Archives For financial regulation

On Wednesday, the U.S. Supreme Court heard oral argument in Halliburton v. Erica P. John Fund, a case that could drastically alter the securities fraud landscape.  Here are a few thoughts on the issues at stake in the case and a cautious prediction about how the Court will rule.

First, some quick background for the uninitiated.  The broadest anti-fraud provision of the securities laws, Section 10(b) of the 1934 Securities Exchange Act, forbids the use of “any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [Securities and Exchange] Commission may prescribe….”  The Commission’s Rule 10b-5, then, makes it illegal “to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading.”

Although Section 10(b) doesn’t expressly entitle victims of securities fraud to sue for damages, the Supreme Court long ago inferred a private right of action to enforce the provision.  The elements of that judicially created private right of action are: (1) a material misrepresentation or omission by the defendant, (2) scienter (i.e., mental culpability worse than mere negligence) on the part of the defendant, (3) a connection between the misrepresentation or omission and the purchase or sale of a security, (4) the plaintiff’s reliance upon the misrepresentation or omission, (5) economic loss by the plaintiff, and (6) loss causation (i.e., the fraud, followed by revelation of the truth, was the proximate cause of the plaintiff’s investment loss).

For most individual investors, the economic loss resulting from any instance of securities fraud (and, thus, the potential recovery) is not enough to justify the costs of bringing a lawsuit.  Accordingly, 10b-5 suits seem like an appropriate context for class actions.  The elements of the judicially created cause of action, however, make class certification difficult.  That is because most securities fraud class actions would proceed under Federal Rule of Civil Procedure 23(b)(3), which requires that common issues of law or fact in all the plaintiffs’ cases predominate over plaintiff-specific issues.  Because the degree to which any individual investor relied upon a misrepresentation (element 4) requires proof of lots of investor-specific facts (How did you learn of the misrepresentation?, How did it influence your investment decision?, etc.), the reliance element would seem to preclude Rule 10b-5 class actions.

In Basic v. Levinson, a 1988 Supreme Court decision from which three justices were recused, a four-justice majority endorsed a doctrine that has permitted Rule 10b-5 class actions to proceed, despite the reliance element.  The so-called “fraud on the market” doctrine creates a rebuttable presumption that an investor who traded in an efficient stock market following a fraudulent disclosure (but before the truth was revealed) “relied” on that disclosure, even if she didn’t see or hear about it.  The theoretical basis for the fraud on the market doctrine is the semi-strong version of the Efficient Capital Markets Hypothesis (ECMH), which posits that securities prices almost instantly incorporate all publicly available information about the underlying company, making it impossible to earn above-normal returns by engaging in “fundamental analysis” (i.e., study of publicly available information about a listed company).  The logic of the fraud on the market doctrine is that publicly available misinformation affects a security’s price, upon which an investor normally relies when she makes her investment decision.  Thus, any investor who makes her investment decision on the basis of the stock’s price “relies” on the “ingredients” of that price, including the misinformation at issue.

In light of this logic, the Basic Court reasoned that a defendant could rebut the presumption of reliance by severing either the link between the misinformation and the stock’s price or the link between the stock’s price and the investor’s decision.  To sever the former link, the defendant would need to show that key market makers were privy to the truth, so that the complained of lie could not have affected the market price of the stock (in other words, there was “truth on the market”…great name for a blog, no?).  To sever the latter link, the defendant would need to show that the plaintiff investor made her investment decision for some reason unrelated to the stock’s price—say, because she needed to divest herself of the stock for political reasons.

Basic thus set up a scheme in which the class plaintiff bears the burden of establishing that the stock at issue traded in an efficient market.  If she does so, her (and similarly situated class members’) reliance on the misinformation at issue is presumed.  The defendant then bears the burden of rebutting the presumption by showing either that the misrepresentation did not give rise to a price distortion (probably because the truth was on the market) or that the individual investor would have traded even if she knew the statement was false (i.e., her decision was not based on the stock’s price).

The Halliburton appeal presents two questions.  First, should the Court overrule Basic and jettison the rebuttable presumption of reliance when the stock at issue is traded in an efficient market.  Second, at the class certification stage, should the defendant be permitted to prevent the reliance presumption from arising by presenting evidence that the alleged misrepresentation failed to distort the market price of the stock at issue.

With respect to the first question, the Court could go three ways.  First, it could maintain the status quo rule that 10b-5 plaintiffs, in order to obtain the reliance presumption, must establish only that the stock at issue was traded in an efficient market.  Second, it could overrule Basic wholesale and hold that a 10b-5 plaintiff must establish actual, individualized reliance (i.e., show that she knew of the misrepresentation and that it influenced her investment decision).  Third, the Court could tweak Basic by holding that plaintiffs may avail themselves of the presumption of reliance only if they establish, at the class certification stage, that the complained of
misrepresentation actually distorted the market price of the stock at issue.

My guess, which I held before oral argument and seems consistent with the justices’ questioning on Wednesday, is that the Court will take the third route.  There are serious problems with the status quo.  First, it rests squarely upon the semi-strong version of the ECMH, which has come under fire in recent years.  While no one doubts that securities prices generally incorporate publicly available information, and very quickly, a number of studies purporting to document the existence of arbitrage opportunities have challenged the empirical claim that every bit of publicly available information is immediately incorporated into the price of every security traded in an efficient market.  Indeed, the winners of this year’s Nobel Prize in Economics split on this very question.   I doubt this Supreme Court will want to be perceived as endorsing a controversial economic theory, especially when doing so isn’t necessary to maintain some sort of reliance presumption (given the third possible holding discussed above).

A second problem with the status quo is that it places an unreasonable burden on courts deciding whether to certify a class.  The threshold question for the fraud on the market presumption—is the security traded in an efficient market?—is just too difficult for non-specialist courts.  How does one identify an “efficient market”?  One court said the relevant factors are:  “(1) the stock’s average weekly trading volume; (2) the number of securities analysts that followed and reported on the stock; (3) the presence of market makers and arbitrageurs; (4) the company’s eligibility to file a Form S-3 Registration Statement; and (5) a cause-and-effect relationship, over time, between unexpected corporate events or financial releases and an immediate response in stock price.”  Others have supplemented these so-called “Cammer factors” with a few others: market capitalization, the bid/ask spread, float, and analyses of autocorrelation.  No one can say, though, how each factor should be assessed (e.g., How many securities analysts must follow the stock? How much autocorrelation is permissible?  How large may the bid-ask spread be?).  Nor is there guidance on how to balance factors when some weigh in favor of efficiency and others don’t.  It’s a crapshoot.

The status quo approach of presuming investor reliance if the plaintiff establishes an efficient market for the company’s stock is also troubling because the notion of a “market” for any single company’s stock is theoretically unsound.  An economic market consist of all products that are, from a buyer’s perspective, reasonably interchangeable.  For example, Evian bottled water (spring water from the Alps) is a very close substitute for Fiji water (spring water from the Fiji Islands) and is probably in the same product market.  From an investor’s perspective, there are scores of close substitutes for the stock of any particular company.  Such substitutes would include all other stocks that offer the same package of financial attributes (risk, expected return, etc.).  It makes little sense, then, to speak of a “market” consisting of a single company’s stock, and basing the presumption of reliance on establishment of an “efficient market” in one company’s stock is somewhat nonsensical.

With respect to the second possible route for the Halliburton Court—overturning Basic in its entirety and requiring individualized proof of actual reliance—proponents emphasize that the private right of action to enforce Section 10(b) and Rule 10b-5 is judicially created.  The Supreme Court now disfavors implied rights of action and, to avoid stepping on Congress’s turf, requires that they stick close to the statute at issue.  In particular, the Court has said that determining the elements of a private right of action requires “historical reconstruction.”  With respect to the Rule 10b-5 action, the Court tries “to infer how the 1934 Congress would have addressed the issue had the 10b-5 action been included as an express provision of the 1934 Act,” and to do that, it consults “the express causes of action” in the Act and borrows from the “most analogous” one.  In this case, that provision is Section 18(a), which is the only provision in the Exchange Act authorizing damages actions for misrepresentations affecting secondary, aftermarket trading (i.e., trading after a public offering of the stock at issue).  Section 18(a) requires a plaintiff to establish actual “eyeball” reliance—i.e., that she bought the security with knowledge of the false statement and relied upon it in making her investment decision.  There is thus a powerful legal argument in favor of a full-scale overturning of Basic.

As much as I’d like for the Court to take that route (because I believe Rule 10b-5 class actions create far greater social cost than benefit), I don’t think the Court will go there.  Overruling Basic to require eyeball reliance in Rule 10b-5 actions would be perceived as an activist, “pro-business” decision:  activist because Congress has enacted significant legislation addressing Rule 10b-5 actions and has left the fraud on the market doctrine untouched, and pro-business because it would insulate corporate managers from 10b-5 class actions.

Now, both of those characterizations are wrong.  The chief post-Basic legislation involving Rule 10b-5, the 1995 Private Securities Litigation Reform Act, specifically stated (in Section 203) that “[n]othing in this Act shall be deemed to … ratify any implied private right of action.”  As Justices Alito and Scalia emphasized at oral argument, the PSLRA expressly declined to put a congressional imprimatur on the judicially created Rule 10b-5 cause of action, so a Court decision modifying Rule 10b-5’s elements would hardly be “activist.” Nor would the decision be “pro-business” and “anti-investor.”  The fact is, the vast majority of Rule 10b-5 class actions are settled on terms where the corporation pays the bulk of the settlement, which largely goes to class counsel.  The corporation, of course, is spending investors’ money.  All told, then, investors as a class pay a lot for, and get very little from, Rule 10b-5 class actions.  A ruling eviscerating such actions would better be characterized as pro-investor.

Sadly, our financially illiterate news media cannot be expected to understand all this and would, if Basic were overturned, fill the newsstands and airwaves with familiar stories of how the Roberts Court continues on its activist, pro-business rampage.  And even more sadly, at least one key justice whose vote would be needed for a Basic overruling, has proven himself to be exceedingly concerned with avoiding the appearance of “activism.”  A wholesale overruling of Basic, then, is unlikely.

That leaves the third route, modifying Basic to require that class plaintiffs first establish a price distortion resulting from the complained of misrepresentation.  I have long suspected that this is where the Court will go, and the justices’ questioning on Wednesday suggests this is how many (especially Chief Justice Roberts and Justice Kennedy) are leaning.  From the Court’s perspective, there are several benefits to this approach.

First, it would allow the Court to avoid passing judgment on the semi-strong ECMH.  The status quo approach—prove an efficient market and we’ll presume reliance because of an inevitable price effect—really seems to endorse the semi-strong ECMH.  An approach requiring proof of price distortion, by contrast, doesn’t.  It may implicitly assume that most pieces of public information are instantly incorporated into securities prices, but no one really doubts that.

Second, the third route would substitute a fairly manageable inquiry (Did the misrepresentation occasion a price effect?) for one that is both difficult and theoretically problematic (Is the market for the company’s stock efficient?).

Third, the approach would allow the Court to eliminate a number of the most meritless securities fraud class actions without appearing overly “activist” and “pro-business.”  If class plaintiffs can’t show a price effect from a complained of misrepresentation or omission, then their claim is really frivolous and ought to go away immediately.  The status quo would permit certification of the class, despite the absence of a price effect, as long as class counsel could demonstrate an efficient market using the amorphous and unreliable factors set forth above.  And once the class is certified, the plaintiffs have tons of settlement leverage, even when they don’t have much of a claim.  In short, the price distortion criterion is a far better screen than the market efficiency screen courts currently utilize.  For all these reasons, I suspect the Court will decide not to overrule Basic but to tweak it to require a threshold showing of price distortion.

If it does so, then the second question at issue in Halliburton—may the defendant, at the class certification stage, present evidence of an absence of price distortion?—goes away.  If the plaintiff must establish price distortion to attain class certification, then due process would require that the defendant be allowed to poke holes in the plaintiff’s certification case.

So that’s my prediction on Halliburton.  We shall see.  Whatever the outcome, we’ll have lots to discuss in June.

[The following is a guest post by Thomas McCarthy on the Supreme Court’s recent Amex v. Italian Colors Restaurant decision. Tom is a partner at Wiley Rein, LLP and a George Mason Law grad. He is/was also counsel for, among others,

So he’s had a busy week….]

The Supreme Court’s recent opinion in American Express Co. v. Italian Colors Restaurant (June 20, 2013) (“Amex”) is a resounding victory for freedom-of-contract principles.  As it has done repeatedly in recent terms (see AT&T Mobility LLC v. Concepcion (2011); Marmet Health Care Center, Inc. v. Brown (2012)), the Supreme Court reaffirmed that the Federal Arbitration Act (FAA) makes arbitration “a matter of contract,” requiring courts to “rigorously enforce arbitration agreements according to their terms.”  Amex at 3.  In so doing, it rejected the theory that class procedures must remain available to claimants in order to ensure that they have sufficient financial incentive to prosecute federal statutory claims of relatively low value.  Consistent with the freedom-of-contract principles enshrined in the FAA, an arbitration agreement must be enforced—even if the manner in which the parties agreed to arbitrate leaves would-be claimants with low-value claims that are not worth pursuing.

In Amex, merchants who accept American Express cards filed a class action against Amex, asserting that Amex violated Section 1 of the Sherman Act by “us[ing] its monopoly power in the market for charge cards to force merchants to accept credit cards at rates approximately 30% higher than the fees for competing credit cards.”  Amex at 1-2.  And, of course, the merchants sought treble damages for the class under Section 4 of the Clayton Act.  Under the terms of their agreement with American Express, the merchants had agreed to resolve all disputes via individual arbitration, that is, without the availability of class procedures.  Consistent with that agreement, American Express moved to compel individual arbitration, but the merchants countered that the costs of expert analysis necessary to prove their antitrust claims would greatly exceed the maximum recovery for any individual plaintiff, thereby precluding them from effectively vindicating their federal statutory rights under the Sherman Act.  The Second Circuit sided with the merchants, holding that the prohibitive costs the merchants would face if they had to arbitrate on an individual basis rendered the class-action waiver in the arbitration agreement unenforceable.

In a 5-3 majority (per Justice Scalia), the Supreme Court reversed.  The Court began by highlighting the Federal Arbitration Act’s freedom-of-contract mandate—that “courts must rigorously enforce arbitration agreements according to their terms, including terms that specify with whom [the parties] choose to arbitrate their disputes, and the rules under which that arbitration will be conducted.”  Amex at 2-3 (internal quotations and citations omitted).  It emphasized that this mandate applies even to federal statutory claims, “unless the FAA’s mandate has been overridden by a contrary congressional command.”  Amex at 3 (internal quotations and citations omitted).  The Court then briefly explained that no contrary congressional command exists in either the federal antitrust laws or Rule 23 of the Federal Rules of Civil Procedure (which allows for class actions in certain circumstances).

Next, the Court turned to the merchants’ principal argument—that the arbitration agreement should not be enforced because enforcing it (including its class waiver provision) would preclude plaintiffs from effectively vindicating their federal statutory rights.  The Court noted that this “effective vindication” exception “originated as dictum” in prior cases and that the Court has only “asserted [its] existence” without ever having applied it in any particular case.  Amex at 6.  The Court added that this exception grew out of a desire to prevent a “prospec­tive waiver of a party’s right to pursue statutory reme­dies,” explaining that it “would certainly cover a provision in an arbitration agreement forbidding the assertion of certain statutory rights.”  The Court added that this exception might “perhaps cover filing and administrative fees attached to arbitration that are so high as to make access to the forum impracticable,” Amex at 6, but emphasized that, whatever the scope of this exception, the fact that the manner of arbitration the parties contracted for might make it “not worth the expense” to pursue a statutory remedy “does not constitute the elimination of the right to pursue that remedy.”  Amex at 7.

The Court closed by noting that its previous decision in AT&T Mobility v. Concepcion “all but resolves this case.”  Amex at 8.  In Concepcion, the Court had invalidated a state law “conditioning enforcement of arbitration on the availability of class procedures because that law ‘interfere[d] with fundamental attributes of arbitration.’”   As the Court explained, Concepcion specifically rejected the argument “that class arbitration was necessary to prosecute claims ‘that might otherwise slip through the legal system’” thus establishing “that the FAA’s command to enforce arbitration agreements trumps any interest in ensuring the prosecution of low value claims.”  Amex at 9 (quoting Concepcion).  The Court made clear that, under the FAA, courts are to hold parties to the deal they struck—arbitration pursuant to the terms of their arbitration agreements, even if that means that certain claims may go unprosecuted.  Responding to a dissent penned by Justice Kagan, who complained that the Court’s decision would lead to “[l]ess arbitration,” contrary to the pro-arbitration policies of the FAA, Amex dissent at 5, the Court doubled down on this point, emphasizing that the FAA “favor[s] the absence of litigation when that is the consequence of a class-action waiver, since its ‘principal purpose’ is the enforcement of arbitration agreements according to their terms.”  Amex at 9 n.5 (emphasis added).

By holding parties to the deal they struck regarding the resolution of their disputes, the Court properly vindicates the FAA’s freedom-of-contract mandates.  And even assuming the dissenters are correct that there will be less arbitration in individual instances, the opposite is true on a macro level.  For where there is certainty in contract enforcement, parties will enter into contracts.  Amex thus should promote arbitration by eliminating uncertainty in contracting and thereby removing a barrier to swift and efficient resolution of disputes.

The Securities and Exchange Commission (SEC) recently scored a significant win against a Maryland banker accused of naked short-selling. What may be good news for the SEC is bad news for the market, as the SEC will now be more likely to persecute other alleged offenders of naked short-selling restrictions.

“Naked” short selling is when a trader sells stocks the trader doesn’t actually own (and doesn’t borrow in a prescribed period of time) in the hopes of buying the stocks later (before they must be delivered) at a lower price. The trader is basically betting that the stock price will decline. If it doesn’t, the trader must purchase the stock at a higher price–or breach their original sale contract.Some critics argue that such short-selling leads to market distortions and potential market manipulation, and some even pointed to short-selling as a boogey-man in the 2008 financial crisis, hence the restrictions on short-selling giving rise to the SEC’s enforcement proceedings.

Just one problem, there’s a lot of evidence that shows restrictions on short-selling make markets less efficient, not more.

This isn’t exactly news. Thom argued against short-selling restrictions seven years ago (here) and our late colleague, Larry Ribstein, followed up a couple years ago (here).  The empirical evidence just continues to pile in. Beber and Pagano, in the Journal of Finance earlier this year examine not just US restrictions on short-selling, but global restrictions. Their abstract reads:

Most regulators around the world reacted to the 2007–09 crisis by imposing bans on short selling. These were imposed and lifted at different dates in different countries, often targeted different sets of stocks, and featured varying degrees of stringency. We exploit this variation in short-sales regimes to identify their effects on liquidity, price discovery, and stock prices. Using panel and matching techniques, we find that bans (i) were detrimental for liquidity, especially for stocks with small capitalization and no listed options; (ii) slowed price discovery, especially in bear markets, and (iii) failed to support prices, except possibly for U.S. financial stocks.

So while the SEC may celebrate their prosecution victory, investors may have reason to be less enthusiastic.

TOTM friend Stephen Bainbridge is editing a new book on insider trading.  He kindly invited me to contribute a chapter, which I’ve now posted to SSRN (download here).  In the chapter, I consider whether a disclosure-based approach might be the best way to regulate insider trading.

As law and economics scholars have long recognized, informed stock trading may create both harms and benefits to society With respect to harms, defenders of insider trading restrictions have maintained that informed stock trading is “unfair” to uninformed traders and causes social welfare losses by (1) encouraging deliberate mismanagement or disclosure delays aimed at generating trading profits; (2) infringing corporations’ informational property rights, thereby discouraging the production of valuable information; and (3) reducing trading efficiency by increasing the “bid-ask” spread demanded by stock specialists, who systematically lose on trades with insiders.

Proponents of insider trading liberalization have downplayed these harms.  With respect to the fairness argument, they contend that insider trading cannot be “unfair” to investors who know in advance that it might occur and nonetheless choose to trade.  And the purported efficiency losses occasioned by insider trading, liberalization proponents say, are overblown.  There is little actual evidence that insider trading reduces liquidity by discouraging individuals from investing in the stock market, and it might actually increase such liquidity by providing benefits to investors in equities.  With respect to the claim that insider trading creates incentives for delayed disclosures and value-reducing management decisions, advocates of deregulation claim that such mismanagement is unlikely for several reasons.  First, managers face reputational constraints that will discourage such misbehavior.  In addition, managers, who generally work in teams, cannot engage in value-destroying mismanagement without persuading their colleagues to go along with the strategy, which implies that any particular employee’s ability to engage in mismanagement will be constrained by her colleagues’ attempts to maximize firm value or to gain personally by exposing proposed mismanagement.  With respect to the property rights concern, deregulation proponents contend that, even if material nonpublic information is worthy of property protection, the property right need not be a non-transferable interest granted to the corporation; efficiency considerations may call for the right to be transferable and/or initially allocated to a different party (e.g., to insiders).  Finally, legalization proponents observe that there is little empirical evidence to support the concern that insider trading increases bid-ask spreads.

Turning to their affirmative case, proponents of insider trading legalization (beginning with Geoff’s dad, Henry Manne) have primarily emphasized two potential benefits of the practice.  First, they observe that insider trading increases stock market efficiency (i.e., the degree to which stock prices reflect true value), which in turn facilitates efficient resource allocation among capital providers and enhances managerial decision-making by reducing agency costs resulting from overvalued equity.  In addition, the right to engage in insider trading may constitute an efficient form of managerial compensation.

Not surprisingly, proponents of insider trading restrictions have taken issue with both of these purported benefits. With respect to the argument that insider trading leads to more efficient securities prices, ban proponents retort that trading by insiders conveys information only to the extent it is revealed, and even then the message it conveys is “noisy” or ambiguous, given that insiders may trade for a variety of reasons, many of which are unrelated to their possession of inside information.  Defenders of restrictions further maintain that insider trading is an inefficient, clumsy, and possibly perverse compensation mechanism.

The one thing that is clear in all this is that insider trading is a “mixed bag”  Sometimes such trading threatens to harm social welfare, as in SEC v. Texas Gulf Sulphur, where informed trading threatened to prevent a corporation from usurping a valuable opportunity.  But sometimes such trading creates net social benefits, as in Dirks v. SEC, where the trading revealed massive corporate fraud.

As regular TOTM readers will know, optimal regulation of “mixed bag” business practices (which are all over the place in the antitrust world) requires consideration of the costs of underdeterring “bad” conduct and of overdeterring “good” conduct.  Collectively, these constitute a rule’s “error costs.”  Policy makers should also consider the cost of administering the rule at issue; as they increase the complexity of the rule to reduce error costs, they may unwittingly drive up “decision costs” for adjudicators and business planners.  The goal of the policy maker addressing a mixed bag practice, then, should be to craft a rule that minimizes the sum of error and decision costs.

Adjudged under that criterion, the currently prevailing “fraud-based” rules on insider trading fail.  They are difficult to administer, and they occasion significant error cost by deterring many instances of socially desirable insider trading.  The more restrictive “equality of information-based” approach apparently favored by regulators fares even worse.  A contractarian, laissez-faire approach favored by many law and economics scholars would represent an improvement over the status quo, but that approach, too, may be suboptimal, for it does nothing to bolster the benefits or reduce the harms associated with insider trading.

My new book chapter proposes a disclosure-based approach that would help reduce the sum of error and decision costs resulting from insider trading and its regulation.  Under the proposed approach, authorized informed trading would be permitted as long as the trader first disclosed to a centralized, searchable database her insider status, the fact that she was trading on the basis of material, nonpublic in­formation, and the nature of her trade.  Such an approach would (1) enhance the market efficiency benefits of insider trading by facilitating “trade decod­ing,” while (2) reducing potential costs stemming from deliberate misman­agement, disclosure delays, and infringement of informational property rights.  By “accentuating the positive” and “eliminating the negative” conse­quences of informed trading, the proposed approach would perform better than the legal status quo and the leading proposed regulatory alternatives at minimizing the sum of error and decision costs resulting from insider trading restrictions.

Please download the paper and send me any thoughts.

In light of yesterday’s abysmal jobs report, yesterday’s Wall Street Journal op-ed by Stanford economist John B. Taylor (Rules for America’s Road to Recovery) is a must-read.  Taylor begins by identifying what he believes is the key hindrance to economic recovery in the U.S.:

In my view, unpredictable economic policy—massive fiscal “stimulus” and ballooning debt, the Federal Reserve’s quantitative easing with multiyear near-zero interest rates, and regulatory uncertainty due to Obamacare and the Dodd-Frank financial reforms—is the main cause of persistent high unemployment and our feeble recovery from the recession.

A reform strategy built on more predictable, rules-based fiscal, monetary and regulatory policies will help restore economic prosperity.

Taylor goes on (as have I) to exhort policy makers to study F.A. Hayek, who emphasized the importance of clear rules in a free society.  Hayek explained:

Stripped of all technicalities, [the Rule of Law] means that government in all its actions is bound by rules fixed and announced beforehand—rules which make it possible to foresee with fair certainty how the authority will use its coercive powers in given circumstances and to plan one’s individual affairs on the basis of this knowledge.

Taylor observes that “[r]ules-based policies make the economy work better by providing a predictable policy framework within which consumers and businesses make decisions.”  But that’s not all: “they also protect freedom.”  Thus, “Hayek understood that a rules-based system has a dual purpose—freedom and prosperity.”

We are in a period of unprecedented regulatory uncertainty.  Consider Dodd-Frank.  That statute calls for 398 rulemakings by federal agencies.  Law firm Davis Polk reports that as of June 1, 2012, 221 rulemaking deadlines have expired.  Of those 221 passed deadlines, 73 (33%) have been met with finalized rules, and 148 (67%) have been missed.  The uncertainty, it seems, is far from over.

Taylor’s Hayek-inspired counsel mirrors that offered by President Reagan’s economic team at the beginning of his presidency, a time of economic malaise similar to that we’re currently experiencing.  In a 1980 memo reprinted in last weekend’s Wall Street Journal, Reagan’s advisers offered the following advice:

…The need for a long-term point of view is essential to allow for the time, the coherence, and the predictability so necessary for success. This long-term view is as important for day-to-day problem solving as for the making of large policy decisions. Most decisions in government are made in the process of responding to problems of the moment. The danger is that this daily fire fighting can lead the policy-maker farther and farther from his goals. A clear sense of guiding strategy makes it possible to move in the desired direction in the unending process of contending with issues of the day. Many failures of government can be traced to an attempt to solve problems piecemeal. The resulting patchwork of ad hoc solutions often makes such fundamental goals as military strength, price stability, and economic growth more difficult to achieve. …

Consistency in policy is critical to effectiveness. Individuals and business enterprises plan on a long-range basis. They need to have an environment in which they can conduct their affairs with confidence. …

With these fundamentals in place, the American people will respond. As the conviction grows that the policies will be sustained in a consistent manner over an extended period, the response will quicken.

If you haven’t done so, read both pieces (Taylor’s op-ed and the Reagan memo) in their entirety.

In criticizing Governor Romney’s involvement with Bain Capital, President Obama commented both on private equity and on profit maximization.  Most of the comments I have seen dealt with the private equity.  I thought a comment on profit maximization was important as well.

  • OPINION
  • Updated May 23, 2012, 7:51 p.m. ET

A Tutorial for the President on ‘Profit Maximization’

Profits provide the incentive for firms to do what consumers want.

By PAUL H. RUBIN

In justifying his attacks on Bain Capital, President Obama argues that “profit maximization” might be an appropriate goal for a private-equity firm, but not for more general public policy. This argument ignores one of the most basic premises of economics.

We economists assume that firms always maximize profits, and that profit maximization by firms (all firms, not just private-equity ones) is a very good thing. But this is not because profits are in themselves good. Rather, profit maximization is good because it leads directly to maximum benefits for consumers. Profits provide the incentive for firms to do what consumers want.

Consider what contributes to profit maximization. In simple terms, profit maximization means producing the products earning the highest returns, and producing these products at the lowest possible cost. Both are socially useful behaviors that benefit consumers.

Which products produce the highest returns? The answer is the products that consumers want and are currently underproduced. If there are excess returns (profits) to be earned in some market, that is because consumers are willing to pay more for those products than the current cost of production.

Profits are earned by producing more of these products—that is, by satisfying unmet consumer demands. Profit maximization means doing the best job of satisfying these unmet demands, and so providing benefits to consumers. If the unmet demand is for a currently nonexistent product that consumers will value when it is produced (Facebook, the iPhone, Google search), then of course even more profits can be earned.

A firm such as Bain that is involved in investing capital can only make money if it succeeds in satisfying consumer demands. Of course, its goal in deciding where to invest is to maximize returns for its investors, but that is a detail. It will only succeed in this goal if it does a good job of identifying and satisfying consumer demands for products.

The second trick to maximizing profits is to reduce costs as much as possible. This may involve eliminating some unneeded resources, which may translate into unemployment in the short run. It may involve recombining resources into more productive configurations, or restructuring governance of the firm.

The immediate purpose of reducing costs is to increase the profits of investors, but the ultimate result is to benefit consumers. In the textbook ideal of a purely competitive economy, cost reductions will immediately translate into lower prices for consumers. But in any market structure—competition, monopoly or oligopoly—profit-maximizing behavior translates reduced costs into reduced prices for consumers.

Consider the converse: What if a business does not maximize profits? Then it is either not making the products that consumers want the most, or it is not producing its products at the lowest cost. In either case, consumers are harmed. Any argument against “profit maximization” is an argument against consumer welfare.

Maximizing consumer welfare is the ultimate justification for an economy. Consumers are of course also workers and voters. Contrary to President Obama’s claim, skill at profit maximization does translate directly into skill at governing the economy. Failure to understand this simplest and most basic point is probably itself enough to disqualify someone from the presidency when economic issues are paramount.

Mr. Rubin is a professor of economics at Emory University and president elect of the Southern Economic Association.

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New York Times columnist Gretchen Morgenson is arguing for a “pre-clearance”  approach to regulating new financial products:

The Food and Drug Administration vets new drugs before they reach the market. But imagine if there were a Wall Street version of the F.D.A. — an agency that examined new financial instruments and ensured that they were safe and benefited society, not just bankers.  How different our economy might look today, given the damage done by complex instruments during the financial crisis.

The idea Morgenson is advocating was set forth by law professor Eric Posner (one of my former profs) and economist E. Glen Weyl in this paper.  According to Morgenson,

[Posner and Weyl] contend that new instruments should be approved by a “financial products agency” that would test them for social utility. Ideally, products deemed too costly to society over all — those that serve only to increase speculation, for example — would be rejected, the two professors say.

While I have not yet read the paper, I have some concerns about the proposal, at least as described by Morgenson.

First, there’s the knowledge problem.  Even if we assume that agents of a new “Financial Products Administration” (FPA) would be completely “other-regarding” (altruistic) in performing their duties, how are they to know whether a proposed financial instrument is, on balance, beneficial or detrimental to society?  Morgenson suggests that “financial instruments could be judged by whether they help people hedge risks — which is generally beneficial — or whether they simply allow gambling, which can be costly.”  But it’s certainly not the case that speculative (“gambling”) investments produce no social value.  They generate a tremendous amount of information because they reflect the expectations of hundreds, thousands, or millions of investors who are placing bets with their own money.  Even the much-maligned credit default swaps, instruments Morgenson and the paper authors suggest “have added little to society,” provide a great deal of information about the creditworthiness of insureds.  How is a regulator in the FPA to know whether the benefits a particular financial instrument creates justify its risks? 

When regulators have engaged in merits review of investment instruments — something the federal securities laws generally eschew — they’ve often screwed up.  State securities regulators in Massachusetts, for example, once banned sales of Apple’s IPO shares, claiming that the stock was priced too high.  Oops.

In addition to the knowledge problem, the proposed FPA would be subject to the same institutional maladies as its model, the FDA.  The fact is, individuals do not cease to be rational, self-interest maximizers when they step into the public arena.  Like their counterparts in the FDA, FPA officials will take into account the personal consequences of their decisions to grant or withhold approvals of new products.  They will know that if they approve a financial product that injures some investors, they’ll likely be blamed in the press, hauled before Congress, etc.  By contrast, if they withhold approval of a financial product that would be, on balance, socially beneficial, their improvident decision will attract little attention.  In short, they will share with their counterparts in the FDA a bias toward disapproval of novel products.

In highlighting these two concerns, I’m emphasizing a point I’ve made repeatedly on TOTM:  A defect in private ordering is not a sufficient condition for a regulatory fix.  One must always ask whether the proposed regulatory regime will actually leave the world a better place.  As the Austrians taught us, we can’t assume the regulators will have the information (and information-processing abilities) required to improve upon private ordering.  As Public Choice theorists taught us, we can’t assume that even perfectly informed (but still self-interested) regulators will make socially optimal decisions.  In light of Austrian and Public Choice insights, the Posner & Weyl proposal — at least as described by Morgenson — strikes me as problematic.  [An additional concern is that the proposed pre-clearance regime might just send financial activity offshore.  To their credit, the authors acknowledge and address that concern.]

That’s the title of an interesting article by Emmanuel Farhi and Jean Tirole in the current issue of the  American Economic Review. Here’s the abstract (emphasis added):

The article shows that time-consistent, imperfectly targeted support to distressed institutions makes private leverage choices strategic complements. When everyone engages in maturity mismatch, authorities have little choice but intervening, creating both current and deferred (sowing the seeds of the next crisis) social costs. In turn, it is profitable to adopt a risky balance sheet. These insights have important consequences, from banks choosing to correlate their risk exposures to the need for macro-prudential supervision.

The Federal Trade Commission conference announcement is below; note that public comments on the date of the conference.  This is an important space and should attract some excellent speakers.  The topics suggest a greater focus on consumer protection than competition issues.  Here is the announcement:

The Federal Trade Commission will host a workshop on April 26, 2012, to examine the use of mobile payments in the marketplace and how this emerging technology impacts consumers. This event will bring together consumer advocates, industry representatives, government regulators, technologists, and academics to examine a wide range of issues, including the technology and business models used in mobile payments, the consumer protection issues raised, and the experiences of other nations where mobile payments are more common. The workshop will be free and open to the public.

Topics may include:

  • What different technologies are used to make mobile payments and how are the technologies funded (e.g., credit card, debit card, phone bill, prepaid card, gift card, etc.)?
  • Which technologies are being used currently in the United States, and which are likely to be used in the future?
  • What are the risks of financial losses related to mobile payments as compared to other forms of payment? What recourse do consumers have if they receive fraudulent, unauthorized, and inaccurate charges? Do consumers understand these risks? Do consumers receive disclosures about these risks and any legal protections they might have?
  • When a consumer uses a mobile payment service, what information is collected, by whom, and for what purpose? Are these data collection practices disclosed to consumers? Is the data protected?
  • How have mobile payment technologies been implemented in other countries, and with what success? What, if any, consumer protection issues have they faced, and how have they dealt with them?
  • What steps should government and industry members take to protect consumers who use mobile payment services?

To aid in preparation for the workshop, FTC staff welcomes comments from the public, including original research, surveys and academic papers. Electronic comments can be made at https://ftcpublic.commentworks.com/ftc/mobilepayments. Paper comments should be mailed or delivered to: 600 Pennsylvania Avenue N.W., Room H-113 (Annex B), Washington, DC 20580.

The workshop is free and open to the public; it will be held at the FTC’s Satellite Building Conference Center, 601 New Jersey Avenue, N.W., Washington, D.C.

Jonathan Macey (Yale) defends private equity against nonsensical attacks from Newt Gingrich, Jon Huntsman and others (Rick Perry is spared by Macey, but not by Bainbridge) in today’s Wall Street Journal:

Mitt Romney’s candidacy is subjecting the entire private-equity industry—where Mr. Romney spent most of his business career—to vicious attacks by journalists and several of his rivals for the Republican presidential nomination.

Newt Gingrich’s political action committee is sponsoring a film called “When Mitt Romney Came to Town” that accuses Mr. Romney and his former company, Bain Capital, of taking over companies, looting them, and then tossing their workers out on the street. Jon Huntsman’s attacks on his rival include the description of private equity as a business that “breaks down businesses [and] destroys jobs, as opposed to creating jobs and opportunity, leveraging up, spinning off, [and] enriching shareholders.”

This is anticapitalist claptrap. Private-equity firms make significant investments in companies, mainly U.S. companies. Most of their investments are in companies that underperform industry peers. Frequently these firms are on the brink of failure.

Professor Macey ends with a sharp, and I think wholly appropriate, note:

Assaults on the private-equity industry really are attacks on economic freedom, because the private-equity process is nothing more and nothing less than free-market capitalism at work. Shame on all the people, particularly those who claim to be friendly to capitalism, who attack Mitt Romney because of his association with the U.S. private-equity industry.

There is, of course, another angle to evaluating the attacks against Romney’s private equity experience.  As Larry Ribstein was fond of pointing out, for example here and here:

I understand what the OWS crowd will make of this story.  But they need to persuade me why this story should make Romney look worse than the typical presidential candidate who has spent his life in politics and whose job history has consisted mainly of engineering wealth transfers from weak interest groups (e.g., taxpayers) to more powerful ones (e.g., big banks).

Larry’s critiques, unfortunately, should be mandatory reading not just for the “OWS crowd,” but for the Republican candidates — especially the few that claim to be market-oriented.

Via Professor Bainbridge, I read today about the nonsense surrounding Mitt Romney enjoying firing people.  I’m late to the this one, but here is the quote in context for anybody who missed it:

“I want individuals to have their own insurance,” he said. “That means the insurance company will have an incentive to keep you healthy. It also means if you don’t like what they do, you can fire them. I like being able to fire people who provide services to me.

“You know, if someone doesn’t give me a good service that I need, I want to say I’m going to go get someone else to provide that service to me.”

Bainbridge explains why, even if one was to take this quote and extend it to Romney’s days at Bain Capital, the ability to fire people who are are failing to provide a needed service is a feature of a well-functioning market for corporate control, not a bug:

In many cases, restoring a business to efficiency and profitability thus requires the kind of shakeup occasioned by a corporate takeover, such as the sort of LBOs in which Romney specialized, which brings in new managers who are willing to fire people.   LBO specialists who like to fire people thus played — and still play — a critical role in ensuring that US corporations are sufficiently lean to compete effectively in a pitiless global economy.

The economic point goes well beyond the market for corporate control.  The ability to impose sanctions on an economic partner is fundamental to modern contracting.  In nearly every treatment of the economics of contracting, one begins with the notion that the transacting parties potentially have at their disposal both reputational capital — that is, self-enforcement — and written enforcement as means for assuring contractual performance.  Klein & Leffler (1981) is the model that comes to mind.  The key insight is that parties do not have to rely upon imperfect court enforcement, but can create self-enforcement mechanisms were performance is assured not by litigation, but by threat of termination of the economic relationship.  The costs imposed on the non-performing party are not damages, but the loss of the expected premium stream from the economic relationship. In the economic literature, self-enforcement has been used not just to explain economic relationships in which court enforcement is entirely unavailable, but the complementary nature of written terms and reputational enforcement in a wide array of complex contractual arrangements including franchising arrangements, tying, resale price maintenance and exclusive dealing.  I discuss the distinction between standard economic approaches to contract that ignore these complementarities and the Klein (and also Oliver Williamson) approach to self-enforcement here.

The role of termination in facilitating well functioning economic relationships is critical in not just the market for corporate control,  but it all kinds of product and service markets.   It is hard to take these arguments against Romney seriously — even harder than the arguments disparaging his role at Bain.   In context, what Romney actually said is unremarkable.  How many of us don’t want to be able to terminate our economic relationship with the restaurant that feeds us low quality food or the service person who we find out shirked and provided shoddy quality work after the fact?  Our ability to do so constrains economic opportunism.  Perhaps the real objection is not that Romney talked about termination, but that he expressed a preference for terminating shirkers with whom he has economic relationships.   Not only does he fire people, but he likes it!  Perhaps the appropriate response then, from an economic perspective, is not to pillory him for it a la Huntsman, but to thank him for allowing us to free-ride on his efforts.

Roberta Romano has just posted her paper, Regulating in the Dark. Here’s the abstract:

Foundational financial legislation is typically adopted in the midst or aftermath of financial crises, when an informed understanding of the causes of the crisis is not yet available. Moreover, financial institutions operate in a dynamic environment of considerable uncertainty, such that legislation enacted even under the best of circumstances can have perverse unintended consequences, and regulatory requirements correct for an initial set of conditions can become inappropriate as economic and technological circumstances change. Furthermore, the stickiness of the status quo in the U.S. political system renders it difficult to revise legislation, even though there may be a consensus to do so. This essay contends that the best means of responding to this dismal state of affairs is to include, as a matter of course, in crisis-driven financial legislation and its implementing regulation two key procedural mechanisms: (1) a requirement of automatic subsequent review and reconsideration of the legislative and regulatory decisions at some future point in time; and (2) regulatory exemptive or waiver powers, that encourage, where feasible, small scale experimentation, as well as flexibility in implementation. Both procedural devices will better inform and calibrate the regulatory apparatus, and could thereby mitigate, at least on the margin, the unintended errors which will invariably accompany financial legislation and rulemaking originating in a crisis. Given the centrality of financial institutions and markets to economic growth and societal well-being, it is exceedingly important for legislators acting in a financial crisis with the best of intentions, to not make matters worse.

It’s worth noting that Henry Butler and I, in our book about SOX (at 96-97, footnotes omitted), also suggested “sunset” provisions as an antidote to crisis-driven regulation:

[S]ignificant new financial and governance regulation like SOX that displaces and supplements prior regulatory approaches should be subject to periodic review and sunset provisions. Although Congress, of course, can always undertake such reviews, prior experience indicates that it will not. Legislation is a one-way regulatory ratchet. It arises when the conditions for reform are ripe for a regulatory panic. The conditions for a “deregulatory panic” are less likely to develop. Firms learn to live with the extra costs and may not be willing or able to bear the costs of lobbying for repeal, at least in the absence of a regulatory cataclysm. Thus, it is not surprising that SOX sponsor Michael Oxley, despite recognizing that SOX was “excessive” in some respects, and admitting that it had been rushed through Congress, suggested that Congress would not be revisiting the issue, even as to the seriously affected small companies. He said, “If I had another crack at it I would have provided a bit more flexibility for small- and medium-sized companies.” In other words, Congress normally does not have “another crack” at regulation. A sunset or review mechanism would change that.

Perhaps Congress can learn some lessons from itself. The USA Patriot Act was passed less than one year before SOX and, like SOX, was passed by an overwhelming majority. Unlike SOX, the USA Patriot Act includes sunset provisions for some of its most controversial provisions. The Patriot Act’s sunset provision forced Congress and the president to reevaluate and debate those provisions, in an atmosphere far  removed from the immediate post-9/11 panic. American investors would benefit from a sober reevaluation of SOX. Perhaps the courts will provide that opportunity. For future regulatory panics, Congress would do well to remember the lessons of the Patriot Act.

One footnote in Romano’s article particularly grabbed my attention.  Referring to Jack Coffee’s criticism of sunset provisions in a non-yet-public manuscript (“The Political Economy of Dodd-Frank: Why Financial Reform Tends to be Frustrated and Systemic Risk Perpetuated”), Romano notes:

Coffee (2011:4, 6,9) sweepingly seeks to dismiss the scholarship with which he disagrees by engaging in serial name calling, referring to the authors, Steve Bainbridge, Larry Ribstein and me, as “the ‘Tea Party Caucus’ of corporate and securities law professors” (a claim that would have been humorous had it not been said earnestly), “conservative critics of securities regulation,” (a claim, at least in my case, that would be accurate if he had dropped the adjective), and further referring to Bainbridge and Ribstein, as “[my] loyal adherents.”

 She also observes in this footnote:  

[I]n the American political tradition and academic literature, advocacy of sunsetting has historically cut across political party lines. It has had a distinguished liberal pedigree, having been advocated by, among others, President Jimmy Carter, Senator Edward Kennedy, political scientist Theodore Lowi, and Common Cause (Breyer 1982; Kysar 2005).”

Like Butler and me, she cites the Patriot Act precedent.

Well, I’m proud to be included in Romano’s and Bainbridge’s “tea party” and surprised at being there because I advocated an idea also endorsed by Carter, Kennedy, Lowi and Common Cause.  It’s sad a scholar of Coffee’s stature sees a need to resort to such rhetoric, though almost understandable since Romano’s devastating critique doesn’t leave him much of a ledge to sit on.

 As for Romano’s article, definitely do read the whole thing.  Rather than simply condemning Dodd-Frank, she argues persuasively for a way to avoid future financial over-regulation.

Update:  Matt Bodie confuses blogs and scholarly articles, statutes and people. Bainbridge sets him straight, and Leiter agrees.  But do read Bodie’s post anyway because he links to some great Gretchen posts which even I had forgotten.