I am not a lawyer and the judgement of the Federal Court of Australia dismissing insider trading and conflict of interest charges against Citigroup is 120 pages long, but the sum and substance of the judgement seems to be that absolute perfection is not required in Chinese wall arrangements. The judgement says:
But what the unscripted actions of Mr Sinclair and Mr Darwell show is the practical impossibility of ensuring that every conceivable risk is covered by written procedures and followed by employees.
However, the arrangements required to satisfy s 1043F(b) of the Corporations Act do not require a standard of absolute perfection. The test stated in the section is an objective one. It is, “arrangements that could reasonably be expected to ensure that the information was not communicated”.
In my view, the arrangements referred to by Mr Monaci in his written statement were sufficient to meet the requirements of s 1043F(b). They did not, in express terms, anticipate the situation which arose on 19 August 2005 but they laid down general procedures which could reasonably be expected to ensure that legal or compliance officers of Citigroup vetted any communication of potentially price sensitive information to prevent it crossing the Chinese wall.
The other important part of the judgement is that parties can contract out of a fiduciary relationship. The acquirer’s mandate letter stated that Citigroup was engaged “as an independent contractor and not in any other capacity including as a fiduciary”. With the court holding that this clause absolved Citigroup of all fiduciary (conflict of interest) responsibilities, language of this kind will probably become even more commonplace than it is now.
Fri, 22 Jun 2007
Two events this week have highlighted the persistent problems in US regulation of public offerings: first was the unacceptable effect that the quiet period regulation had on the Blackstone IPO and the other was the decision by the SEC to further tighten short selling activities during a public offering.
While the Blackstone IPO was in progress, a bill was introduced in the US Congress to increase the tax rates applicable to listed private equity firms. Since this proposal came with a five year breather, the market would have benefited from an analysis by the company explaining the tax incidence in the light of anticipated profit realization during the next five years. Unfortunately, as the Lex column in the Financial Times pointed out (“Blackstone’s tax bill”, June 18, 2007), the quiet period regulation prevented Blackstone from commenting on the situation at all. This is a totally unacceptable outcome. Clearly, the regulations that were framed long ago in a much slower paced era need to change to keep up with the times.
Sometimes, however, when regulations are changed, they are changed for the worse. The SEC’s proposal to tighten short selling restrictions during public offerings of securities is an example of this kind. The SEC states:
When a trader expects to receive shares in an offering, there is an incentive to sell short prior to pricing an offering and then cover that short position with shares bought at the reduced offering price. By doing so, the trader can cover the short sale with minimal risk, and generally lock in a guaranteed profit – to the detriment of the issuer and the other shareholders.
The amendments change the way the rule works to prevent this from happening. They replace the rule's current limitation on covering the short sales in the offering with a prohibition on purchasing in the offering after a short sale in the securities. This change was triggered by persistent non-compliance with the rule and a string of strategies to conceal the prohibited covering. Under the amended rule, if a person sells short during the restricted period prior to pricing, that person is prohibited from purchasing the offered security. Thus, the amended rule changes the prohibited activity from covering to purchasing the offered security.
Accurate price discovery is as important (if not more important) during a public offering as at other times and short selling is a critical element of good price discovery. In the absence of this process, there is a risk that companies and their underwriters would be able to manipulate the market and overprice their issues. In this light, the rule proposed by the SEC is a step in the wrong direction.
Tue, 19 Jun 2007
The Indian financial press has widely reported the Mastercard Centres of Commerce 2007 study that listed Mumbai among the top 10 cities in the world in terms of financial flows ahead of Hong Kong and Shanghai. Many of these reports did not mention that despite faring so well on this sub index, Mumbai ranks 45th out of 50 in the overall index of global centres while Hong Kong ranks 5th.
Mumbai ranks high only in the financial flows sub index while ranking near the bottom (below 40) on all other components. Even within the financial flows sub index, Mumbai owes its place primarily to the vibrant equities market. (Measuring derivative activity in terms of number of contracts also helps since the single stock futures contracts popular in India have small contract sizes.) Even then, the gap separating Mumbai (38.71) from Shanghai (38.30) and Hong Kong (38.06) is quite low compared to the gap that separates Mumbai from Seoul (53.00) or Tokyo (53.39).
The Mastercard study serves to remind us that the equity markets are the real success story in Indian financial sector reform. We do need to replicate this success in other sectors.
Thu, 14 Jun 2007
The US SEC has finally decided to abolish the rule that prohibited shares being shorted except on an uptick. The surprising thing is that it has taken 70 years (almost three generations) to get rid of a stupid idea that entered the statute book in 1938.
Of course, in a balancing act, the SEC also tightened rules on “naked short selling”. There is a genuine problem that these rules are trying to address, but this problem is not short selling, it is failed settlement. Though the US has a three day settlement cycle, an unacceptably large proportion of trades fail to settle for several days beyond that date.
It is really fortunate that India avoided importing the system of “continuous net settlement” which is the root of the settlement problem in the US. The Indian approach of ruthless penalties for settlement failures is the right solution to this problem. Instead the SEC wants to look at the whether the failure was intentional or unintentional. It uses silly notions like “abusive short selling” to decide which settlement failures ought to be penalized. It is much better to focus on consequences and penalize all failures regardless of intention. The Indian system has the additional advantage of using a civil liability to deal with a contractual violation. The US system tries to elevate a contractual violation to the level of a fraud.
At a deeper level, the problem of naked short selling is a failure of the securities lending system. The US has a highly developed system for this, but even this system does not work well for all stocks. India faces the challenge of building a securities lending system from scratch, but without any past baggage, it has the potential to build a system with universal access.
Wed, 13 Jun 2007
Sjostrom has an excellent paper on SSRN about how PIPE (Private Investment in Public Equity) deals can be regarded as a form of regulatory arbitrage. Sjostrom’s argument is that the hedge fund that invests in a PIPE deal is performing the same economic function as an underwriter without being subject to either the NASD’s cap on maximum underwriting fees or the due diligence liability that the SEC imposes on underwriters. The paper also argues against the harsh posture that the SEC has adopted against PIPE deals.
I agree with much of this analysis but this line of thinking raises a few other broader issues that Sjostrom does not touch upon:
- Why should the regulation of primary market offerings be so dramatically different from that of secondary market trades? In the US, people often joke that this is largely because the Securities Act was enacted in 1933 while the Exchange Act was enacted only in 1934. This is a silly reason in the US and even sillier in the rest of the world.
- Is the regulatory regime for underwriters anti competitive and has it contributed to the emergence of a cosy oligopoly?
- Is it sensible to bundle due diligence liability and underwriting market risk as inseparably as the current regulatory regime seeks to do in the US?
- Why should regulators not embrace simple auctions as the best way to conduct follow on public offerings?
In an earlier blog entry, I argued that “Regulators however continue to act as if anything unfamiliar is worse than the status quo even when it is potentially better.” The SEC’s response to PIPE deals seems to fit this description. PIPE deals which are not of the death spiral variety appear to me to be a very legitimate financing vehicle
Thu, 07 Jun 2007
Last week, Eliot Spitzer, Governor of New York created the New York State Commission to Modernize the Regulation of Financial Services. Among the reasons for setting up the Commission, Spitzer’s order refers to:
- allegations by financial services companies about unnecessary, burdensome and inconsistent regulation,
- allegations by various consumer advocacy groups that regulation does not adequately protect consumers, and
- global competition and the need for world class financial services regulations to remain the global leader in the sector.
The mandate of the Commission is to suggest regulatory changes needed to:
- promote economic innovation and protect consumers,
- promote competition and the growth of the business while effectively protecting both consumers and businesses from unfair or unethical practices, and
- ensuring that regulations do not impose costs higher than any benefits they provide
This mandate appears to me to be well balanced and sound. I like the pro competitive and pro market approach to regulation. As Attorney General of New York, Spitzer earned a reputation for tough enforcement of laws. Tough enforcement makes sense only when the laws themselves are sound as Stigler taught us in his classic paper 35 years ago (Stigler, J. “The optimum enforcement of laws”, Journal of Political Economy, 1970, 526-536). As Governor, Spitzer now has a chance to work on that side of the equation as well.
Frank Partnoy has an article in the Financial Times of June 6, 2007 (“A gamekeeper turns to the poachers”) defending Spitzer’s decision to appoint senior executives from financial services firms on this Commission.