's 2005 election campaign - an election in which Thompson "faced only token opposition" and in which he was "reelected with more than 90% of the vote." Among other firms, the Kirby, McInerney & Squire firm is reported to have given $39, 975, and the Wolf Popper firm is reported to have given $36,256. Wikipedia notes that Thompson is a leading candidate to become the Mayor of New York in 2009 and has amassed a compaign fund of over $2 million.

In addition, the editorial reports that the head of the pensions division in the city's Law Department said that the Grant & Eisenhofer "brought the idea of NYCERS filing a lead plaintiff application to the Law Division." In other words, the editorial notes, the city didn't discover it was injured and look for a lawyer, "a lawyer chased down a perfectly healthy client and brought the client the idea of a lawsuit, even though the Apple stock the city owned was up 600% in the past two years." The editorial concluded that:

It's one thing... to take campaign money from trial lawyers. It's another thing entirely to turn around and allow those lawyers to use the good name of the city pension fund to pursue litigation with no redeeming value other than racking up huge fees for those same trial lawyers. The price Mr. Thompson pays for the more than $100,000 in campaign contributions he has taken from the class-action aecurity lawyers who represent the city is inevitability that the newspapers -- and, someday, perhaps, voters -- are going to question his judgment in pursuing this sort of litigation.

The Sun added a third editorial on February 28, 2007, entitled "Absentee Trustees" (here) in which the paper took a closer look at Thompson's assertion that a pension fund Board of Trustees had supervised the decision to pursue securities litigation on behalf of the fund. The paper found that at the October 24, 2006 Board "regular meeting" at which the city's Law Department claims that the vote to pursue litigation took place, "the so-called meeting of the 'board' included not 11 trustees [the total number of trustees on the board], not 10 trustees, not nine trustees, not eight trustees, but exactly one. That's right, just one actual trustee." The editorial points out that the board may want to reconsider its processes; "after all, the directors of Apple Computer are being sued by NYCERS for allegedly failing to provide proper oversight." The editorial concludes with the observation that "if things take an unfortunate turn for the New York City Employees' Retirement System, it's conceiveable that some enterprising class-action lawyer might look at them as a target. Apple stock appreciated 600% and it still got sued."

Way back in the optimistic era of securities litigation reform, back when Chris Cox was still just a Congressman from Orange County, when Congress enacted the Private Securities Litigation Reform Act of 1995, there was a notion that institutional investors needed to become more involved in order to eliminate abusive lawyer-driven securities litigation. So Congress promulgated a lead plaintiff process, in which the "most adequate platiniff" would be selected based on which plaintiff showed the "largest financial interest." Whatever Congress thought might result from this reform, it seems fairly likely that it did not envision institutional plaintiffs pursing lawsuits as a result of an unsupervised and campaign finance driven process, supplemented by a revolving door between the institutional investors and the plaintiffs' firms. (As an aside, I also suspect that Congress did not envision institutional investor driven opt-out litigation either, about which I recently commented here.)

The Sun identifed the ironic propinquity of the Bloomberg/Schumer report's release and NYCERS' selection as lead plaintiff in the Apple litigation. An irony the Sun missed is that the Paulson Committee Interim Report (here), which preceded the Bloomberg/Schumer report by only a few weeks and raised similar concerns about the adverse competitive effects of meritless securities litigation, specifically decried "pay to play" practices between institutional investors and the plaintiffs' bar. The Paulson Committee Report asserted that:

When political contributions are made by lawyers to individuals in charge of a state or municipal pension fund, the attorneys should not be permitted to represent the fund as a lead plaintiff in a securities class action. Following the lead of the municipal bonds industry, the securities litigation regulations should be comprehensive and should cover any direct contributions as well as indirect contributions (made through "consultant" or other similar arrangements) ... At a minimum, the SEC, as an amicus, should ask courts to require disclosure of all political contributions or fee-sharing arrangements between class counsel and a lead plaintiff (or controlling individuals within the lead plaintiff organization). This disclosure should occur prior to the court's appointment of either counsel or plaintiff and should be followed by a similar disclosure at the fee award hearing. (Emphasis added)

 

The D & O Diary has a suggestion for Mayor Bloomberg. If he really thinks abusive securities lawsuits are undermining the competitiveness of his city's financial markets, he should toss the report that he and Senator Schumer paid McKinsey to write and read the Paulson Committee's Interim Report's comments about "pay to play" practices. And then he should take a very hard look at practices in his city's Law Department. The good news for Mayor Bloomberg is that he doesn't even need to await the SEC action the Paulson Committee's Interim Report advocated; he can institute his own securites litigation reform without any fuss or bother or press conferences or grandstanding speeches or anthing like that. For reasons the D & O Diary has elaborated upon at length elsewhere (most recently here), this reform is unlikely to affect the relative competitiveness of the city's financial markets in the global marketplace, but it certainly would clean up some pretty unattractive looking circumstances and practices.

How to Find out Who is "Paying to Play": Readers who are interested to know more about plaintiffs' lawyers campaign contributions (or those of anybody else, for that matter) will definitely want to spend some time on the website (here) of the Center for Responsive Politics, where campaign contributions are searchable by donor name. (Click on the "Who Gives" tab and select "Donor Lookup" from the dropdown menu.) For example, a search on the name William Lerach identifes 150 separate donations totaling $1,283,430 (including several donations to Hillary Clinton ) A search on the name Mel Weiss shows that Weiss made 120 donations totaling $699,102. Among other candidates, Weiss made a number of donations to Senator Schumer. Hmmm, that's kind of interesting... maybe after the law firm's indictment, Schumer felt he could...yep, that's probably it.

Isn't It Ironic, Don't You Think?: The Sun obviously has an eye for irony and an interest in securities fraud litigation. The Sun's outlook must be in its DNA, because its founding investors, according to Wikipedia (here), included none other than Conrad Black, who has been working for years on his own wing in the securities fraud litigation house of blues. You don't suppose that has anything to do with the paper's obvious and manifest hostility to securites lawsuits? Nahhh...

The D & O Diary wishes to acknowledge with grateful thanks the two alert readers who prefer anonimity and who provided links to the Sun editorials and to the Center for Responsive Politics website.

 

 

 

 

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The would-be reformers who propose restructuring the U.S securities regulation regime cite the loss of U.S. IPO market share to overseas markets, particularly London's Alternative Investment Market (AIM), as justification for regulatory reform. But as The D & O Diary has previously noted (most recently here and here), these overseas markets, especially the AIM, face precisely the opposite pressure - that it, to validate their regulatory integrity in order to maintain investor confidence.

Along those lines, on February 20, 2007, the London Stock Exchange (LSE) announced a variety of new rules for AIM companies, providing further disclosure obligations and clarifying guidance regarding the rules for "Nominated Advisors" (or Nomads, as they are more popularly known). In its press release (here) announcing the rules changes, the LSE said that the "changes are intended to ensure the AIM maintains the right regulatory balance as the market continues to grow and thrive internationally." The AIM Director of Markets is quoted as saying that "as the market grows and becomes increasingly international, the Exchange will take incremental steps to build on the quality and integrity of the market."

The LSE's summary of the rules changes, as well as a summary of the process leading up to the changes, can be found here. The amended Rules for AIM Companies can be found here.

The key changes in the new Rules for Companies include new requirements for disclosure of critical information on each AIM Company's website; enhanced disclosure requirements for pre-admission announcements; and guidance regarding reverse takeovers. The changes also include revisions to the AIM disciplinary guidelines, including the provision for the LSE to be able to issue warnings for AIM rules violatins, and an increase in the maximum disciplinary fine (from 25,000 pounds to 50,000 pounds). A good summary of the new rules by the Pillsbury Winthrop Shaw Pittman law firm can be found here.

The AIM summary of the changes (here) notes that a number of commentators on the proposed rules during the notice-and-comment period had suggested that that the LSE "should mandate particular corporate governance requirements for AIM companies." The LSE declined to implement uniform corporate governance standards, observing that "given the wide range of companies that admit to AIM, the Exchange believes that the corporate governance measures to be adopted remain a matter for the nomad to provide advice about, on a company-by-company basis, both on admission and also on an ongoing basis as the company develops."

Even though the LSE declined to require uniform governance measures, the LSE's increased emphasis on disclosure, and tightened requirements for Nomads, as well as the increased disciplinary provisions, bespeak an appreciation for the need to encourage regulatory integrity to maintain investor confidence. As The D & O Diary has noted in the past, companies attracted to the AIM out of a perception of a lighter regulatory touch there will find that they still face regulatory scrutiny. Moreover, the changes suggest that the comparative landscape among the various global exchanges is evolving. For that reason, the U.S. should hesitate to alter its regulatory structure to address what may be transient differences in the global financial marketplace.

Special thanks to Werner Kranenburg of the With Vigor and Zeal blog and to alert reader Doug Edinburgh for links regarding the AIM rules changes.

A Baker's Dozen of Canadian Securities Regulators: In the meantime, Canada is wrestling with a different issue - whether to unite its current system of 13 provincial securities regulators into a single, national regulator. According to news reports (here), a panel convened last year concluded that a single regulator could "consistently enforce investor rights across Canada." Canada is the "only major developed country without unified securities regulation, " as a result of which bad actors who have been fined or barred from activity can simply move from province to province.

The push for a single unified regulator has recently gained momentum because of several high profile insider trading cases, and the movement got a further boost when Alberta's finance minister came out in favor of a unified regulatory approach (here). But the boost proved shortlived, as the head of the Alberta securities commission publicly opposed both the single regulator proposal and the finance minister (here). The Ontario government has been pushing for a single regulator, but other provinces, notably Quebec, have been pushing back.

Epic Poet: Homer -- first the Illiad and the Odyssey, then the Simpson. Read Homer's most eternal statements, here. (Better not to have any food in your mouth when you read these.)

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Regular readers know that I have previously questioned (most recently here) the case for regulatory reform. Among the grounds the reformers routinely cite as the basis for regulatory reform is the U.S.'s loss of global IPO marketshare. A February 20, 2007 Wall Street Journal article entitled "Do Tough Rules Deter Foreign IPO Listing in the U.S.?" (here, subscription required) reports the findings of a recent study by Thomson Financial which found "little evidence of foreign companies shying away from U.S. exchanges since the adoption of Sarbanes-Oxley." Thomson Financial apparently studies new stock issues in the past 20 years and concluded that "in terms of dollars raised, foreign IPO activity in the U.S. looks very healthy indeed."

The study found that foreign IPOs (excluding investment funds and closed end funds) accounted for 16% of 2006 IPOs in U.S. exchanges, the highest proportion in the 20-year period studied. In addition, the $10.6 billion raised in foreign company offerings represents 26% of 2006 IPO volume, the highest level since 1994. According to the study's author, "the statistics show that things look rather healthy" and that even after Sarbanes-Oxley, "there doesn't seem to be any really significant deterioration of the IPO market."

The competitive challenge for the U.S. markets is not that they can't attract foreign companies' listings, it is that financial activity in general is increasingly global, and that global growth has more to do with what is happening overseas than with the state of regulation in the U.S. markets. As the February 20, 2007 Bloomberg.com article entitled "IPOs Shun U.S. Exchanges While Wall Street Collects Record Fees" (here) points out, activity on overseas markets may be booming, but "it is not that America's economy and markets are shrinking - it is that the other ones are growing." The article also notes that "for companies based in Europe, the Middle East and Asia, the choice of where to raise capital often comes down to geography and time zones."

The increasing competitiveness of the global financial marketplace is due to a host of causes, most having nothing to do with the level of regulatory scrutiny in the U.S. As I have noted in prior posts, we should be wary of allowing the effects of larger global financial forces to serve as a pretext for reducing the level of regulation in our markets. The evidence above does not support the hypothesis that foreign companies are unwilling to list their shares here, and the increased financial activity overseas has no relation to the level of regulatory rigor in this country.

There is, however, one area, where the U.S. securities markets clearly are at a competitive disadvantage - cost. As the Bloomberg article notes, "for all the talk about keeping U.S. markets competitive and safeguarding jobs, the reality is that investment banks have helped price the U.S. out of the global IPO market." U.S firms charge more to underwrite shares than do firms elsewhere; according to Bloomberg, U.S. investment banks charged fees averaging 4.4 percent of the value of stock sales in 2006, by comparison than 2.3 percent in Europe.

Whether or not the higher underwriting costs for listing in the U.S. really are deterring foreign business, cutting costs would be a particularly easy way to remove at least one impediment to doing business here, and it is a step that doesn't require any governmental authority's cooperation to accomplish. At a time when U.S. financial firms are booking record profits, this seem like a reasonable first step toward removing impediments to the competitiveness of the U.S markets.

In my commentary on reform proposals, I have also frequently noted (refer here) that other countries' reforms are narrowing differences between the U.S. and other countries. An article in the February 17, 2007 issue of the Economist magazine entitled "If You Can't Beat Them, Join Them" (here, subscription required) comments that while European business interests may not welcome American style class action lawsuits, "welcome or not, class action lawsuits are on the way." Britain, Netherlands, Germany and Spain all already permit some form of collective action, and Italy and France are considering their own versions. (France recently tabled its version until after the May elections.) To be sure, these European versions lack many of the attributes of American class action litigation, including contingent fees, jury verdicts on damages, and the possibility of punitive damages awards. The Economist declares that these new forms of collective action deserve a "caution welcome" because they permit efficient resolution of widespread claims, and because they provide injured European investors a way to seek remedies without having to resort to U.S. courts.

Reasonable minds can disagree over whether the differences or similarities between the U.S and the European models of collective civil actions are most important now. But as global investors become more accustomed to seeking judicial remedies for management misconduct, the similarities will matter more than the differences.

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In a recent post (here), I noted that the cross-border Siemens bribery investigation shows that regulators throughout the world increasingly recognize the importance of vigilance and scrutiny, and that the extent of alleged misconduct in that case could spur further efforts for oversight and reform. In that same vein, a February 15, 2007 New York Times article entitled "Germany Battling Rising Tide of Corporate Corruption" (here) notes with respect to the Siemens case and other investigations that "the current spate of scandals will prompt a serious, systemic effort by German companies to impose more stringent internal controls and systems of legal compliance to stop corruption from happening in the first place."

Whether the current wave of German corruption cases reflects lax legal compliance or simply more aggressive prosecution, it is clear that the number of cases is increasing. Germany did not have laws allowing prosecutors to bring bribery cases until 1997, by contrast to the United States, which has had the Foreign Corrupt Practices Act for over 30 years. One source quoted in the article says that in the last five years, "the notion that we need to prosecute economic criminality took on an entirely new dynamic."

This new dynamic clearly will influence both prosecutorial priorities, and by extension, expectations of corporate compliance. As I have previously noted (here), as these regulatory efforts elsewhere gain traction, differences in regulatory standards between the U.S. and other countries will diminish - a consideration that is clearly relevant to the current calls for regulatory reform in the U.S.

Ready, Fire, AIM: In prior posts, I have raised concerns (most recently here) about regulatory standards for London's Alternative Investment Market (AIM), and more recently (here) I have suggested that the AIM may be facing increasing pressure to tighten up. In a February 12, 2007 article in The Times (London) entitled "Most AIM Fundraisers Fail to Enrich Backers Over Three Years" (here) takes a look at the 802 companies that listed on the AIM during the three years ending on December 31, 2006, and finds that 52 percent were "either trading at or below their issue price, or have had their shares suspended."

The Times concludes that the "findings are likely to fuel criticism of AIM that, although it has been the most successful growth market in terms of new listings, it has often sacrificed quality for quantity."

Whatever conclusions may be drawn from the data about the quality of AIM listed companies, the fact that over half of the last three years' listings have failed to make money for investors does have important implications for the likelihood of the past level of listings to continue in the future. This is just one more example of the reasons why current global marketplace circumstances may well change for their own reasons, without any of the regulatory revisions for which the would-be reformers in the U.S. are clamoring.

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At the heart of recent calls for regulatory reform in the Interim Report of the Committee on Capital Markets Regulation and in the Bloomberg/Schumer Report is the assertion that the U.S. securities markets are losing global IPO marketshare because of supposed regulatory overkill and the litigious environment in the U.S. Accompanying this assertion is the concern that foreign securities markets (particularly in London) are supposedly attracting IPO activity by their comparatively light regulatory touch. Reform of the U.S regulatory approach and litigation system is needed, these Reports assert, so that the U.S. can recapture a larger share of the global IPO activity.

The D & O Diary has previously presented (most recently here) its belief that the reformers' case for regulatory reform is "weak." More recently, events both overseas and in the U.S. further belie both ends of the reformer's premise - that is, these recent events suggest that companies (even foreign companies) may yet seek to list on U.S. exchanges, in preference to other exchanges, even without regulatory reform; and that companies might not be able to count on a lighter regulatory touch on competing exchanges.

1. London's Attraction To (or Appetite For) Russian and Chinese Companies May be Waning:

A very large part of the London markets' success in growing their share of the global IPO market in recent years has been based on their success in attracting listings from Russia (and other former Soviet republics) and from China. Indeed, in 2006 alone, 12 offerings by companies from Russia or other former Soviet republics raised proceeds of nearly 6.6 billion pounds. But now in early 2007, the bloom very much seems to have gone off the rose for Russian offerings in London. As reported in a February 8, 2007 Financial Times article (here), the listing of the shares last week of two Russian companies (Polymetal and Sitronics) came in at the low end of the offering range and in response a third company, GV Gold, withdrew its offering amidst "lackluster demand." According to the Financial Times article, these developments "underline the increasingly tough environment companies from Russia and other former Soviet states are likely to face this year as investors become increasingly selective."

At the same time the pipeline of Russian companies to London has started to slow, two Chinese companies, 3SBio and JA Solar Holdings, completed successful offerings on NASDAQ.

Without the flood of Russian listings, and with Chinese companies successfully listing in the U.S., the apparent market share advantage enjoyed by the London exchanges could be diminishing

2. The Successful Fortress Investment Group IPO Will Attract Additional Hedge Fund and Private Equity Fund Listings on U.S. Exchanges

Fortress Investment Group's successful February 9, 2007 IPO was not the first public offering by a private equity fund or hedge fund, nor was it the largest. But it was the first public hedge fund offering on a U.S securities exchange, and it was the most successful. According to the February 10, 2007 Wall Street Journal (here, subscription required) 19 private equity and hedge fund firms sold shares in 2006 on foreign markets, raising $12.4 billion. U.S. groups have been among the firms to list their shares in these offering. KKR, for example, sold shares in a private equity fund on the Euronext Amsterdam exchange. But the KKR fund shares trade in a narrow range close to their offering price.

Fortress chose to list its shares on the NYSE, notwithstanding those supposedly prohibitive regulatory constraints that are driving companies away from the U.S. securities markets. Its reward was that its offering priced at the top end of the range and its shares jumped 68% in the first day of trading. Commentators can argue all they want about whether regulatory burdens are deterring companies from listing on U.S. exchanges, but high valuations and a successful debut like Fortress Investment Group's will unquestionably attract companies to list on U.S. exchanges.

The title of the Wall Street Journal's February 10, 2006 article about the offering, "Hedge Fund Crowd Sees More Green As Fortress Hits Jackpot with IPO" (here, subscription required) says it all. Along those lines, a February 9, 2007 Business Week article (here) reporting on the Fortress Investment Group IPO contained a prediction that more than 30 hedge funds and private equity funds could seek to list their shares on U.S. exchanges by the end of 2008.

It should also be noted that the Fortress group was one of 17 offerings this week on U.S. securities exchanges, raising over $3.4 billion, the most active week in terms of deal value in over three years. It certainly seems like the market for IPOs on the U.S. exchanges is healthy -- perhaps healthy enough to question whether the reformers' dire warnings about the competitiveness of the U.S. markets are seriously overblown.

3. London's Regulators, Perhaps Spurred by Criticism, Have Begun to Show Some Teeth

It probably has nothing to do with the remarks (here) of John Thain, the head of the NYSE, at the recent World Economic Forum in Davos, Switzerland, that the London markets need to "tighten up" to avoid "damage" to "their reputation." But within days of these remarks, the U.K.'s Serious Fraud Office launched an investigation (here) into Torex Retail, following the London Stock Exchange's suspension of trading of Torex Retail's shares on the Alternative Investment Market (AIM).

The Torex Retail matter may involve only one company, but it does serve as a reminder that markets will strive to maintain their integrity in order to preserve investor confidence. There are no advantages for being perceived as having won the race to the bottom. Companies attracted to the London markets out of a perception of a lighter regulatory touch will find that they still face regulatory scrutiny. It will not take too many cases like Torex Retail before the London regulators will have shown their vigilence is not less than regualtors elsewhere.

UPDATE: On February 12, 2007, another AIM listed company, Adamind LTD, disclosed (here) that the Financial Services Authority had initated an investigation regarding the company. The Adamind investigation is noteworthy because it involves one of those companies -- Adamind is a U.S.-based company with R & D facilities -- that chose to list in London and about which the would-be reformers have been fretting so much. Special thanks to alert reader Uri Ronnen of the AccountingClues blog for the link to the Adamind disclosure.

Each of these developments serve as a warning against seizing upon possibly temporary or transient phenomena as pretexts for reducing regulatory rigor in the U.S. In the global economy, transactions will go where they can realize their greatest financial advantage. The factors that in the recent past led to a greater number of listings in London may have had little to do with the regulatory regime in the U.S. The changing IPO market place so far in 2007 suggests that the competitive landscape among the various securities markets is already evolving, and will continue to evolve - and that that is happening without the adoption of any of the various proposed regulatory reforms. We should be very wary of compromising this country's regulatory rigor based on transient shifts in the global financial marketplace that have no relation to the level of regulation in this country.

Now This: When we heard about the untimely death of Anna Nicole Smith, we found that we could not think of her marriage to J. Howard Marshall without associating this scene from the film, Best in Show:

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In prior posts (here, here and here), I argue that the Committee on Capital Markets Regulation (popularly known as the Paulson Committee) made a "weak case" in its Interim Report for regulatory reform. Virtually all of my points apply equally to the recently released Bloomberg/Schumer report as well. The themes I sounded in my earlier posts are underscored in a January 25, 2007 Wall Street Journal article entitled "In Call to Deregulate Business, a Global Twist" (here, subscription required), which suggests that "the changing nature of global finance," rather than the U.S regulatory environment, explains U.S. markets' declining share of global finance business.

The Journal article explores at length the improved competitiveness of foreign markets, which in recent years have closed their "quality gap" with the U.S. markets. Developing world markets are "deep enough and liquid enough" that listing companies no longer have any financial imperative to list or trade their shares on U.S. exchanges, as they may have had in the past.

The article also zeroes in on one of the prime points cited to justify regulatory reform - that is, the declining U.S share of global IPOs. With the exception of the London's Alternative Investment Market (AIM), IPOs are down on all developed countries' exchanges - "the London Stock Exchange's blue-chip Main market has seen foreign listing decline 23% since 2000. The Deutsche Borse is down 58%; Tokyo down 39%." In other words, the declining IPO volume "is hardly an American disease." And even with respect to AIM, the article points out that many of the AIM companies don't "meet U.S. requirements" or are "too small to attract interest from U.S. underwriters and investors." (My prior post, here, reviews the Bloomberg/Schumer report's discussion of the AIM and the report's conclusion that the U.S. markets should not lower its standards to compete for more of AIM's business.).

The article also shows that overseas companies are now able to trade their shares freely, and even attract U.S. investors, without the need for a U.S. listing - or the need to pay the $1 million NYSE listing fee. In addition the article examines the fact that increased private equity takeover activity is a global phenomenon, not just a U.S. trait, and that rather than reflecting U.S. companies' interests to "go private" and avoid public company regulation, the high level of private equity activity is simply a reflection of the fact that private equity firms have so much cash.

At the same time as global markets have become better, they have also closed the regulatory gap with the U.S. The article quotes the director of the SEC's office of international affairs as saying that Sarbanes-Oxley has "not competitively disadvantaged U.S. markets, simply by virtue of the fact that they have been widely adopted elsewhere." Even though the U.S. regulatory burden has risen, the same is true for most countries' markets.

The article gives the advocates for regulatory reform an opportunity for rebuttal. The best that Glenn Hubbard, the chair of the Paulson Committee, can offer, is the declining "investment premium" enjoyed by foreign companies based in developed countries that cross list their shares on U.S. exchanges. Hubbard argues that the declining investment premium for these developed world companies shows that for companies already meeting their more stringent governance standards at home, the costs of meeting the U.S. benefits exceeds the costs.

I have extensively examined the investment premium issue before (here), but it is worth noting here what a total non sequitur Hubbard's argument is. First, it concedes that there is still an investment premium for companies based in developing countries - that is, the countries with the growing economies that are most likely to be the source of increased economic activity in the years ahead. Second, while the investment premium for companies based in developed countries has declined, it has not gone away, there is still an investment premium for listing on U.S. exchanges, and that is because of the integrity of the U.S. markets, which would be eliminated if regulation were relaxed. And third, to the extent the investment premium has declined, isn't it obvious that it is because the integrity of many foreign markets has improved? If that is the case, then why does that argue in favor of weakening U.S markets' regulation? It just seems to me that the only conclusion that can be drawn from the investment premium issue is that we would be best served by striving to maintain the integrity of our markets, not weakening our regulatory rigor in a race for the bottom.

All of this underscores the point I have made in prior posts that business interests in the U.S. may be seizing on the effects of the changing global finance environment as a pretext to undermine regulatory requirements that may occasionally prove uncomfortable because the requirements actually have teeth. The advocates for regulatory reform may want to advance U.S. competitiveness, but steps that threaten to weaken the integrity of the U.S regulatory structure could remove the greatest advantage the U.S. markets enjoy - that is, the U.S. markets are the most highly regarded precisely because they are the most tightly regulated.

That is not to say that none of the reformers' ideas have validity. To the contrary, the Bloomberg/Schumer report's suggestions for immigration reform and immediate adoption of the Basel II Capital Accords are sound and should be pursed, as should many of the report's suggestions for harmonization of competing U.S. regulatory structures, and the harmonization of U.S and international accounting standards. But aggressive revision of the U.S regulatory and legal structure, at least in the name of the competitiveness of the U.S. markets, could represent a misplaced effort that could do more harm than good.

It is worth noting that the Journal article contains an interesting quote from former Treasury Secretary Lawrence Summers, who says that "well-functioning capital markets are central to the success of the economy. What faction of capital market transactions runs through New York is of much less broad-based significance." Summers' observation is one that is not being heard much, but it is a point worth keeping in mind. Perhaps we should be more focused on adapting to the new reality of the global marketplace, rather than attempting to preserve the benefits of market advantages that no longer exist.

Finally, it is worth noting that several of the overseas companies discussed in the Journal article mentioned the high listing fees for U.S. exchanges. While the two task force reports released so far have tried to downplay the importance of listing fees and U.S underwriters' fees (which also tend to be higher than European fees, as much as twice as high), evidence and logic suggest that these fees and costs are a factor affecting overseas companies' willingness to list on U.S. exchanges. As I have argued before, the U.S. financial industry, rather than sniping at a regulatory structure that other countries are imitating, perhaps they should overhaul their cost structure, which the rest of the world has substantially improved upon.

UPDATE: The January 26, 2007 New York Times has an article (here) that raises many of the same themes as the Journal article linked about, including specifically the point that the U.S. should not be stressing about the loss of very small companies to the AIM.

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On Monday January 22, 2007, Republican New York City Mayor Michael Bloomberg and Democratic New York Senator Charles Schumer released the joint report they commissioned from McKinsey & Company, entitled "Sustaining New York's and the U.S.'s Global Financial Services Leadership." The report can be found here, and the joint press release describing the report can be found here. The report is written in the same vein as the Interim Report of the Committee on Capital Markets Regulation, or the Paulson Committee as it is popularly known, and the two reports are both of similarly impressive length. (My prior discussion of the Paulson Committee Report can be found here). There are, however, several important differences between the two reports, both in tone and in substance.

Among the more important visual differences is the explicit bipartisan support for the Bloomberg/Schumer report. Indeed, newly elected Democratic New York Governor Eliot Spitzer showed up for the ceremony to release the report, about which there is some significant irony, given the report's concern about the problems caused by conflicting regulatory schemes. The Wall Street Journal's discussion of the unsubtle irony of Spitzer's involvement can be found here and here (subscription required).

The Bloomberg/Schumer report, like the Paulson Committee's Interim Report, is focused on the competitiveness of the U.S. capital markets, but its recognition of the reasons for the heightened competitiveness of foreign securities markets is more comprehensive and detailed than the Paulson Committee's Interim Report. The Bloomberg/Schumer report examines at length the "strong dynamics outside the U.S. driving international growth." Its review of the reasons why many foreign companies are seeking to list their shares on exchanges outside the U.S. examines at length the geographic and economic reasons for this shift, including in particular the increased availability of adequate capital in foreign markets and improved technology and communications that has opened these markets to all international investors (including even U.S.-based investors).

The Bloomberg/Schumer report is also much less concerned about the purported threat of London's Alternative Investment Market (AIM) that then Paulson Committee's Interim Report. While recognizing that the AIM has successfully tailored its listing requirements to attract smaller companies, the Bloomberg/Schumer report also notes that "small-cap markets are clearly riskier that their more established counterparts." The report also notes in a sidebar that while the AIM has attracted a growing number of listings in recent years, the growing number "masks the large and increasing number of de-listings (480 since the beginning of 2003) and low liquidity of most AIM stocks." The Bloomberg/Schumer report concludes that because of concerns over the "disproportionate impact a bear market might have on small-cap markets and investors," and the limited economic benefit of such markets, the report "does not recommend that U.S. exchanges lower their listing requirements to attract more small issuers.'

The Bloomberg/Schumer report also emphasizes several issues that are not addressed at all in the Paulson Committee's Interim Report. For example, the Bloomberg/Schumer report takes a look at legal barriers that may prevent domestic markets from attracting top global financial talent and concludes that U.S immigration policies are making it harder to attract non-citizens to move to this country, and these barriers are undermining the competitiveness of U.S. securities markets. The report proposes a number of specific immigration reforms. The Bloomberg/Schumer report also recommends the rapid implementation of the Basel II Capital Accords, so that U.S.-based commercial banking institutions do not face higher capital level requirements than their foreign counterparts, which would put them at a competitive disadvantage.

Based on its conclusion that the regulatory and legal environment in this country is a substantial factor diminishing the attractiveness of U.S capital markets, the Bloomberg/Schumer report proposes a number of reforms. While the Bloomberg/Schumer report, like the Paulson Committee report, singles out Section 404 of the Sarbanes-Oxley Act, the Bloomberg/Schumer report comments that the fault does not lie with the Act itself but with the implementing regulations. (This observation coincides with the remarks of SEC Commissioner Paul Atkins on January 22, 2007 at the Corporate Directors Forum, here). The Blooberg/Schumer report urges the SEC and the PCAOB to proceed quickly with their current efforts to reform the implementing regulations (see the PCAOB's press release on its current reform efforts, here), provide further guidance with regard to what constitutes a "material weakness" in internal controls, and help implement an internal control review that is "top-down, risk-based, and focused on what truly matters to the integrity of a company's financial statement.'

The report also suggests that the SEC should consider giving "smaller companies" (the report does not define "smaller") the opportunity to opt-out of the more onerous requirements of the Sarbanes-Oxley Act, provided the choice is "conspicuously disclosed to investors." In addition, the report suggests that the SEC should consider exempting foreign companies from certain parts of the Act, provided they already comply with sophisticated, SEC-approved foreign regulators' requirements.

The Bloomberg/Schumer report also proposes limited "securities litigation reform," which it proposes that the SEC implement through its authority under Section 36 of the Securities Exchange Act of 1934 to exempt certain companies from regulations when it deems such exemptions to be in the public interest. Specifically, the report suggest that the SEC choose to limit the liability of foreign companies with U.S. listings to securities related damages proportional to their degree of exposure to U.S. markets; and impose a cap on auditors' damages that would maintain a deterrent effect but reduce the likelihood that the auditing industry would lose another major player. The report also repeats the suggestion that the SEC could allow companies to opt out of part of SOX (again, with "conspicuous disclosure.") The report also proposes that the SEC promote arbitration as a means of resisting disputes between public companies and investors.

The report also proposes two legislative changes to address "long-term structural problems." The report suggests that Congress should consider limiting punitive damages and allow litigants in federal securities actions to appeal interlocutory judgments immediately to the Circuit Courts. The report contains a number of suggestions to harmonize the various U.S. regulatory structures. It also suggests the creation of a permanent body (the "National Commission on Financial Market Competitiveness") to focus on the competitiveness of the U.S securities markets.

Compared to the Paulson Committee Interim Report, the Bloomberg/Schumer report is both more comprehensive (for example, with its reference to immigration reform and the Basel II Capital Accords) and, in some ways, more realistic (for example, in its recognition of the myriad reasons not to lower regulatory standards simply to attract smaller listing companies). The report also presents a few modest proposals that could help incrementally improve the competitiveness of the U.S. securities markets. The report struggles to maintain the air of modesty for reforms that may not be quite so modest or feasible (for example, using federal legislation to eliminate state law provisions for punitive damages, or using regulatory provisions to create damages caps). The proposal to create an arbitration remedy for investors disputes with public companies may seem superficially attractive, but even a brief referral to one of the more serious securities class action lawsuits will reveal that these kinds of lawsuits are peculiarly unsuited for that forum and process.

But with the arrival of the Bloomberg/Schumer report and its addition to the Paulson Committee's Interim Report, and with the added prospect of the conference that the Treasury Department plans to hold this spring on the issue of the competitiveness of the U.S Securities markets (here), it is pretty clear that momentum is building for action to be taken to assist the U.S. markets. In this environment, particularly where there seems to be a bipartisan consensus emerging, it seems likelier that regulatory and even legislative reforms may well occur. In this environment, ideas such as the increased regulatory flexibility for smaller companies and foreign companies, may receive a more sympathetic reception, even though it would have to be asked whether these changes might represent a lowering of standards that arguably could weaken the overall strength and integrity of the markets.

It also appears the regulators are reading reading the newspapers. The PCAOB's intiative to reform Auditing Standard 2 and argubly even the Department of Justice's revision of the Thompson Memo with the release of the McNulty Memo are undoubtedly the result of a multitude of factors, but the timing of these reforms may be due to the growing calls for reform. The regulators may well be attempting to get ahead of the curve; there may be further regulatory intiatives ahead.

One final observation: it is interesting to note that the Bloomberg/Schumer report concludes, in examining the reason for the decline in the number of securities class action lawsuits in 2005 and 2006, that the decline in the number of lawsuits is largely attributable to favorable economic conditions and that "if economic conditions were to decline in the future, then a strong resurgence of lawsuits would likely follow."

Additional interesting commentary about the Bloomberg/Schumer report can be found at the AAO Weblog (here) and the SOX First blog (here).

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When the Committee on Capital Markets Regulation (popularly known as the Paulson Committee) in its Interim Report (here) recommended "setting a cap on auditor liability," the Committee relied for support on the steps in that direction that have been taken by the European Commission. In its latest effort along those lines, the European Commission on January 18, 2007 launched a "public consultation on whether there is a need to reform the rules on auditor liability in the EU." A copy of the Commission's press release can be found here. A copy of the Staff Working Paper can be found here.

In the Working Paper, the Commission's staff offered four alternative proposals to cap the liability accounting firms potentially face when auditing public companies. (The Commission is asking for comment on the four proposals by March 15, 2007.) The four proposals are: a fixed monetary cap on damages that could be sought from auditors; a cap based on the audited company's market capitalization; a cap based on a multiple of the audit fees charged; or the introduction of proportionate liability , which would hold the auditor responsible only for the damages that could be specifically attributed to them.

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