Showing a picture of a star NFL player or a world class skier in their sports gear, the commercial begins by identifying the athlete as pure aggression. The athlete then raises his or her arms and the gear is removed. Each is dressed in fine evening clothes, the football player in an expensive looking suit and tie, the skier in an elegant evening gown. Like the automobile of the company sponsoring the advertisement, the athletes are now beautiful. The message is that aggression is still there, you just cannot see it through the “pretty.”
In the aftermath of the market crisis one of the critical causes tied to its origin is a lack of transparency. Investors and the markets could not see the huge risks being taken by firms, the fault lines in the esoteric products being sold as the next great investment vehicle or the conflicts of interest on which those products were built.
Congress reacted by writing over two thousand pages of new legislation. Lawmakers directed agencies such as the SEC and the CFTC to write hundreds of new regulations and conduct numerous studies which might form the predicate for additional legislation and rules. A major point is to bring sunshine to previously dark corners of the securities business along with oversight.
It is undoubtedly too early to reach final conclusions about the impact of the new legislation and rules. Two examples, however, offer some insight into the question.
One is the Volker rule. The idea was simple: Delimit proprietary trading by financial institutions because of the risks. The proposed rule is not so simple. It is hundreds of pages of legalize which approaches being unreadable, unknowable and unusable. If the point is to eliminate all trading by obfuscation, the rule may be successful. If the point is to permit all trading because enforcement of the rule is impossible, it may also be a success.
A second is “window dressing” which presents even more critical questions. This is a practice identified by the Lehman trustee in his discussion of the so-called “Repo 105” transactions. They are period end transactions undertaken to make the numbers reported to investors and the market look pretty, like redressing the athletes. The clothes do not change the athletes. They are just seen differently. The period end transactions do not change the financial condition of the company. Shareholders and the markets just do not see the actual financial condition of the company.
The Lehman trustee flagged the Repo 105 transactions for enforcement officials. No enforcement actions have been brought. Rather, the SEC took a survey with a “Dear CFO letter” to analyze the practice. Months later the Commission wrote a new rule requiring more disclosure. It has yet to take effect.
Now reports have surfaced that MF Global, the trading firm which collapsed into bankruptcy last week, was not only heavily leveraged at 34 to 1 but also repeatedly dressing its period numbers, according to the Wall Street Journal. The pretty numbers undoubtedly looked better to investors and the markets, like the football play and the skier. Investigators will determine if those numbers were what the owners of the business should have seen.
These examples suggest a fundamental flaw in the approach to the market crisis. Before a maze of rules is written there should be some analysis of whether those on the books are adequate and have been effectively enforced. If new rules are written they should be clear and enforceable. In the case of the Volker Rule no doubt existing rules did not delimit proprietary trading. The proposed rule however is anything but clear and may well be unenforceable. In that case it is no rule at all.
Whether the window dressing rule is required is at best questionable. The Exchange Act reporting requirements and the antifraud provisions of the securities laws appear to give the Commission all the tools it needs to prevent management from not telling shareholders the truth. Those provisions require management to tell investors the true financial condition of the company. The management discussion and analysis section, for example, requires management to put the investor in the shoes of the corporate insider and show that investor the important cash flows of the company. Nothing in those provisions says “make the financial results pretty.” While the additional disclosure the new window dressing rule requires may be useful, the Commission has all the tools it needs on the books and in effect to solve the problem of “window dressing.”
In the end, more and more rules will not necessarily solve the problems that caused the market crisis. What is critical is that the rules on the books are properly enforced through a national enforcement program that has been carefully crafted to effectuate the goals of the federal securities laws. This means that enforcement investigations and cases are more than just another inquiry or law suit. The DOJ brings individual criminal cases which are resolved on an individual basis, not a part of a program. In contrast the goal of the SEC’s enforcement program is to bring a new ethics to the market place. While the program is a collection of individual investigations and cases they are more than that, they are part of a program.
The ultimate success of Dodd-Frank and all the new rules being written may well not be known for years. What is clear, however, is that before more rules are rolled out, there should be a careful evaluation of those already on the books. What is critical is that the statutes and rules on the books be effectively enforced, not just written over in a blizzard of new regulations. More rules will not by themselves prevent another market crisis. Effective enforcement as part of a carefully fashioned program and new rules when necessary that are clearly written and enforced can help achieve that goal.