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The George Mason Law & Economics Center invites applications for the following five 2013 Workshops for Law Professors. Each Workshop offers a unique opportunity to join colleagues from around the country to learn from some of the most well-respected scholars in the law-and-economics field. There is no tuition, and all but one program provides hotel rooms and group meals at no expense to the professors. The LEC will begin reviewing applications on October 15, 2012.  Interested applicants can contact the  LEC here.


LEC Workshop for Law Professors on the Economics of Contracting

January 25-28, 2013

South Seas Island Resort, Captiva Island, FL


LEC Workshop for Law Professors on the Economics of Litigation and Civil Procedure

January 25-28, 2013

South Seas Island Resort, Captiva Island, FL


LEC Workshop for Law Professors on Public Choice Economics

January 25-28, 2013

South Seas Island Resort, Captiva Island, FL


LEC Workshop for Law Professors on Empirical Methods

May 20-24, 2013

George Mason University School of Law, Arlington, VA


LEC Economics Institute for Law Professors

July 7-19, 2013

Park Hyatt Beaver Creek Resort, Avon, CO

There are many days that I wish Larry Ribstein were still here, and today is definitely one of those days.  He would have had a lot to say about the tenth anniversary of SOX today.  He and Henry Butler noted in their book “The Sarbanes-Oxley Debacle: What We’ve Learned; How to Fix It” that:

“while the direct costs are substantial, they are only the tip of the iceberg….An important aspect of SOX’s indirect costs is the Act’s impact on litigation. SOX gives litigators the benefit of 20/20 hindsight to identify minor or technical reporting mistakes as the basis for lawsuits against corporations, officers, and directors. While the first major market correction will be painful for investors, SOX will surely turn it into a festival for trial lawyers. Litigation on this scale should not be confused with shareholder protection. SOX has created a ticking litigation time bomb.”
Kevin Lacroix discusses a 2011 study from Cornerstone Research that demonstrated just how prescient Larry and Henry were on this aspect of SOX.  This study shows how cases involving accounting allegations are increasingly common in nearly all of the years after SOX, that cases involving internal control weakness allegations are much more likely to settle, and that cases involving accounting allegations dominate settlements as they make up 70-90% of total settlement dollars.  So it turns out, as Larry and Henry predicted, SOX has become quite the precocious child at tens-years old (which corresponds, I am told, with fourth grade). offers advice for the precocious fourth grader that might prove useful to the parents of little SOX:
“With increased participation in school and extracurricular activities, in addition to her growing sense of self, and ability to process the world around her, fourth grade can be a heady time.  It’s important to help your child learn to budget and manage her time effectively, making sure, especially, that she always gets a good night’s rest.  If your fourth grader becomes withdrawn or seems stressed, try helping her pare down some of her activities until she has a schedule that allows for unscheduled play and quiet time. “

We will miss you Larry

J.W. Verret —  24 December 2011

The world will be a different place without Larry Ribstein.  I and many others know how generous he was with his time in mentoring students and junior scholars, a generosity that is precious for someone as prolific as Larry.  When he shared feedback, he always insisted that a scholar give their best, as he did with everything he put to mind.  When I think of what it means to be a legal scholar, in my head I will always have a picture of Larry Ribstein.

In the spirit of Christmas, I thought I would take an opportunity this holiday season to tell the embattled Secretary of the Energy Department “I told you so” over the Solyndra solar development loan debacle.  Here’s my op-ed in the Washington Times today (also available here):

VERRET: No, dude, we don’t need more Solyndras

Beltway rent-seekers will always find business failure

By J.W. Verret

The Washington Times

Friday, December 9, 2011

Illustration: Burning money by John Camejo for The Washington TimesIllustration: Burning money by John Camejo for The Washington Times

Every once in a while in Washington, you see a power grab so blatant and unabashed that it shocks the consciences of even Beltway veterans who make their livelihood in the government game. This brings me to a recent opinion column featured in Politico in which venture capitalist Joe Horowitz, a Solyndra investor, argued that the U.S. government actually needs to invest in more … Solyndras.

Many Americans are concerned that federal bailouts have resulted in a transfer of wealth from taxpayers to big banks and businesses. In the case of the Department of Energy’s loan guarantee program for clean-energy projects like Solyndra’s, however, the wealth transfer is both more egregious and more evident: from taxpayers to political contributors.

The Solyndra scandal demonstrates that often, the real beneficiaries of government interference, be it subsidization or regulation, are elected officials and their preferred interest groups. Additionally, unnecessary government involvement in marketplaces, like that for “green” energy, stifles competition and inhibits companies from producing novel, moneymaking ideas and instead encourages them to expend resources keeping their government supporters happy.

Economists call the payments that politicians get from conferring government-provided benefits onto certain companies “rents.” The best way to succinctly describe rent-seeking behavior is simple: The big players in an industry enjoy profits they don’t deserve and earn only because of their access to politicians. Subsidies, cheap loans and regulations that favor some companies over others are the most frequent ways this happens.

Solyndra represents an almost perfect case of rent-seeking behavior by political insiders. The resulting direct losses caused by this rent-seeking is also easy to identify in a loss of more than $500 million in taxpayer money. The indirect losses could be far higher.

Once the rent-seeking culture infects a company, the accountability and moral fiber of its executive leadership begin to atrophy quickly. Rather than a sleek incentive to make the business work, the executives focus on maximizing their ability to manipulate the Beltway rent-seeking culture. The poster children for this problem, Fannie Mae and Freddie Mac, have sucked more than $100 billion from taxpayers and continue to live on like immortal vampires feasting on America’s gross domestic product.

In the normal course of business, outside the Washington Beltway, the revenue line on a company’s income statement provides a logical discipline. It reflects a precise measure of how much the world values the goods a company is producing. But in the case of Solyndra and other companies like it, their revenue numbers reflected imaginary demand created by a combination of government subsidies and preferential treatment by government regulators. In short, the revenue line on Solyndra’s income statement didn’t reflect real demand, it only reflected short-lived and unjust government rents.

In fact, I wrote a paper two years before the Solyndra fiasco in which I warned that government ownership of businesses and government provision of subsidized loans to businesses would result in highly inefficient allocation of resources, and I specifically referenced theEnergy Department’s energy loan program. I shouldn’t – but I can’t resist: Energy Secretary Steven Chu, I told you so.

Evidence brought forward in the congressional investigation surrounding Solyndra’s $535 million loan guarantee from the department suggests that political pressure may have motivated both the original funding of Solyndra and the department’s agreement allowing new investors to get paid out first in the case of the company becoming insolvent, as well as the department’s continued support of Solyndra in the press even in the face of troubling financial reports from the company.

However, even if the loan guarantee program hadn’t worked to benefit political interests, it represents a bigger and, perhaps, more pervasive government folly: government interference in the private marketplace for innovation.

Not only should Energy not be gambling with taxpayer money, but this gamble serves only to hurt the future ability of solar power and other green energy to compete with traditional sources. The department’s guarantee program caused much of the venture-capital industry to focus on those firms able to obtain funding through negotiations with the government rather than on firms able to germinate profitable ideas.

J.W. Verret is an assistant law professor at the George Mason University School of Law and a scholar at the Mercatus Center.

The “I told you so” comes from a piece I published in the Seton Hall Law Review last year and submitted in 2009, “The Bailout Through A Public Choice Lens: Government Controlled Corporations as a Mechanism for Rent Transfer” available here.  The article’s primary focus was the bailout and government control through equity holdings, but it also referenced the DOE’s alternative energy loan program and the government’s control through debt.  Here’s the abstract:

Through the Troubled Assets Relief Program (TARP) bailout, the government took a controlling interest in a number of companies that remain publicly traded. There is significant prior debate over the consequences of government control of private-sector resources, but the present dynamic of government ownership through voting equity in publicly traded equity is fairly novel in the modern U.S. economy. This Article considers how the government is likely to put political pressure on firms taking bailout support through its equity voting power to cater to politically influential interest groups.

This Article first explores a number of instances of government pressure at bailed-out firms that have worked in favor of politically influential interest groups. It then explains the process by which this occurs through a novel contribution to public choice theory. This contribution treats rent-seeking as a two-step process by which government-controlled firms use their politically conferred rents to subsidize transfers to interest groups. The Article also examines the incentives facing bureaucrats in overseeing the government’s investment.

This Article then considers the constraints of administrative law and reveals how in this context they offer little remedy against the public choice conflicts of government-controlled firms. In part this is due to the exceptions to administrative law constraints found in the bailout legislation, but in larger part it is due to the fact that the government’s power is often implicit in this context.

This Article closes with an examination of the TARP Recipient Ownership Trust Act, which would house the government’s investment in a number of trusts governed by independent trustees, which among other provisions is designed to serve as a buffer between political pressure and private industry. This Article also offers criticism of a counter-proposal from Professor Emma Coleman Jordan, issued through the Center for American Progress, that requires nomination of “public directors” to the Boards of bailout recipients who are accountable directly to the government.

The result is a thorough understanding of how public choice theory offers some predictions for how the government will use its controlling investment in bailout recipients and an understanding of whether, and to what extent, properly designed trusts can limit some of these costs.



I don’t share this to offer an opinion on the underlying action, but I thought it would be an item of interest to our readers.  Much has been written on this blog about challenges in the SEC’s FCPA enforcement process.

I am surprised the news media hasn’t touched Herman Cain’s relationship with AGCO Corp. during the FCPA Oil-for-Food bribery settlement given the recent focus on his campaign.  I thought I would share the facts with limited editorializing.  Maybe the story is that it is an issue calling Herman Cain’s business judgment into question, then again maybe the point is how the FCPA is so harsh that even upstanding business leaders can get caught up in it.

Herman Cain was a member of the Board of Directors of AGCO Corp. from December 2004 until 2011.  He also joined the Audit Committee of AGCO in December 2004, which had enhanced obligations for overseeing company internal controls after passage of Sarbanes-Oxley in 2003.  Like many companies, including General Electric, AGCO was implicated in the Oil-for-Food scandal in which Saddam Hussein’s regime coerced companies selling food or other items permitted under exemptions to the UN embargo to give kickbacks to the regime.

The SEC filed a complaint in 2009 charging AGCO with violations of the Foreign Corrupt Practices Act in connection with the Oil-for-Food program.  The SEC complaint alleges that “AGCO failed to accurately record in its books and records the kickbacks that were authorized for payment to Iraq.  AGCO also failed to devise and maintain systems of internal accounting controls to detect and prevent such illicit payments.” The complaint describes an internal procedure whereby “sales and marketing personnel were able to enter into contracts without review from the legal or finance departments.”   AGCO earned nearly $14 million on the contracts secured through the kickbacks.

AGCO settled with the SEC without admitting or denying the allegations in the complaint and paid nearly $20 million to settle the SEC and companion actions by the DOJ and Danish authorities.  AGCO also entered into a deferred prosecution agreement with the DOJ over the companion criminal charges.  The deferred prosecution agreement called on AGCO to fix problems in its internal controls to prevent future FCPA violations.

The SEC Complaint describes illicit activity taking place between 2000 and 2003 (ending in March 2003 with the US invasion), all of which occurred prior to Herman Cain joining the Board of AGCO in 2004.  The SEC complaint also notes that AGCO senior managers received a red flag in 2004 indicating the prior bribery in the form of questions from a news reporter.   AGCO’s fiscal year in 2004 ended in March, the SEC complaint doesn’t indicate whether the 2004 red flag came before or after March, and therefore whether AGCO’s Audit Committee would have discussed it if they knew about it in leading up to filing the 2004 annual financial statements in March of 2005.

Now, its clear that there is no evidence to indicate that Herman Cain had anything to do with the bribery.  And, its also clear that almost all, if not in fact all, of the failure of management to catch the bribery occurred before his joining the Board or the Audit Committee.  If the internal audit procedures were actually fundamentally flawed as the SEC alleged, I do think however it may be legitimate to ask what Herman Cain did to fix them during his tenure on the Audit Committee.  That’s not to say it makes him complicit or liable, but it’s at least more relevant than some of stories we’ve seen in the silly season thus far in the last six months.

These things continue to fascinate me and provide lots of opportunity for procrastination.  The Iowa University Prediction Market IEM has a new update on the Republican presidential primary:

Romney Leads the Iowa Electronic Markets

October 26, 2011 |  The Iowa Independent

by: Lynda Waddington

The value of the former Massachusetts governor continues to rise above all other 2012 GOP candidates for the real-money future traders on the Iowa Electronic Markets.

At this same time in 2008, contracts for Mitt Romney were trading at 30.2 cents, meaning that the futures traders believed he had a roughly 30 percent chance of claiming the GOP presidential nomination. Today, contracts for Romney are trading at nearly 68.8 cents.

The futures trading closest to Romney presently are those for the “Rest of Field,” or individuals for whom there is no current contract on the market. The ROF contract is selling at 15.5 cents. Other contracts selling on the GOP convention market presently are Texas Gov. Rick Perry at 11.5 cents, U.S. Rep. Michele Bachmann at 3.4 cents and U.S. Rep. Ron Paul, at 1.4 cents.

Historically, however, there is a word of caution from the markets for Romney and a ray of hope for those trading at lesser levels. John McCain’s price on the Iowa Electronic Markets at this time four years ago was 7.1 cents, meaning that traders believed at that time he only had a 7 percent chance of capturing the nomination. McCain began trending upward during the first week in December, and became the IEM’s most probable candidate on Jan. 1, 2008, when his contract was selling for 29.6 cents.

What GOP candidate was leading the pack on the IEM at this point during the 2008? Former New York Mayor Rudy Giuliani, whose contract was selling for 40.1 cents.

The IEM is operated by the University of Iowa’s Tippie College of Business. Contracts for the correct outcome pay off at $1, all other contracts pay off at zero. Traders can invest up to $500 in the market.

Now readers may ask, could the primary field really have changed that much in 2008 within a matter of weeks?  That’s the thing about markets, we’ll never know what the “true” odds were at the time.  But ask yourself whether you think pundits will systematically do a better job of predicting election outcomes than the prediction markets.  If the answer is no, then guess what?  You’re a Hayekian.

As a side note, I wondered whether the site was covered under SEC or CFTC jurisdiction.  In fact, its not.  The site explains:

The IEM has received two no-action-letters from the Division of Trading and Markets of the Commodity Futures Trading Commission. Without explicitly asserting jurisdiction over the IEM or any of its submarkets, these letters, dated February 5, 1992, and June 18, 1993, extended no-action relief to the IEM’s Political and Economic Indicator Markets. The letters are available at the CFTC website as part of their Freedom of Information Act documents:

Law Review Editors…take note.  You may get an opportunity to catch this one in February if you play your cards right.

I’ve been blogging updates of my research for a new article developing what the economic analysis provisions of the National Securities Markets Improvement Act of 1996 requires of new SEC rulemaking.  Blog colleague Prof. Wright has a great title suggestion: “The Law and Economics Revolution in Securities Law.”  I like it.  I would add: “Constructing the Four Pillars.”

This project is inspired by the DC Circuit’s opinion in Business Roundtable v. SEC, which revives the four principles in a tremendous way, and the project forms the heart of my research plan as a fellow at the Hoover Institution this semester studying economic analysis of law and my syllabus for a seminar in the law and economics of financial regulation I am teaching at Stanford Law School this semester.  Prior posts are referenced here.

In prior posts I described the first portion of this article, which will use legislative and judicial history to elaborate on the SEC’s mandate to consider the impact of new rules on what I am calling the “four pillars” or “four principles” of securities regulation:  investor protection, efficiency, competition, and capital formation.  The second portion of the article will seek to link the various relevant literatures to prospective rulemaking.

The second portion of the article will start with a broad view of various strains of the economic literature and move to a more particular focus on individual articles.  Along the way I’ll be calling balls and strikes for the relevance of entire strains of the securities regulation, economics, and financial economics literature generally, and individual articles in particular.  I will do so using the hurdles presented by the legislative and judicial history of the NSMIA that, like Prometheus stealing flame from Olympus, brought us the four principles as a light by which to interpret the means and ends of securities regulation more clearly.

This article will be controversial (at least I hope).

The legislative and judicial history from the first half of this article will describe a lot of nuance, but the dominant theme taking shape is that the drafters of the NSMIA were inspired by the benefits of cost-benefit analysis (CBA) and economic analysis as a guiding principle in securities regulation.  The legislation was largely authored by Congressman Jack Fields who was appointed to chair the subcommittee overseeing the securities laws.  The law was promulgated pursuant to the Contract With America.  On the Senate side the legislation was sponsored by Senator Phil Gramm.  The legislative history, as described in a prior post, clearly envisioned in part some version of the regulatory analysis conducted by the SBA for small businesses and by the White House Office of Management and Budget (OMB) Office of Information and Regulatory Affairs (OIRA) more generally.  In the three judicial cases interpreting the NSMIA (all of which ruled against the SEC) the court demonstrated a premier focus on the empirical economic literature as well as a focus on indirect costs.  The four principles take cost-benefit analysis to a new level by considering impact on institutional incentives, capital market efficiency, and competition.

Logistical problems that should be considered:

1) What is the significance of what I would call the patchwork problem?  So many SEC regulations reference other regulations, and presume the existence of a number of other levers in the system of SEC regulation, and in some rule proposals also assume the existence of regulatory regimes administered by other agencies.  Must new regulations be measured against the alternative of not only the status quo, but of actually amending or eliminating prior regulations?

2) What about looking back?  Is a sunset requirement in SEC regulations generally, or in some specific areas, advisable?  Does it speak toward a heightened scrutiny from the DC Circuit for regulations that do not have a sunset requirement?  Does it require the SEC conduct a CBA at some point (5 or 10 years) after the rule is adopted?  What are the corresponding uncertainty or transition costs associated with firm compliance flowing from such a requirement?

3) What about the issue of potential implicit NSMIA repeal as Congress issues mandates that would otherwise fail a proper cost-benefit analysis?  The SEC has taken the position that it is not required to perform CBA where Congress explicitly mandates that it promulgate a rule.  But the SEC certainly has discretion at multiple decision points in adopting a rule.  Consider all the discretionary decisions that must be made by the SEC staff as they write a multi-hundred page rule proposal implementing a rule required by a paragraph long amendment in the authorizing legislation.  Shouldn’t the SEC be held to a requirement that it meet CBA requirements whenever it actually exercises discretion?  Conversely, if the SEC’s position is that Congress implicitly pre-empted the NSMIA with an affirmative requirement to adopt a rule, shouldn’t the SEC be required during judicial review to demonstrate that position by showing that there is no way to implement the rule in a way that would survive review under the four pillars of the NSMIA?

4) Position consistency is a principle that must be part of this calculus.  Should the SEC be allowed to take mutually inconsistent positions in different rules?  Note that the SEC cited a couple of studies in the final draft of Reg FD (which inhibited selective provision of information to analysts and required industry-wide announcements if any information is publicly provided) arguing that issuers had plenty of incentive, in spite of Reg FD, to share information with the market to facilitate new offerings and to maintain long term customer and supplier relationships.  That position directly contradicts the agency’s position in a number of other rules mandating affirmative disclosure of various items.  How does this play into judicial review for agency consideration of the four principles?

Thoughts taking shape about the various economic literatures:

A) Public Choice/Public Finance Economics—–I am not aware of a single instance where Henry Manne or Jon Macey’s work in the public choice problems of securities regulation have ever been cited in the cost-benefit analysis section of an SEC rule.  The Commission should be held to some consideration of the effect of new rules on this problem.  New rules alter the relationships between market participants in ways that accrue rents to I-bankers, lawyers, and accountants, particularly those with prior SEC experience.  I see no reason why this impact shouldn’t be relevant.  Deadweight losses are quite costly when rules are adopted.  With respect to analysis post-rule, one would need to ask to what extent rent seeking effects are dynamic, and to what extent they are static and thus capitalized into stock price as of the rule’s adoption.

B) Austrian Economics—–I think Austrian thought will be most useful in this project in offering some broad insights for regulatory architecture.  For instance, the role of the entrepreneur in discovering information and the pervasive uncertainty of the future demonstrated by the Austrian literature seem to argue against the SEC’s obsessive focus on uniformity.  This is true in accounting rules, in market structure, in the broker fiduciary duty debate, in mandatory private equity and hedge fund registration, and in the “dark pool” controversy.  There seems to be a marked hesitation at the SEC for diverse paths that develop for forming capital or institutions that develop idiosyncratic methods for valuing assets, structuring their board, deploying capital, etc.  This literature’s influence will be subtle, it won’t help to measure a compliance cost dollar figure for instance, but I think I can certainly incorporate the literature in a broad way to inform how the regulatory adoption process must be structured.  Reading Rizzo and Kirzner on the economics of time and information, I am convinced of the necessity to require that SEC rules be considered not only at the point of adoption, but that they must also be subject to an economic analysis requirement post-implementation.

C) Behavioral Economics—–Given the disclosure-based system, and the fraud on the market presumption, and the use of event studies in determining damages, the legislative history and judicial interpretations of the ’33, ’34 and ’40 Acts seem to presume semi-strong market rationality.  I think the four principles must be read in light of that presumption.  Thus behavioral economics has little relevance for new SEC rule-making with respect to arguments about the rationality of investors.  If we look to rationality arguments with respect to the biases of regulated actors, like directors or managers, in the vein of Don Langevoort’s work (see e.g. here), there are relevant issues to consider.  Although, once that door is opened, you also have to consider the behavioral biases exhibited by regulators along the lines of Professor, and current SEC Commissioner, Troy Paredes’ work here.

D) Financial/Empirical Economics—–The DC Circuit has demonstrated a particular focus for this type of work to demonstrate either the cost or the benefit side of the equation.  What types of studies count?  In corporate governance many writers have used event studies, but for the purpose of considering new rules event studies require an unanticipated event which will rarely be true for new rule proposals unless significant elements of the rule are unanticipated.  Most of the corporate governance empirical literature has also tried to compare different governance characteristics across firms to make a case for which governance methods should become mandatory, but that type of inquiry often suffers from quite severe endogeneity problems.

The real interesting question is what variables matter and which don’t, because I can see a potential for gamesmanship in selecting the variables impacted based on the what a writer wanted to accomplish.  SEC rules have at times cited to studies looking at impact on abnormal stock price returns, the bid-ask spread, Tobin’s q, trading volume, trading volatility, and brokerage costs, among a variety of other variables.  But how does one choose between these variables as superior indicators of the two “pillars” of efficiency and capital formation?  And what about considering a new SEC rule’s impact on bond yields or on the price of derivatives linked to common equity?  Surely the “capital formation” pillar should include the impact of a new rule on debt and derivatives instruments as well as equity?  What about impacts of rules on the debt/equity tradeoff?  The Miller/Modigliano Theorem of financing irrelevance envisions taxes and bankruptcy as primarily driving the debt/equity financing tradeoff, but shouldn’t we also consider the impact of mandatory disclosure on securities class action risk as well (in other words, the more onerous the risk of securities class action risk, the more attractive debt financing becomes)?

E) Direct Compliance Costs—–The SEC has often made use of direct industry compliance costs in its economic analysis of new rules.  This is a particularly limited measure and is frequently underestimated.  Not much in the way of applicable economic literature here, this estimate mostly relies on conflicted best guesses by SEC staff and likely conflicted estimates from industry comment letters.  The ridiculousness of the SEC staff estimates when viewed post-adoption argues in favor of a mandatory look-back requirement for economic analysis.  (When I say ridiculous, I am thinking of the SEC’s estimate in the rule implementing Sarbox Section 404 that implementation costs would average $90,000 per firm.  An SEC study five years later admits it was more like $2 million per firm.)

In a subsequent post, I will consider how to make more use of the transaction cost or New Institutional Economics literature, particularly with respect to rulemaking under the SEC Division of Corporation Finance and Division of Investment Management jurisdictions, as well as how economic game-theory can prove more useful to inform rulemaking in SEC oversight of the exchanges and SROs through the SEC Division of Trading and Markets.

The semester is off to a bang.  I arrived at Stanford Monday to start teaching in the Law School and begin a research fellowship at the Hoover Institution.  Yesterday I hiked in the mountains overlooking the SF Bay.  Today I am flying back to DC (and blogging in flight, how cool is that) to testify Thursday before the House Committee on Financial Services alongside SEC Chairman Schapiro, former Chairman Pitt, and former Commissioner Paul Atkins on proposed legislation from Congressman Scott Garrett and Chairman Spencer Bachus to reform and reshape the SEC.

Part of the hearing, titled “Fixing the Watchdog: Legislative Proposals to Improve and Enhance the Securities and Exchange Commission” will deal with the study on SEC organizational reform mandated by the Dodd-Frank Act and conducted by the Boston Consulting Group.  Frankly, I found it full of quotes from the consultant’s desk manual, with references to “no-regrets implementation,” “business process optimization” and “multi-faceted transformation.”  I believe the technical term is gobbledy-gook.

The remainder of the hearing will involve a discussion of the SEC Organizational Reform Act (or “Bachus Bill”) and the SEC Regulatory Accountability Act (or “Garrett Bill”).  The Bachus Bill proposes a number of organizational reforms, like breaking up the new Division of Risk, Strategy, and Financial Innovation to embed the economists there back in to the various functional divisions.  The Garrett Bill seeks to strengthen the guiding principles originally formulated in the NSMIA amendments by elaborating on how the agency can meet its economic analysis burden in rule-making.

I thought I would give TOTM readers a sneak peak at my testimony.  I aim to make two key points.  First, sincere economic analysis is important.  SEC rules have consistently done a poor job of meeting the mandate of the NSMIA to consider the effect of new rules on efficiency, competition, and capital formation, and they will continue to do a poor job until they hire more economists and give them increased authority in the enforcement and the rule-making process.  Second, the SEC’s mission should include an explicit requirement that it consider the effect of new rules on the state based system of business entity formation.

Here’s a sneak peak at my testimony for TOTM readers:

Chairman Bachus, Ranking Member Frank, and distinguished members of the Committee, it is a privilege to testify today.  My name is J.W. Verret.  I am an Assistant Professor of Law at Stanford Law School where I teach corporate and securities law.  I also serve as a Fellow at the Hoover Institution and as a Senior Scholar at the Mercatus
Center at George Mason University.  I am currently on leave from the George Mason Law School.

My testimony today will focus on two important and necessary reforms.

First, I will argue that clarifying the SEC’s legislative mandate to conduct economic analysis and a commitment of authority to economists on staff at the SEC are both vital to ensure that new rules work for investors rather than against them.  Second, I will urge that the SEC be required to consider the impact of new rules on the state-based system of business incorporation.

Every President since Ronald Reagan has requested that independent agencies like the SEC commit to sincere economic cost-benefit analysis of new rules.  Further, unlike many other independent agencies the SEC is subject to a legislative mandate that it consider the effect of most new rules on investor protection, efficiency, competition and capital formation.

The latter three principles have been interpreted as requiring a form of cost-benefit economic analysis using empirical evidence, economic theory, and compliance cost data.  These tools help to determine rule impact on stock prices and stock exchange competitiveness and measure compliance costs that are passed on to investors.

Three times in the last ten years private parties have successfully challenged SEC rules for failure to meet these requirements.  Over the three cases, no less than five distinguished jurists on the DC Circuit, appointed during administrations of both Republican and Democratic Presidents, found the SEC’s economic analysis wanting. One
failure might have been an aberation, three failures out of three total challenges is a dangerous pattern.

Many SEC rules have treated the economic analysis requirements as an afterthought. This is in part a consequence of the low priority the Commission places on economic analysis, evidenced by the fact that economists have no significant authority in the rule-making process or the enforcement process.

As an example of the level of analysis typically given to significant rule-making, consider the SEC’s final release of its implementation of Section 404(b) of the Sarbanes-Oxley Act.  The SEC estimated that the rule would impose an annual cost of $91,000 per publicly traded company.  In fact a subsequent SEC study five years later found average implementation costs for 404(b) of $2.87 million per company.

That error in judgment only applies to estimates of direct costs.  The SEC gave no consideration whatsoever to the more important category of indirect costs, like the impact of the rule on the volume of new offerings or IPOs on US exchanges.

In Business Roundtable v. SEC alone the SEC estimates it dedicated over $2.5 million in staff hours to a rule that was struck down.  An honest commitment by the SEC to empower economists in the rule-making process will be a vital first step to ensure the mistakes of the proxy access rule are not replicated in future rules.

I also support the goal in H.R. 2308 to further elaborate on the economic analysis requirements.  I would suggest, in light of the importance and pervasiveness of the state-based system of corporate governance, that the bill include a provision requiring the SEC to consider the impact of new rules on the states when rule-making touches on issues of corporate governance.

The U.S. Supreme Court has noted that “No principle of corporation law and practice is more firmly established than a state’s authority to regulate domestic corporations.”

Delaware is one prominent example, serving as the state of incorporation for half of all publicly traded companies.  Its corporate code is so highly valued among shareholders that the mere fact of Delaware incorporation typically earns a publicly traded company a 2-8% increase in value.  Many other states also compete for incorporations, particularly New York, Massachusetts, California and Texas.

In order to fully appreciate this fundamental characteristic of our system, I would urge adding the following language to H.R. 2308:

“The Commission shall consider the impact of new rules on the traditional role of states in governing the internal affairs of business entities and whether it can achieve its stated objective without preempting state law.”

The SEC can comply by taking into account commentary from state governors and state secretaries of state during the open comment period.  It can minimize the preemptive effect of new rules by including references to state law where appropriate similar to one
already found in Section 14a-8.  It can also commit to a process for seeking guidance on state corporate law by creating a mandatory state court certification procedure similar to that used by the SEC in the AFSCME v. AIG case in 2008.

I thank you again for the opportunity to testify and I look forward to answering your questions.

We’ve been discussing the proxy access case, see here,  here, and here, where the DC Circuit overturned an SEC rule for failure to meet its requirement under the National Securities Markets Improvement Act of 1996 to consider the effect of the rule on efficiency, competition, and capital formation in addition to its historical mandate to consider investor protection.  As I mentioned in my last post on the topic, I am working on an article this semester to draw the boundaries for what the four principles require in SEC rule-making.

We haven’t had a good blog confrontation in awhile, so I am glad Jay Brown, our rival at Race To The Bottom, has decided to engage with my efforts.  Jay takes issue with my recent post:

There are several comments to be made about this approach.  First, the post mistakenly assumes that the issue in the case was cost-benefit analysis.  In fact, the primary authority used by the court in Business Roundtable was the SEC’s obligation to analyze the effects of a rule on competition, efficiency and capital raising.  See Section 3(f), 15 USC 78c(f).

Incorrect.  In the view of Congress, cost-benefit analysis is part and parcel of any consideration of efficiency, competition, capital formation, and investor protection for that matter.  His review of the legislative history of the NSMIA is incomplete.  Congress clearly had cost-benefit analysis in mind as it considered the bill.  Consider this statement from Thomas J. Bliley Jr. (R), Chairman of the House Commerce Committee that reported out the bill:

The substitute (the NSMIA)  maintains the provision (the efficiency, competition and capital formation language) requiring cost benefit analysis in SEC rulemaking, which we think is very important in light of the enhanced Congressional role mandated for SEC and SRO rules under the Small Business Regulatory Enforcement Act of 1996. (1996 WL 270857 (F.D.C.H.))
Or consider this from Congressman Jack Fields, the original sponsor of the NSMIA, at the first hearing on the legislation:
On the subject of capital formation: My bill calls for the SEC to consider the promotion of efficiency, competition and capital formation when it makes rules.  This is an important provision of the bill becasue it wil introduce an element of explicit cost benefit anaysis into SEC rulemaking.  We want to encourage the SEC to take efficiency, competition and capital formation into account in its rulemaking.  We view these goals as complimentary to the important goal of investor protection. (1995 WL 706020 (F.D.C.H.))
Jay Brown critiques my argument further:

Second, the comment that cost-benefit analysis “is the only legitimate mode of analysis” reflects JW Verrett’s “policy” perspective but it does not reflect the law.  In adopting Section 3(f), Congress had this to say:

  • “The new section makes clear that matters relating to efficiency, competition, and capital formation are only part of the public interest determination, which also includes, among other things, consideration of the protection of investors.  For 62 years, the foremost mission of the Commission has been investor protection, and this section does not alter the Commission’s mission.”

H. Rep. 104-622, 104th Cong., 2nd Sess., at 39 (June 17, 1996).  See also Section 3(f) in 1996, Pub. L. No. 104-290, § 106(a), 110 Stat. 3416, 3424).  In other words, the efficiency analysis was only one step required of the Commission.  Congress left open the possibility that the goals of investor protection could sometimes override the results of the economic analysis.

He closes by observing that “perhaps JW Verrett could use a course in administrative law.”  I admire Jay’s sharp rhetoric, and I certainly opened the door.

That said, he’s completely off-the-mark on his second counter to my post.  First, to clarify, what I said was: “The legislative history of the securities laws makes clear that the objective is a purely economic one, to stabilize markets, prevent fraud, and maximize economic growth.  The 33′ and 34′ Acts were a response to the stock market crash of 1929 after all.  Cost-benefit analysis is a tough fit in areas where nebulous ideas like justice or equity are at issue (though it is still quite informative) but where as here the underlying objectives are purely economic it is the only legitimate mode of analysis.”

The latter three principles, as we saw above, encompass in large part a wide form of cost-benefit analysis.  What about investor protection?  First we have to consider what investor protection meant in 1933 and 1934, and then we need to consider how it stands in relation to the recent additions.  My review of the legislative history of the 33 and 34 Acts isn’t yet completed because, if you include the Pecora hearings, and I think you should, we’re talking thousands of pages of material.  But there is one theme emerging about how Congress understood the phrase “investor protection” and that is a focus on fraud prevention through disclosure about the value of traded assets and through prohibition of manipulative trading schemes.

During the hearings on the NSMIA, apparently there was concern from then SEC Chairman Arthur Levitt that eliminating “investor protection” as a guiding principle of the SEC would be detrimental.  The compromise that Republicans on the Hill and Chairman Levitt , appointed by President Clinton, reached maintained investor protection as a guiding principle and the three new economic analysis constraints would only apply in cases where the SEC is acting “in the public interest,” a phrase which appears frequently in the 33, 34 and 40 Acts, including Section 10b and Section 14 of the 34 Act.  The “public interest” modifier also responded to concerns from Chairman Levitt that the constraints would apply to enforcement or adjudication decisions.  The compromise is described in a statement from Rep. Ed Markey (D), ranking member of a subcommittee considering the bill:
With respect to the SEC’s mission, we’ve agreed that the promotion of capital formation, competition, and market efficiency must be factors considered whenever the SEC is undertaking a rulemaking based on a public interest determination. This responds to Chairman Levitt’s concern that the original bill might have potentially compromised the SEC’s ability to take actions needed to protect investors.  (1996 WL 134449 (F.D.C.H.))

The investor protection rationale would be limited to rules on disclosure about the value of investments or rules aimed at manipulative trading schemes.  With this limitation, investor protection actually doesn’t apply in many contexts.   In the context of proxy access, that means the SEC could take into account the possibility of fraud in the rule’s requirements on nominee disclosure for example.  Minimization of principal-agent costs doesn’t however fit within the investor protection principle taken in light of its historical meaning.

The investor protection principle does not apply to the Commission’s decision to make the proxy access rule mandatory rather than opt-out or opt-in, which was the issue at the heart of the proxy access challenge.  (One reader comments that the Dodd-Frank Act proxy access section specifically references investor protection.  It does not amend the NSMIA however, so I don’t buy his argument that the DFA language sets the other principles aside or changes the meaning of investor protection from its historical roots).

In contexts where the investor protection rationale does apply, Jay seems to view investor protection as a trump card that could be used to exempt the Commission from the latter three principles.  But the legislative history doesn’t indicate the principles are mutually opposed, and economic analysis is certainly relevant when considering the effects of fraud and the market processes that evolve to remedy fraud.  The more logical view is to consider including investor protection as a principle gives added weight to the cost of fraud in weighing the costs and benefits of new rules.

This discussion will form a substantial portion of the course I am teaching this semester as a Visiting Assistant Professor of Law at Stanford Law School on The Law and Regulation of Financial Institutions.  I will be sure to send Jay links to my course materials.

Bob Monks has a lot to say about Business Roundtable v. SEC.  Some notable quotes:

“The DC Circuit now has really made a reputation over four or five years of throwing out SEC regulations.  Their reason for doing it is that the SEC has failed to generate cost-benefit information that conforms with their interpretation of what the APA requires for the validity of new regulation.  Obviously this is a judgment that court can make, but if they’re making that judgement four times running it tells you a little more about the court perhaps than about the specific issue or the SEC….What Douglas Ginsburg adduces is a failure of the SEC to produce information about the costs of having independent nominations on the company ballot.  And he speaks of the cost of the directors exercising their fiduciary duty, whether or not to place the name of a nominee on the ballot….You begin to wonder whether there’s any substance to what Douglas Ginsburg is saying.  I mean if he’s scraping up something like the fiduciary duty of the board to consider the nominee you know this is a matter of a de minimis amount of money.  Any why, how can one accord credibility to this opinion?  …It is simply the ranting of the DC Circuit Court that says they haven’t satisfied the gravamen of proof necessary to demonstrate cost-benefit.”

He goes on to call Judge Ginsburg “obdurate.”

I think its important to interpret the Monks rant in historical context.  Bob Monks ran the Office of Pension and Welfare Benefits at the Labor Department during the early Reagan years.  His work there culminated in a mandate issued by his successor that plan fiduciaries are required to actively vote their shares.  Almost immediately upon leaving his post, he founded Institutional Shareholder Services, a proxy advisory company that profited from the artificial demand for proxy advisory services created by the regulatory regime he helped to institute.  He has since been a leading profiteer of the corporate governance advisory industry.  It is an impressive example of rent-seeking in action.

I don’t the see the logic to Bob’s point that the SEC’s four losses before the DC Circuit in the last ten years demonstrate a problem with the Court.  Whether you agree with the NSMIA’s requirement that the SEC perform robust economic analysis of new rules or not, it is apparent that the SEC has ignored continued warnings from the Court.  In the interim, it has wasted agency resources in promulgating rules that are ultimately overturned.  For example, the SEC estimates that it wasted 2.5 million dollars on the failed proxy access rule.  I think that estimate is actually a lowball, as it includes 21,000 man hours of SEC staff time and does not account for opportunity costs.  Imagine what 21,000 hours of time devoted to a ponzi scheme task force could have done, or a top-to-bottom review of SEC rules to highlight inefficient rules for repeal (as President Obama’s recent executive order to the independent agencies actually requires) could have accomplished.

Others have similarly charged reactions to the proxy access case.  In a WaPo article today Harvey Goldschmid, the former SEC Commissioner who championed the first proxy access rule in 2003, responds to the Court scrutiny of the SEC’s economic analysis by urging “But how do you prove that empirically?  If the Court’s unrealistic requirements were applied across the board, the regulatory process would grind to a halt.”  J. Robert Brown is also quoted as saying “What the court is doing is second-guessing economic analysis that can always be second guessed.”

Harvey and Jay no doubt have an impressive knowledge of the securities laws.  I think they could profit from a course in policy analysis.  The legislative history of the securities laws makes clear that the objective is a purely economic one, to stabilize markets, prevent fraud, and maximize economic growth.  The 33′ and 34′ Acts were a response to the stock market crash of 1929 after all.  Cost-benefit analysis is a tough fit in areas where nebulous ideas like justice or equity are at issue (though it is still quite informative) but where as here the underlying objectives are purely economic it is the only legitimate mode of analysis.  It is hard to demonstrate net benefits from new rules, that’s true.  But does that mean we shouldn’t even ask the question?  I suspect their hostility to cost-benefit analysis is actually grounded in their belief that independent agencies are useful tools to accomplish a progressive agenda, including empowering labor unions, promoting climate change regulation, fair trade, affirmative action, and a variety of other liberal causes.  Putting these issues in the hands of independent agencies politicizes the SEC, undermining its credibility and hindering the SEC’s job of promoting the efficient function of American capital markets.

Commissioner Casey announced that she is stepping down from the SEC.

SEC Commissioner Kathleen L. Casey announced that she is leaving the agency today, having completed her five-year term on June 5 of this year.

Commissioner Casey was sworn in on July 17, 2006, and has been a staunch advocate of the agency’s mission to protect investors, facilitate capital formation, and ensure transparent, efficient, and competitive capital markets. During her tenure on the Commission, she was actively engaged on international matters, particularly in her capacity as chair of IOSCO’s Technical Committee and as the SEC’s representative to the Financial Stability Board.

“I feel fortunate to have served on the Commission during such a critical time and alongside such talented, hardworking and dedicated professionals,” said Commissioner Casey.

Prior to joining the SEC, Commissioner Casey spent 13 years on Capitol Hill, ultimately serving as Staff Director and Counsel of the Senate Banking, Housing, and Urban Affairs Committee. She earned her law degree at George Mason University School of Law in 1993, and received her BA in International Politics from Pennsylvania State University in 1988.

George Mason Law School should be proud of its distinguished alum.  She has been in the center of every major securities regulatory debate of the last 15 years, applying the law-and-economics toolkit that we specialize in providing our law students.  Few know that she was a student of our own Prof. Ribstein when he was still at GMU.

Commissioner Casey displayed a dedication to the SEC’s mission of protecting investors and encouraging capital formation.  She wasn’t afraid to speak up when the SEC overstepped its bounds, but was also known for her unfailing respect for the SEC and its staff during some very heated debates over the last 5 years.  She is far too diplomatic to say “I told you so.”  But I think someone should say it for her.

Commissioner Casey really hit her stride with a uniquely prescient warning about the SEC’s 2010 proxy access rule when it was adopted:

Let me start with an observation and a prediction. The observation is that it appears that a primary, if unstated, objective of this rule is to put the issue of proxy access behind the Commission once and for all. My prediction is that, paradoxically, the rule that the Commission adopts today virtually guarantees that the Commission will be forced to deal with this issue for years to come. I say this for two reasons. First, I believe that the rule is so fundamentally and fatally flawed that it will have great difficulty surviving judicial scrutiny. Second, an inevitable consequence of this rule, if it survives, is that the staff will be tasked with the unenviable responsibility of brokering disputes and addressing a broad array of issues arising from the operation of this new federal right every proxy season.

She also correctly observed about the proxy access rule:

Unfortunately, the adopting release goes through a jiu-jitsu exercise of purporting to give deference to state law and to increase shareholder choices under state law, when in fact the rules do exactly the opposite. As a result, the logic does violence to our historical understanding of the roles of federal securities law, state law, shareholder suffrage and private ordering, with potentially far-reaching implications. The consequences of this exercise include a series of arbitrary choices that are not tethered to empirical data and a number of internal inconsistencies that make the rules difficult to defend. Furthermore, the rules continue a disturbing trend of empowering institutional shareholders to the detriment of individual shareholders. Finally, the policy objectives underlying the rule are unsupported by serious analytical rigor, and the release fails to fairly and adequately consider the costs and impact of these rules. In this regard, I believe these rules are likely to result in significant harm to our economy and capital markets.

When the SEC adopted rules implementing NRSRO credit rating agency requirements in 2007, she warned:

Credit rating agencies play an important role in our securities markets, and Congress has placed on us the responsibility to ensure that NRSROs meet certain minimum standards, that the disclosure of their policies and procedures, including policies for managing conflicts of interest and handling material nonpublic information, is accurate, and that certain unfair and coercive practices are prohibited. As we move forward, we must exercise our oversight authority cautiously and judiciously. Congress did not intend us to become a merit regulator.

She reminded us in 2009 that much of the “dark pool” controversy was fueled by commentators with little understanding for the operation of the securities markets:

Today’s proposing release concerns the regulation of non-displayed trading interest. These dark pools of liquidity have been around for a long time. Ironically perhaps, the floor of the New York Stock Exchange was the single largest dark pool for many years. Notwithstanding a name that lends itself to sensationalism, there is nothing sinister about dark pools; they exist for legitimate economic reasons. Institutional investors seeking to make large trades have always wanted to avoid revealing the total size of their order. The number of dark pools has certainly increased in recent years, particularly since the advent of decimalized trading, and the way non-displayed stock trading occurs has changed due to technology.

She also wasn’t afraid to challenge the legitimacy of the Enforcement Division’s case against Goldman Sachs on the Abacus deal.

Congratulations to Commissioner Casey on a successful five-year tenure at the SEC.  She will be a tough act to follow.

S&P Credit Rating Drop

J.W. Verret —  6 August 2011

There are few things in this world I enjoy as much as an opportunity to say “I told you so.”  Well, I told you so.

In May of 2010 I published an op-ed where I said:

If Washington properly accounted for its debt and deficit, we might be in the same situation. A threat to the US credit rating may even be beneficial, a sign that we’ve hit rock bottom and need to recover from this deficit addiction. Credit warnings would result in a diminished appetite for Treasury bonds, forcing the Treasury Department to borrow at higher interest rates and curb its habit for runaway spending.

The full faith and credit of the US is not a depthless well. Future generations bear the risk of high inflation, increased taxes, and interest payments on Treasury bonds that take up an ever-increasing share of the federal budget.

This was in the context of my argument that the federal government should be required to include the debt of companies which it controls, including GM, Fannie, Freddie, AIG and a number of remaining companies, in the national debt ceiling calculation and in the federal government’s accounting statements.  A full journal article on that issue is forthcoming in the BYU Law Review, “Separation of Bank and State.”  Check it out for everything you ever wanted to know about the law of the debt ceiling and the deficit.