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Former SEC Chairman Back Obama

Three former chairmen of the Securities and Exchange Commission publicly endorsed Democratic Sen. Barack Obama's bid for the presidency Wednesday, including one who served under President Bush.  William Donaldson, who was SEC chairman for approximately 2½ years under current President Bush, along with Clinton and Reagan appointees Arthur Levitt and David Ruder, have now joined forces with former Fed Chairman Paul Volcker in support of Senator Obama.  Chairman Donaldson’s endorsement is especially telling given that he served under the current Administration and was at the SEC when Enron melted down.

What is equally interesting is that Senator Obama is doing surprisingly well raising money from Wall Street.  According to the Wall Street Journal:

Through March, the latest data available, employees of banking and finance companies have favored Democratic presidential candidates over Republicans by 55% to 45%, according to OpenSecrets.org, a campaign finance Web site operated by the nonpartisan Center for Responsive Politics. Among candidates over that period, Sen. Obama has raised the most -- about $9 million -- with Sen. Clinton raising $8.5 million. Sen. McCain has raised $5.7 million from those employees, putting him behind Mitt Romney and Rudy Giuliani, two Republican candidates who dropped out of the race earlier this year.

Obama’s fundraising strength on the Street, and these endorsements, send a clear signal -- those who know our capital markets best believe we are heading in the wrong direction.  The current Administration has gutted the SEC and consistently opposed shareholder rights.  While there may be some people left who believe these developments are positive, their ranks are growing smaller and smaller. 

Who Gave “Say On Pay” Right? AFLAC

Earlier this month in an annual meeting, Aflac’s shareholders had their say on the company’s executive compensation policies. With 93% of Aflac’s shareholders saying “yes” to the compensation packages of its five top executives, Aflac became the first American public company to give shareholders a nonbinding voice on executive pay including its CEO’s compensation package of nearly $12 million. This extraordinary vote is of course the exception as there were more than 90 shareholder proposals this year alone that demanded companies give the same “say on pay” right.

Moreover, other companies should look toward Aflac as a model to what it actually means to be shareholder-friendly. To compensation experts like Irving Becker of the Hay Group, it is no surprise with the outcome as “Aflac’s CEO has created a lot of value for shareholders over his long tenure, and his pay package is shareholder-friendly.” According to Aflac’s press release, since Daniel Amos became Aflac’s CEO in 1990, the Company’s “total return to shareholders, including reinvesting cash dividends, has exceeded 3,867%, compared with 69% for the Dow Jones Industrial Average and 583% for the S&P 500.”

UBS Agrees to Repurchase Illiquid Auction Rate Securities from Massachusetts Municipal Entities

As we have been discussing, the market for Auction Rate Securities (ARSs) froze up in mid-February of this year -- leaving investors largely unable to unload these debt securities at anything approaching fair market value. A number of Massachusetts municipalities and other entities got stuck holding illiquid ARSs, which they were using to finance public works projects. According to a recent article in Securities Law 360 (subscription required), The Massachusetts Turnpike Authority; the towns of Andover, Merrimac, Hudson, and Winchester; and the cities of Holyoke and Chicopee were all left holding ARSs.

These Massachusetts entities purchased their ARSs through UBS, which apparently marketed the ARSs as permissible investments for municipal entities under Massachusetts law. In response to the ARS crisis, the Massachusetts attorney general, Martha Coakley, stepped in and questioned UBS about its investment recommendations. UBS promptly agreed to return the $35 million that these municipal entities had invested in ARSs by repurchasing their securities at par value.

While this is a great result for the Massachusetts entities and municipalities involved, UBS was quick to caution that “the reasons supporting this agreement apply only to the circumstances of this specific case.”  UBS explained that individuals do not share the same protection under Massachusetts law -- leaving individual investors with little recourse against marketers of ARSs. What these investors do have are billions of dollars worth of illiquid securities that, oftentimes, were represented as being no riskier than money market accounts.

From the Pages of The Pomerantz Monitor: The Market for Auction Rate Securities Freezes Up

As Shaheen Rushd writes in the current issue of The Pomerantz Monitor, auction rate securities form a $330 billion market. Issuers include closed-end bond funds, cities, municipalities, student loan companies, and nonprofit entities. Brokers mostly sold auction rate securities to conservative investors, marketing them as being as liquid as cash but with better yields. But investors were recently stunned to find that no one wants to buy auction rate securities any more and they cannot be converted into cash.

Auction rate securities are debt instruments whose interest rates are reset every seven to ninety days at auctions held by Wall Street dealers. Until recently, investors could readily convert them into cash by selling them at auctions. But with the subprime mortgage meltdown and the related credit crunch, buyers for the securities evaporated and auctions began failing. By February of this year, auction rate securities had become almost completely illiquid even though they were not subprime and were not in default.

Brokerage houses reportedly sold the securities to investors without disclosing the risks that the auction market might dry up. In fact, unbeknownst to investors, real auctions have not been occurring in recent years. Instead, the Wall Street firms in charge of the auctions acted as bidders themselves. Investors were unaware that these few firms formed the entire market for these securities.

Corporate America woke up to the problem much sooner than individual investors. Corporations, which owned $170 billion face amount of auction rate securities as of July 1, 2007, had apparently unloaded half their holdings by the end of the year, leaving the average investor holding the bag. The question is whether, as corporations sold, brokers were steering individuals to buy in order to bail out their corporate clients.

Meanwhile, people who believed they had invested in cash-like securities do not have access to their principal, and there is no end in sight. Only a handful of issuers have expressed an interest in redeeming early, and a few issuers have refinanced the securities or started bidding in their own auctions. But that’s only a drop in the bucket. The Financial Industry Regulatory Authority (“FINRA”) has suggested that investors who need to access their cash might borrow from the brokerage firms against the value of their holdings. But as FINRA itself acknowledged, there are adverse tax consequences and risks associated with this strategy. Adding to the pain, UBS and some other underwriters are marking down the value of auction rate securities in their customers' accounts.

The consequences of illiquidity can be serious. As the head of America Watchdog said in discussing complaints he received from over a thousand investors, "The majority of people have $200,000 to $300,000 invested, but it's their life savings, and they were told this was the same as a money market or C.D . . . I must have 50 or 60 people that were buying houses that were supposed to close in March and their earnest money is at risk of forfeiture because they relied on the liquidity of these things."   

Former SEC Chairmen Weigh In on Paulson’s Plan

Much has been written over the past month including on these very pages about Treasury Secretary Hank Paulson’s plan to “reform” the U.S. financial services regulatory system. Among the critics of the plan are three former chairmen of the SEC who have weighed in on the proposals – particularly the effect they will have on the Commission --  in interviews and in a NY Times OpEd piece available here. Those chairmen, William Donaldson, Arthur Levitt, Jr. and David Ruder rightly believe that a more measured response to the current financial crisis than Paulson proposes is in order.

One of the concerns expressed by the former chairmen regards the plan to move the SEC to a system of principles- rather than rules-based regulation. Proponents tout the former approach as being more suited to the dynamic nature of markets in the modern age, enabling a more flexible system of enforcement. But it must be recognized that many components of Paulson’s plan were formulated before the current crisis when markets were strong and regulation was more widely believed to hinder growth. Such proposed changes ignore and, if adopted, might worsen the present-day state of affairs.

Even given the SEC’s considerable failure to meet its current mandate, moving away from a rules-based approach is still not the solution investors could hope for. While the former chairmen may have more faith than we do in the SEC’s ability going forward to police the markets, there is no question that the weakening of the enforcement structure overseen by SEC Chairman Cox, including a reduction in funding and diminution of the independence of staff lawyers who negotiate settlements with companies, has had a negative impact yet to be thoroughly quantified. Strengthening the rules and improving enforcement capabilities would be the appropriate response.

Real reform is necessary. But such drastic restructuring, without a thorough examination of the actual roles various regulatory agencies played in the current crisis, will only increase the likelihood of problems in the future. This view comports with that of many groups involved in investor protection, including the North American Securities Administrators Association – whose members are state and provincial regulatory agencies that would lose some of their powers under the proposal because of federal preemption. In its reaction to Paulson’s plan, the NASAA argued against the wholesale restructuring as ultimately benefiting Wall Street stating that “what [investors] need is a willingness on the part of all regulators to carry out their investor protection mandate.” We couldn’t agree more.

Still No Say-On-Pay

With at least $312 billion of asset write-downs and losses by financial firms since the start of 2007, investors thought this would be the perfect year to pressure corporate boards on executive pay and give shareholders non-binding advisory votes on executive compensation. In the past few years, shareholders in various companies have been trying to get more say on executive compensation through so called say-on-pay proposals, without much luck. Similar to past years, these proposals have failed at this year’s annual meetings at some of the major financial corporations that have posted the largest asset write-downs and credit losses since the beginning of 2007 such as Citigroup, Merrill Lynch, Bank of America and Morgan Stanley.

These defeats demonstrate the difficulty in changing policies at companies where large institutional shareholders such as Fidelity Investments “tend to oppose or abstain on say-on-pay proposals.” For instance, the proposals introduced by the American Federal of State, County and Municipal Employees for Citigroup and Morgan Stanley actually received less support this year than last year. According to Institutional Shareholders Services, it is “a little surprising given the shareholder anger at a lot of the companies” given the current financial crisis. Also, a compensation analyst at the Corporate Library suggests that institutional shareholders view these proposals “as a protest against the company’s compensation policy, and they don’t want to do that.”

Credit Rating Agencies Under Intense Scrutiny

The SEC has launched a two-pronged attack on the credit rating agencies believed to be partially responsible for the subprime mortgage debacle.  The agencies -- namely, Moody’s Investors Service, Standard & Poor’s, and Fitch Ratings -- have recently come under fire for issuing unjustifiably high ratings on mortgage-backed securities and for failing to lower those ratings once the securities started to perform poorly in the marketplace.  The SEC has commenced an investigation of all three agencies and has promised that new rules regulating how the agencies do business are forthcoming.

The investigation, which should be wrapped up sometime this summer, is focused on “whether credit rating agencies departed from their standard procedures for determining credit ratings in order to give securities a higher rating than they truly deserved and whether they effectively managed potential conflicts of interest…” according to a recent Securities Law 360 article (subscription required).

The new rules, then, are set to build upon the results of this SEC investigation.  That is, the rules should require “better disclosure of past ratings and limiting conflicts of interest,” according to SEC Chairman Christopher Cox in recent testimony before Congress.  He also said that “the coming rule proposals will be aimed at fostering greater accountability, transparency and competition in the industry.”

Well, we can hope.  But, unless these new rules specifically address the disclosure of the role of third-party due diligence in the rating assignment process, little will have been accomplished to break up the cozy world of bond ratings.  For, as we have reported before, the rating agencies, themselves, work closely with issuers and underwriters in structuring transactions; and, in turn, issuers routinely pay the ratings agencies for their highest credit ratings.

Who, then, keeps a disinterested check on the ratings process?  With this question in mind, Senator Charles Schumer has suggested to Chairman Cox that the new rules should require “‘some really tough disclosures’ that would tell investors how ratings were reached,” according to a recent article in Dow Jones Financial News Online.

Chairman Cox has stated that his goal is to have new rules enacted by the end of 2008.  This means that we can expect the rule proposals sometime in the next couple of months.

From the Pages of The Pomerantz Monitor: Study Shows Institutional Investors Play Key Role In Securities Litigation

As reported in the current issue of The Pomerantz Monitor, the Corporate Library, the research organization that has weighed in on executive pay, recently released another study, concluding that companies whose CEO compensation practices are poorly aligned with shareholder interests, according to Corporate Library criteria, were five times more likely to be the subject of a securities class action. This correlation suggests that CEOs with bloated incentives may have a greater temptation to cook the books in order to reap those rewards. This finding, which is consistent with findings for prior years, suggests that institutional investors' attacks on bloated pay practices are not just an effort to rein in wasteful spending, but also a way to prevent securities fraud.

The study also found that pension funds and other institutional investors have taken a growing role in securities litigation. For example, public pension funds were named lead plaintiff in 14 of 25 securities class action cases filed in 2007 where a lead plaintiff was appointed. This is understandable, given that institutional investors hold more than 60% of the traded stock in almost all the companies that were the subject of a securities class action in 2007. The study concludes that "public pension funds in particular have grown increasingly comfortable with the use of securities class-action litigation not only to recoup very real investment losses, but also to signal to their political constituencies a willingness to tackle head-on the specter of white-collar crime."

Regulation and baseball: why the Paulson plan makes no sense

A lot of ink has been spilled on Treasury Secretary Hank Paulson's plan to close the Commodity Futures Trading Commission, Office of the Comptroller of the Currency, and Office of Thrift Supervision, and shift their duties to the SEC.   Most of it relates to assumptions that multiple regulators are inefficient, or worse, counterproductive.  For example, industry lobbyist John Dearle told Bloomberg that "with overlapping, multiple regulators supervising the same things, you've got three well-intentioned outfielders running after the same fly ball.''   

We applaud Mr. Dearle on the analogy, but remind him that baseball teams do not avoid this problem by trimming their roster to a single outfielder.  Instead, they improve the communication among their players.  Financial regulators should follow the same approach.

The slash-and-burn mentality seems especially ill-suited to the current environment.  We are told that without Federal Reserve intervention, Bear Stearns would have gone bankrupt.  Through new facilities like TAF and TSLF, the Fed has also funneled well over a hundred billion dollars to aid other crippled institutions.  Are we really to believe that these institutions need less regulation?  And what pittance could we really expect to save through reduced headcount of regulators?

Merits of consolidation aside, we question the decision to vest more power in the SEC.  As discussed in prior Pomtalk articles, the agency has proved itself to be ineffective even in its current sphere of enforcement.  In contrast, the CFTC appears to be doing a much better job with its limited regulatory charge.  Recall that futures markets continued to function without any taxpayer bailout when Refco, one of the largest futures brokers, unraveled. 

Finally, the Paulson plan fights yesterday's war.  Even a cursory glance at the headlines over the past year indicates that today's problems lie in off-exchange structured financial instruments like collateralized debt obligations ("CDOs"), structured investment vehicles ("SIVs"), and auction rate securities ("ARS").  Consolidating regulators of different exchanges will not address threats posed by these instruments. 

The recent credit meltdown reaffirms our need for effective regulation.  Why take a step backward now?

Senators Call for Examination of SEC’s Enforcement Division

Democratic Senators Christopher Dodd and Jack Reed recently asked the Government Accountability Office to initiate an examination of the SEC’s Enforcement Division.  Specifically, Dodd (the Banking Committee Chairman) and Reed (the Securities Subcommittee Chairman) are focused on whether the SEC has fundamentally altered its enforcement policy.  “There has been less emphasis on investor protection and more on this issue of the competitiveness of markets,” according to Reed.

This is the second time in 18 months that a member of Congress has called for an investigation into the ways the SEC is doing business.  And no wonder.  The Senators cite the fact that the SEC reduced by 50% last year the penalties it required firms and individuals to pay in connection with enforcement actions.  They also note that the Commission lowered by over one-half the amount of corporate disgorgements that it ordered.  No doubt the Senators feel that the SEC has grown lax, considering that in 2007, investors on their own recovered approximately $6 billion in fraud-related losses in private litigation -- according to yesterday’s PomTalk post, “The Power of Myth.”

In fact, the SEC seems to be “bending over backward to not discomfit the banks and firms it regulates,” according to a New York Times commentator (in an editorial accessible here).  We would point out that there have been a number of distressing changes made at the Commission by former Republican Congressman Christopher Cox -- now Chairman of the SEC.  For one thing, since taking the helm in 2005, Chairman Cox has given his commissioners increased authority over enforcement penalties -- taking that authority away from SEC staff attorneys.

Indeed, SEC lawyers have begun complaining about the commissioners’ exercise of this authority -- and the concomitant reduction of fines and penalties levied on wrongdoers.  One particular instance, discussed by the Times in an earlier article (accessible here), involved the commissioners’ reduction of a settlement reached with JPMorgan Chase.  The bank had already agreed to pay a $25 million settlement when the commissioners voted to reduce that amount by over 90% -- to $2 million.

Chairman Cox defended the new policy earlier this month, saying that it ensures that enforcement staff have the “full backing of the commission” when they “seek to obtain the best possible results for America’s investors.”  One must wonder, though, how “America’s investors” feel about the whole thing.  For it was their SEC that recovered a mere one-twelfth of what they were able to recover in their own private litigation efforts last year.