John F. Sacco
Associate Professor
Department of Public and International Affairs
3F4
George Mason University
Fairfax, Va, 22030
jsacco@gmu.edu
Art Sauer
Former Deputy Director for the Budget Committee, U.S. House of Representatives
art_sauer@hotmail.com
Acknowledgements
The author would like to thank Gabriel Hudson, Ph.D. candidate in the
Department of Public and International Affairs at George Mason
University and Matt Marro, Law student at the George Mason University
Law School for their considerable assistance in research on this paper,
the responsibility for the content rests with the author.
Abstract
While the recent credit crisis is about the bailout, this paper recommends greater ability of citizens to seek reduce of grievances. Market works when more eyes are available to track transparent risk, when auctions determine asset bailout prices and when finance officers are aided by market participants.
Challenges that on the surface appear unwieldy such the credit crisis of 2008 can sometimes be dealt with by addressing a few basic weaknesses rather than viewing the problem as an uncountable number of threads where pushing one thread only results in another thread appearing (Ockham's razor). That is: “The principle of Ockham's razor is a rule of economy which in one form states that we should not clutter up our theories with unnecessary entities.” (R. W. Pfouts . 1967: 463) This policy paper starts with one such fundament flaw in the oversight and transparency of the securities’ industry surrounding the credit crises that have been so common since the 1980s. It is the 1995 Private Securities Litigation Reform Act (PSLRA) which put the right to justice in the hands of the federal government and thus diminished the power of civil class actions available under the Racketeer Influenced and Corrupt Organizations Act (RICO) of 1970.
The main premise is that such a change, that is, undoing PSLRA, will allow more individual eyes because government oversight and investment transparency is restricted by the volume of investments and lobbying (sometimes called rent seeking). The faster this “more oversight eyes” action is undertaken by Congress the quicker the bailout will slow. Thus, the emergency is not the bailout but more eyes on the securities’ industry sparing everyday people the pain and prices as seen in the cutbacks in prescriptions drugs. In this sense, the issue of oversight and transparency in the security industry, including banks, investment firms and others, such as mutual money market funds, is a constitutional one, particular first amendment freedom for everyone including lobbyist and people who choose to take civil action. Within the first amendment one of the problems in these financial crises is the reduction of the right of everyday people to redress grievances that took place under RICO.
The paper shows, among other things, how Congress reduced markets efficiency and allowed poor transparency with the 1995 PSLRA. Other recommendations are added. These include using information technology (IT) technology to show risk of loss as in the case of models such as Value at Risk (VaR) and Expected Tail Loss (ETL). (Aragonés José R and Carlos Blanco, 2008). As for the credit crisis of 2008, the damage is done and in order to bring back greater market efficiency and rapid disclosure, the bailout needs an immediate full stop date along with serious consideration for an auction approach, that is, what can the security firms bid to obtain assistance and how quickly can any acquired assets be auctioned in order to determine the market value of the assets? If none of these are done the solution is left to what might be called “pain, people and prices” of everyday people. Foreclosures are one such pain. In fact, of these recommendations, the first, repairing civil rights to redress grievances will turn around the recession of 2008 that will unfortunately continue in 2009. As for quickly getting money to people, the negative income tax, extended beyond individuals to businesses, is another Ockham's razor tactic and a way for the federal government to get around banks’ unwillingness to extent credit.
Important too, notwithstanding the pain, is to recognize the entrepreneurial quality of everyday people to adjust such as with the reduction in use of gasoline, careful shopping and finding opportunities for earning money in distressed times. While difficult to find in light of the federal government’s many proposals, they do exit. The Daily Post of Liverpool (2008) report that “Spirit of enterprise alive and kicking …” The Entrepreneurial Industry is moving into full gear with articles such as What can Entrepreneurs do to Deal with the Credit Crisis? (Business Trends, 2008).
The first recommendation is to do away with legislation such as the Private Securities Litigation Reform Act (PSLRA) of 1995. This Act requires all securities type civil cases to be brought under the federal domain. The PLSRA has very stringent requirements for bringing civil fraud charges in securities cases. Thus, it has in essence made it difficult for RICO civil cases for securities type conspiracies. According to Zensky and Sorkin (2008, no page given)
The 1980s and early 1990s witnessed explosive growth in the use of the federal Racketeer Influenced and Corrupt Organizations Act (RICO)— and its treble-damages remedy—in civil suits predicated on alleged violations of the anti-fraud provisions of the Securities and Exchange Act of 1934.
While the Zensky and Skoring view of PSLRA is very pessimistic RICO indictments are still being made but as expected the number of cases in 1994 and after PSLRA, 1996 and 1997, show the decline in RICO indictments.
Table 1: Decline in RICO indictments, 1994, 1996 and 1997
Year 1994 1996 1997
Number 194 181 144
Number dropped 13 50
Percentage drop 6.7 25.8
Undoing the PSLRA maybe a difficult task. Underlying the passage of PSLRA may have been a function of lobbying by firms vulnerable to RICO. In the view of Lerach (2002), offering a lawyer’s or litigious view:
Sensing their first opportunity in decades to roll back the securities laws, corporate interests, the accounting oligopoly and the Wall Street bankers descended on Congress with a massive political lobbying and public relations campaign to seek enactment of what came to be known as the Private Securities Litigation Reform Act of 1995 ("PSLRA") … After a bitter political fight, the massive lobbying campaign of the corporate and financial community succeeded. The PSLRA was enacted on December 22, 1995, when the Senate overrode President Clinton's veto by just a few votes.
Historically, and in a more academic vein, KHANNA (2003-2004, see original for footnotes) says:
Corporate interests have also been known to oppose increased enforcement by private litigants while being less opposed to increased government enforcement. This is consistent with the notion … that corporate interests may prefer government enforcement because it is more targeted and more subject to their control. For example, in the 1970s there were attempts to permit state attorney generals to bring antitrust suit on behalf of their citizens and then permit follow on private enforcement. Corporate interests (led by the Business Roundtable) lobbied heavily against this. …This is consistent with the notion that corporate interests prefer government enforcement to private litigant enforcement and similarly may prefer corporate crime legislation over increases in corporate civil liability.
According to Bessette and Biles (2001: 2) the courts have followed PSLRA and made it more difficult for complaints to have scienter than under RICO. They say:
“The required state of mind, or scienter, has been defined as “a mental state embracing intent to deceive, manipulate, or defraud.”
Continuing with Bessette and Biles (2001:2) “Although there is considerable debate in the federal courts concerning the level of specificity and detail that is now required to satisfy the strong inference requirement, there is no doubt that Congress enacted the PSLRA to heighten the scienter pleading requirements.”
In light of argument by Lerach (2002) and Khanna (2003-2004) and the views of Bessette and Biles (2001) considering data on campaign contributions is necessary to assess the extent to which business lobbying influence Congress. While most of the campaign contributions to the House co-sponsors of PSLRA came from individuals, reflecting the campaign years of 1993 and 1994, 51.92%; the remainder, 42.40%, came from lobbying groups such as 28.87% from Finance industry and Insurance PACs. While not overwhelming, the finance industry did make its mark during the passage of PSLRA.
The arguments presents in favor of the PLSRA for the lobbyists were summarized by Apel (2007, see original for footnotes):
Abusive litigation severely affects the willingness of corporate managers to disclose information to the marketplace by instilling a sense of fear that this information will later trigger the filing of class-action securities claims…. Recognizing this chilling effect, Congress adopted a safe harbor provision to enhance market efficiency by encouraging companies to disclose forward-looking statements. Accordingly, the provision grants protection to any forward looking statement that is ‘accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in the forward-looking statement.’ For statements to lose their protection, the plaintiff must prove that the statement was issued with actual knowledge that it was false or misleading.
Notwithstanding the admonishment of PSLRA for companies to disclose more information about securities, the string of corporate and investment failures in the 1990s and credit crisis of 2008 strongly suggests that material information is not disclosed in a transparent fashion. Moreover, Congresses’ willingness to provide more latitude to banking and investment firms comes to light when the Securities and Exchange Commission (SEC) Financial Reporting Requirement of 1997, FRR 48, (namely, requiring Value at Risk disclosure) for more disclosure on derivatives was strained by the Gramm-Leach-Bliley act of 1999 (which passed 90-8 in the Senate) which overturned the Glass Steagall Act of 1933. With banks and other investment institutions obtaining the ability to cross mortgage lending with securitization, these financial institutions became originators shifting the risk to a large volume of hedge funds. Given this vast array of financial operations and financial instruments, the SEC was limited in tracking such a volume. Bryon Dorgan (D, North Dakota) warned that Congress would be sorry in 2010 about overturning Glass-Steagall (Leonhardt, 2008).
The second element of this thesis for dealing with the credit crisis of 2008 is for the government to push disclosure and transparency of two of the risk analysis measures, VaR and Expected Tail Loss (ETL). VaR looks at average risk whereas ELT considers risk under extreme conditions such as financial crises (Aragonés J. R and C. Blanco. 2008). ETL takes into account the tail of the Gaussian (normal) curve which can be high showing dramatic risk. Disclosure needs to be more visible than the current reporting in the SEC 10-Ks. Visible means a “ticker” for the risk measures in fashion similar to stock prices. For example, at the end of the first quarter of 2007, 3/31, CITIGROUP DIVERSIFIED FUTURES FUND LP, reported VaRs that showed infinitesimally low risk. With a total capitalization of $810,396,568, the Over the Counter (OTC) risk for OTC contracts was $2,151,193 or .0027 or .27% VaR (about ¼ of a percent) and that was the highest of all categories.
As for the bailout, the more temporary the bailout, the quicker the crisis will be resolved. The signal that the bailout is temporary and that individuals will receive a greater ability to sue with overturning PSLRA, the quicker the securities’ industry will be more sensitive to taking inordinate risk. In addition, the federal government needs to change the terminology of the game; that is, collateralized auction, not bailout. Any assets taken over and taken over temporarily by the federal government must be put up for auction quickly to see the market value. Such a practice would force firms to show what collateral they have and for that to be placed in the market by auctions. The volume of poor performing assets is too large for the government to value and handle.
Unfortunately, Congress may move slowly on these policy recommendations and much of the burden will fall on the combination of pain and prices everyday people face. The fortunate aspect is that by nature, by the simple fact that people are human beings, individuals are entrepreneurial. Being confronted by pain and prices, the inherent entrepreneurial character will provide the resiliency needed to maintain a productive capitalist system.
Federal financial officials, who have a huge task in these credit crises, can benefit by looking at the notion of more eyes proposed in this paper. Irrespective of whether market logic is used or coordinated federal finance theory, in a democracy, participation is valuable even when costs seem high. Perhaps the costs under RICO were smaller than the cost of the bailout. If RICO had been slightly trimmed the securities’ industry may have been more reluctant to take on such considerable risks. As for the pain people are suffering, some of it goes to individual responsibility but given the information advantage (information asymmetry) the securities’ industry has, many individuals were simply “taken.” Huge stimulus packages first of all face earmarks and generally take a long period to make a mark, sometimes being inflationary.
In the end, capitalism survives on first amendment freedoms so integral to a democratic society and in light of business cycles on the inherent entrepreneurial ability of everyday people to find niches, substitutes and re-capitalization of their abilities. Rule of law, namely the ability to seek redress in the courts, even in the face of rent seekers, must be available to moderate the pain and provide protection for entrepreneurial discovery.
End notes
Apel, J.W. (2007). “Eliminating claims that jeopardize the stature of America's capital markets. DePaul Business & Commercial Law Journal. Spring.
Aragonés J. R and C. Blanco. (2008). “Incorporating correlation regimes in an integrated stressed risk modeling process”. Journal of Economics and Finance; Apr 2008; 32, 2.
Besswtte, P.R and M. J. Biles (2001) “Financial restatements and securities fraud liability – Do they necessarily go hand in hand?” Securities News, Vol. 11, No. 3, Fall.
Small Business Trends. October 6, 2008 Monday 1:00 PM EST. What can Entrepreneurs do to Deal with the Credit Crisis?
Daily Post (Liverpool). July 2, 2008, Wednesday. Mersey Edition. “Spirit of enterprise alive and kicking …”
Khanna, V (2003-2004). “Corporate crime legislation: a political economy analysis.” Working paper series. Law and Economics working paper. No. 03-04. Boston University School of Law.
Leonhardt D. (2008). “Washington's invisible hand.” New York Times Magazine; Sep 28, 2008; Research Library Core. pg. 32
Lerach, W. T (2002). "THE CHICKENS HAVE COME HOME TO ROOST". How Wall Street, the Big Accounting Firms and Corporate Interests Chloroformed Congress and Cost America's Investors Trillions William S. Lerach of MILBERG WEISS BERSHAD HYNES & LERACH LLP.
R. W. Pfouts (1967). “Artistic Goals, Scientific Method and Economics Author(s)” Southern Economic Journal. Vol. 33, No. 4: 457-467
Zensky and Sorkin. (2008). “State Rico and the PSLRA”. The National Law Journal. March 31st.
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