Crony Commentarism

The FLUBA Committee for Krugman Early Warning Alerts (KEWA) notes the nomination of California Congressman Chris Cox to head the SEC is already the source for a Semi-Daily Journal post. Krugman having the day off, Stephen Labaton runs the first leg of the relay for him:

Bush S.E.C. Pick Is Seen as Friend to Corporations

....Mr. Cox - a devoted student of Ayn Rand, the high priestess of unfettered capitalism - has a long record in the House of promoting the agenda of business interests that are a cornerstone of the Republican Party's political and financial support.

A major recipient of contributions from business groups, the accounting profession and Silicon Valley, he has fought against accounting rules that would give less favorable treatment to corporate mergers and executive stock options. He opposes taxes on dividends and capital gains.

And he helped to steer through the House a bill making investor lawsuits more difficult.

That last sentence is a flat out denial of reality as a visit to this Stanford website will show. For the five years preceding the Private Securities Litigation Reform Act of 1995 (PSLRA) Bill Lerach and other securities litigation experts filed an average of 190 such class action lawsuits, with the high being 231 in 1994. For the five years following passage, the average was 187, with a high of 241 in 1998.

Then the fun began. The numbers being: 493 in 2001, 272 in '02, 219 in '03, and 237 in '04.

In addition the dollar settlements to these cases have tripled.

This legislation was bi-partisan, with Joe Lieberman and Chris Dodd championing it in the Senate. Bill Clinton vetoed it as a sop to his trial lawyer campaign contributors, and Congress overrode his veto.

What the Act did was require that a securities lawsuit have a particular rationale behind it, rather than merely be filed because the price of a share of stock of a corporation had declined. Which had been the law prior to 1988:

Prior to 1988, shareholders had to demonstrate the specific information they relied on was fraudulent and specify the losses they incurred as a result of their reliance on that information. That was until the Supreme Court decision re: Basic v. Levinson, a case which centered on corporate disclosure obligations during pre-merger negotiations and the truth of those statements.

In that decision the Court embraced a concept called 'fraud on the market', saying that financial analysts played a key role in gathering and interpreting information from a company and that information was ultimately reflected in the company's stock price. In effect, the Court said that investors, in order to participate in class action cases, did not have to demonstrate reliance on specific corporate information but need only rely on the stock price.

This opened the gates for securities class action suits to be filed on the basis of a precipitous drop in stock price (usually in the 10% range or more) as preliminary evidence that the company had provided fraudulent information to investors. The allegation was usually that the company made optimistic public statements and knew the statements were incorrect or the statements had became invalid and the company failed to publicly correct or update them.

Since the drop in stock price became the trigger, plaintiffs' attorneys, particularly those firms specializing in these suits, would file within hours of a precipitous drop in stock price, making general allegations of fraud with the expectation that they could later prove fraud during the discovery process. Also, allegations of insider trading were usually thrown in whereby the plaintiffs hoped to show, also during discovery, that key executives traded on the knowledge that the stock was worth less than what was reflected in the market.

Moreover, these firms had stables of professional plaintiffs who owned a few shares in a number of companies and would lend their names to be used, often without their immediate knowledge, as the named class plaintiff. Moreover, they were often paid a bounty for the use of their name. These were suits initiated by plaintiffs' attorneys for the benefit of plaintiffs' attorneys. It was also important to be the first to file since the lead attorney received more of the settlement fees than the lawyers who subsequently filed on behalf of their plaintiffs.

Easy to see why Clinton's donors didn't want their cash cow messed with.

But the funniest thing about this molehill sized mountain is that both Paul Krugman (NY Times February 1, 2002) and Ben Stein went for the trial lawyers' hook, line and sinker. Krugman's rewrite of the talking points memo being:

Once upon a time, the threat of lawsuits hung over companies and auditors that engaged in sharp accounting practices. But in 1995 Congress, overriding a veto by Bill Clinton, passed the Private Securities Litigation Reform Act, which made such suits far more difficult. Soon accounting firms, the companies they audited and the investment banks that sold their stock got very cozy indeed.

His normally bitter adversary Stein, saying:

In the late 1980s and early 1990s, as a result of a mass of securities frauds in Silicon Valley and in the Drexel Milken world and in the S&L’s, there were hundreds of securities law private class action suits against managers, directors, lawyers, and accountants. The recoveries in these cases were in the tens of billions. The accountants were called to account and hated it. Their insurers on their malpractice policies hated the suits. So did Silicon Valley.

The defendants did a smart cost-benefit analysis. They figured out that they would be better off if they got new laws to hinder lawsuits against them than if they actually went to the immense trouble of doing their work properly. It was far cheaper to pay campaign contributions to Congress than to forgo their freewheeling ways. So money was paid, promises were made, and the law was changed in 1995. The Private Securities Litigation Reform Act, possibly the most anti-capitalism law ever passed in Congress since the New Deal, greatly cut down on the rights of shareholders. Powerful restraints were put in place about discovery, who could sue, who could represent shareholders (and sometimes bondholders), and how one would prove a case against malfeasors of great wealth, as one might say. The ability of shareholders to keep control over their own capital and their own managers was greatly hindered.