5 Regulation and operation of the exchanges
5.2 Role of a regulatory authority
Topmost in the list of functions of a regulatory authority is that it: establishes guidelines and rules of prudential supervision based on existing laws; licenses the different players who operate in the environment under its jurisdiction and revokes their licenses when
they misbehave; and ensures that all operations in the securities exchange business comply with laws and rules and applies penalties when they do not. A regulatory authority does this in order to:
Ensure an orderly market,
Indirectly protect the investors, and
Avoid systemic risk due to big financial failures.
A regulatory authority does not necessarily decide whether or not a company is finan- cially sound. It simply ensures that everything is disclosed in the proper manner, and that financial statements are reliable. Also, it ensures that there is transparency in the exchange, thereby permitting investors to make learned decisions. This is the meaning of indirect protection previously referred to.
A critical issue connected with regulation and supervision is whether the entity to which this responsibility has been assigned has the authority necessary to take immediate corrective action. A case in point isRegulation T. Theoretically, US law does not allow bankers to lend money that will be used for purchase of stock. Regulation T deals with this issue. However, this is one of the laws that are not being enforced – even if its enforcement is important for reasons of:
Curtailing equity speculation, Avoiding booms and busts, and
Assuring better control of the expansion of credit.
In terms of law enforcement, the penalization of insider trading has been more success- ful. Board members, executive directors and other insiders have been prosecuted by the SEC for this reason. The financial press publishes lots of information oncorporate insider activity, which essentially profits some people who buy or sell shares at the expense of the other investors.
When we talk of the role of a regulatory authority it is important to keep in mind that several players in stock exchanges are not inclined to respect the law, particularly when major market events take place. In July 2001, for example, insider sales have exceeded purchases by a four-to-one ratio. Such a preponderance of selling was influenced by the bear market and it is presumed to have had negative implications for:
The performance of listed companies, and
The fortune of all types of investors who trusted them by purchasing their stock.
Moreover, while insider buying is typically done because insiders have information which provides them with an optimistic outlook for the company and its stock, insider selling can be done for reasons other than just a negative outlook. Reasons other than negative outlook are diversification by purchasing non-financial assets, end of a lock-up period on an IPO, and so on.
One way for regulatory authorities to establish a level ground for market players is to look whether investors have been oversold risky issue, because they do not understand the risks they are assuming. As an example, in late August 1998 Merrill Lynch agreed to pay a $2 million penalty for its part in the 1994 bankruptcy of Orange County. This
specific penalty has been over and above a prior $400 million settlement by Merrill Lynch to Orange County in compensation for huge losses suffered by collateralized mortgage obligations (CMOs) sold to it by the broker:
The SEC accused the broker of negligence for failing to warn the investor of the risks.
Merrill Lynch agreed to both payments while denied wrongdoing.1
Since 1995, the SEC has imposed billions in fines on different parties, but half of this money has never been collected. The better managed firms and speculators who care to clear their name usually pay up. Michael Milken paid $450 million in fines, the largest bill paid by any person so far. Others, however, chose to go bankrupt, exploiting loopholes in the law.
The largest ever Wall Street settlement, at least so far, came on 28 April 2003, in the aftermath of findings of fraud with associated penalties and disgorgements to the tune of nearly $1.4 billion. Announcing the settlement, William Donaldson, chairman of the SEC, himself a former investment banker, said ‘I am profoundly saddened – and angry – about the conduct that’s alleged in our complaints. There is absolutely no place for it in our markets, and it cannot be tolerated.’2
That behavior which made Donaldson saddened and angry was widely tolerated during the boom years of the late 1990s and beyond, and such tolerance allowed banks and hedge funds to behave as if they were unaware of legal risk involved in their acts. Table 5.1, which shows the parties in this settlement, shows how wide the misbehavior of well-known financial institutions has been.
Usually, the SEC does a fairly good job within the confines of its charter, but its charter does not include the supervision of all US financial institutions. Neither is it like that of the Federal Reserve and of the Controller of the Currency (OCC) in
Penalty Disgorgement Independent research
Inventor education
Total
Citigroup 150.0 150.0 75.0 25.0 400.0
Crédit Suisse First Boston 75.0 75.0 50.0 0.0 200.0
Merrill Lynch 100.01 0.0 75.0 25.0 200.0
Morgan Stanley 25.0 25.0 75.0 0.0 125.0
Goldman Sachs 25.0 25.0 50.0 10.0 110.0
Bear Stearns 25.0 25.0 25.0 5.0 80.0
JP Morgan 25.0 25.0 25.0 5.0 80.0
Lehman Brothers 25.0 25.0 25.0 5.0 80.0
UBS Warburg 25.0 25.0 25.0 5.0 80.0
Piper Jaffray 12.5 12.5 7.5 0.0 32.5
Total 487.5 387.5 432.5 80.0 1387.5
Note:
1 Payment made prior to April 2003 settlement.
Table 5.1The 28 April 2003 settlement with Wall Street firms (in $ millions, in order of importance)
terms of power of inspection of credit institutions. There is a gap in the US regulatory armory because the Fed’s and the OCC’s examiners have no mandate for inspecting non-banks, like hedge funds. The Commodities Futures Trading Commission (CFTC) might have had such a mandate if Congress had not clipped its wings.3
One of the regulatory domains where LTCM, Enron, Global Crossing, Adelphia, WorldCom and their like have much in common is the lack of a safety net to com- pensate the financially weak victims of hedge funds and credit institutions, or even industrial companies (see Chapter 15 on Parmalat) acting as hedge funds. The best example of what I mean is the FDIC, which guarantees deposits of up to $100 000 per person, thereby providing a safety net.
Small investors and employees who were victims of CEO malfeasance were right when they said that they would like to see former Enron chairman Kenneth L. Lay, former CEO Jeffrey Skilling, former CFO Andrew Fastow, members of Enron’s Audit Committee, other top officials of Enron, and the partners at Arthur Andersen and Vinson & Elkins, personally repay the financial losses they had created. But this type of action regarding investor compensation because of senior management malfeasance,
Is not part of the charter of regulators and supervisors,
Yet there are stakeholders of failed companies who received a triple hit as employees, investors and pensioners.
Deprived of direct protection under the Securities Exchange Act of 1934, investors suffering from senior management malfeasance resort to class actions. On 8 April 2002, four months after the fall of Enron, nine big banks and two law firms were added to a class-action lawsuit against Enron that alleged that they had helped Enron defraud shareholders.
This 485-page complaint named J.P. Morgan Chase, Citigroup, Merrill Lynch, CSFB, Canadian Imperial Bank of Commerce (CIBC), Bank of America, Barclays Bank, Deutsche Bank and Lehman Brothers as key defendants. The target of this class action was a series of allegedly fraudulent transactions, creating a ‘mythical picture’
of Enron’s profitability.
Through information from Congressional hearings and press reports, investors par- ticipating in these actions established that several of the aforementioned banks took stakes in off balance sheet partnerships created by the energy company’s chief finance officer (CFO), that helped Enron to hide debt. In the aftermath, Enron produced under- writing files on debt issues sold to the public, showing that its finances were sound, while senior management seemed to know otherwise.4In the ensuing years, these meth- ods and tools of creative accounting and investor deception have been ‘improved’, as we will see in Chapter 15 with the case study on Parmalat.