SM Blogwatch

Yesterday, a legal writing instructor reminded me of this infamous post, in which I suggested that Dean Erwin Chemerinsky avoid creating a "legal writing program, moot court competitions, student-edited law reviews, clinics, or any other co-curricular offerings." That's a post I should have written backwards. The conclusion was premised on the idea that U.S. law schools would be migrating to two-year programs, an idea that seemed somewhat ridiculous at the time of my post (despite a couple of existing programs at Southwestern and Dayton), but gained some traction this past summer when Northwestern University Law School announced plans to "begin offering students a chance to get a law degree in two years instead of the traditional three."

As fate would have it, Austen Parrish just posted on this topic at PrawfsBlawg. Like most commentators, Austen is cautiously open to the idea, but he set me to thinking about the curricular innovations at Stanford. I blogged about Dean Larry Kramer's views on the first year of law school here, but what about the last two years? Dean Kramer: "Law schools have traditionally taught one thing: how to think like a lawyer... [Most students learn to think like lawyers in the first year of school, meaning] it's the second and third year where we are pretty much failing our students."

So if the first year of legal education is about building blocks, what should happen in the last two years? Again, Dean Kramer from a 2006 announcement of his ambition for curricular reform:

Lawyers need to be educated more broadly with courses beyond the traditional law school curriculum if they are to serve their clients and society well.

Business, medicine, government, education, science, and technology have all grown immensely more specialized, Kramer said. Legal education must adapt. How can a lawyer truly comprehend and grapple with a complex intellectual property dispute without understanding anything about the technology at issue? What counselor can effectively advise a client about investing in China or India without understanding their particular legal structures, to say nothing of their different cultural expectations and norms?

To serve clients capably or address major social and political issues, lawyers now must work in cross-disciplinary/cross-professional teams, particularly given that they work in increasingly sophisticated industries and fields engineering, medicine, biotech, the environment. They must also practice law in a global context. Where only a tiny number of graduates used to practice law across national borders, today only a tiny number do not, Kramer noted. International law, particularly the law governing private actors in the international arena, has gone from the periphery to the center, and law schools have been scrambling to adapt.

Although lawyers were historically called upon (and trained) mainly to identify problems, they are increasingly being called upon to help solve them. To do this, especially in a world where the problems have grown more intricate, lawyers need to understand what their clients do at a much more sophisticated level than can be taught through the existing law school curriculum or in the traditional law school classroom.

This is an inspiring pitch, though the current SLS website does not suggest the implementation of revolutionary reforms (see here on the popularity of Stanford's joint programs). Yet. My guess is that wholesale reform of the later years of law school is not much easier than reforms of the first year. Inertia is a powerful constraint.

Even if Dean Kramer's managed to implement his aspiration, would Stanford "provide a model for legal education generally," as the 2006 announcement suggests. Or is "Stanford Law School is in a unique position among law schools to broaden the curriculum because of the concentration of top rated graduate programs on one campus"? Hmm.

The big reforms in legal education over the past several decades actually provide substantial evidence of the difficulties faced by reformers. The biggest reforms have involved the creation of clinics or other additions of professional ("skills") faculty, which suggests to me that it's much easier for tenured faculty to outsource reform than to create it from within. The result, as I observed in the comments to the infamous post, is the replication of the "old apprenticeship model of legal training, except that it occurs in a law school rather than in a lawyer's office." The discussion over there contained this penultimate comment from Ray Ward, who took the time to read and understand my views:

I know you don't denigrate those skills; you just think that teaching them should be someone else's job. A reasonable person might agree that it doesn't matter where the students learn the skills, as long as they learn them. The trouble is that the "someone else" who would teach those skills doesn't exist. So if law schools don't teach them, then they won't get taught.

So we have three models of the new law school: (1) the current trend favors a three-year law school with substantial skills training, especially in the third year; (2) the two-year law school that focuses on classroom instruction is still limited to a few schools; and (3) the three-year law school that follows Dean Kramer's model of interdisciplinary training, which no one has implemented and most schools would not be able to implement, given other institutional constraints.

Where is your money?

Remember my September 14 post about the impending financial crisis leading to a reshaping our regulatory system? When I suggested that we would someday be comparing the regulatory reforms to the New Deal, some people scoffed. The same thing happened to me a month later (this time via email, so I can't link to it), when I was quoted in the National Law Journal with the following:

What Delaware should be most worried about is if people begin to associate the financial crisis with executive misconduct. If people really believe this crisis was caused by greed or failure of oversight, well, Delaware, by and large, regulates those through its fiduciary law.

A very prominent corporate lawyer emailed: "I think this angle on the crisis is ridiculous and trivial." He was speaking normatively, not descriptively, and as noted in my post on the subject, I agree. The case against Delaware is weak. Nevertheless, "I am not so sanguine about Congress' ability to craft an appropriate regulatory response or to refrain from messing with Delaware."

Now comes this from the W$J:

The lesson of Enron is, sadly, that there are no lessons.

Less than seven years ago, federal prosecutors began pouncing on the fallen energy company, eventually convicting 22 employees. When Chairman Kenneth Lay and Chief Executive Jeffrey Skilling were finally convicted in May 2006, House Financial Services Committee member Michael Oxley crowed that "justice has been served" and that the "entire debacle" had reinforced executives' duties to public corporations.

Today's financial crisis has shown what a real debacle looks like. And it has made clear that executives' duties to public companies have, if anything, been loosened, not reinforced. What is worse, the post-Enron crackdown appears not only to have failed to stop flagrant corporate risk-taking, but to have lulled Washington to sleep.

The article quotes Larry Ribstein, who certainly doesn't have it in for Delaware, but the larger point is the one I was making to the NLJ: the debate over the legacy of the financial crisis has begun, and fiduciary duties are on the table.

One of the topics discussed several times at last week's Tackling Your 2009 Compensation Disclosures: The 3rd Annual Proxy Disclosure Conference and the 5th Annual Executive Compensation Conference was pledging of securities by executives, typically done under margin arrangements. A NY Times article from last week was among the latest media reports to note the rise in insider sales of securities necessary to satisfy margin requirements. The article notes the inadequacy of disclosure regarding pledged securities, despite the fact that the SEC specifically required disclosure of pledged shares in the Beneficial Ownership Table when it adopted the 2006 amendments to the executive compensation disclosure requirements.

Volatility in the stock market will continue to drive this trend along with all of its potential pitfalls for executives and their companies. Because company stock may be pledged as collateral for margin on an account where an executive maintains a more diversified portfolio of securities, broad market swings can result in margin calls and the forced liquidation of company securities even in situations where the company's share price remains relatively stable. Unfortunately, this issue may often be a blind spot in company policies on stock ownership, insider trading, codes of conduct, etc. As a result, many companies will need to re-examine this issue in light of the current turmoil - and before year-end - so that any necessary changes can be highlighted in the Compensation Discussion & Analysis for the 2009 proxy statement.

Look for more on this critical topic in the upcoming issue of The Corporate Executive. If you aren't a subscriber to The Corporate Executive, take advantage of a "Rest of '08 for Free" no-risk trial. If you are a current subscriber, be sure to renew for '09 since all subscriptions are on a calendar-year basis.

A Banner Year for SEC Enforcement?

Last week, the SEC announced that the agency had the second highest number of enforcement actions take place in fiscal 2008, with 671 actions brought through the September 30, 2008 end of the fiscal year. The glowing press release notes that the SEC brought the highest number ever of insider trading cases during fiscal 2008, as well as a sharp increase in the number of market manipulation cases. The press release also notes the obvious uptick in Foreign Corrupt Practices Act cases, with 15 such cases filed in 2008 and a total of 38 FCPA cases brought since January 2006. Interestingly, the press release does not note how many cases the agency brought to suspend trading in and/or revoke the registration of delinquent filers, which has been a significant focus (in terms of the number of cases) over the past few years. The SEC notes that, for a second year in a row, more than $1 billion was returned to harmed investors through Fair Funds distributions.

The Division of Enforcement and the Commission's attitude toward Enforcement matters have been under quite a lot of scrutiny recently, so it is good to still see these impressive numbers. While much might be made of the mix of cases that the SEC has brought (i.e., too much insider trading and not enough accounting fraud), it is important to keep in mind that priorities change over time and the agency always has to make due with its limited resources by focusing its enforcement efforts. Further, the Enforcement process even with the many improvements made in recent years remains relatively slow and will lag to a great extent the issues that are in the immediate public consciousness. All in all, these results should be taken as a positive sign that the SEC remains on the beat.

Unfortunately, the same might not be said for the FBI in its efforts to investigate financial fraud. This NY Times article notes that the FBI's staff of white collar investigators shrank as the agency's role shifted toward terrorism and intelligence. Most disturbing is the possibility that the shrinking ranks of white collar investigators may have thwarted efforts to investigate financial fraud occurring in the housing market in 2003 and 2004, when perhaps the criminal authorities could have made a real difference in how the financial crisis ultimately played out.

PCAOB Proposes Audit Risk Standards

Last week, the Public Company Accounting Oversight Board announced seven proposed auditing standards relating to the auditor's assessment of and responses to risk. The PCAOB notes that these proposed standards would supersede the interim auditing standards related to audit risk and materiality, audit planning and supervision, consideration of internal control in an audit of financial statements, audit evidence, and performing tests of accounts and disclosures before year end. These new standards are all built around the concept of audit risk, which is the risk that an auditor will express an inappropriate opinion when financial statements are materially misstated. The titles of the proposed standards are:

- Audit Risk in an Audit of Financial Statements
- Audit Planning and Supervision
- Identifying and Assessing Risks of Material Misstatement
- The Auditor's Responses to the Risks of Material Misstatement
- Evaluating Audit Results
- Consideration of Materiality in Planning and Performing an Audit
- Audit Evidence

The proposals are out for a generous 120-day comment period, ending February 18, 2009.

Now that the Treasury Department has decided to let banks announce when the Treasury Department has decided to pony up money, banks are falling over themselves to issue press releases announcing the news.

The funny thing - depending on your sense of humor - is that most of the press releases sound as if they were written by the same exact person, because many of them sound as if they were doing Treasury, and by extension, the American public, a favor by taking the money. Take this one from SunTrust (STI), which announced yesterday morning that it had received preliminary approval to sell $3.5 billion in preferred stock to Treasury.

Our participation in the Capital Purchase Program enhances SunTrust's already solid capital position and will permit us to further expand our business and take advantage of growth opportunities, said James M. Wells III, Chairman, President and CEO. In addition, we are pleased to support the Treasury in its ongoing effort to address dislocations in financial markets and spur the market stabilization that is in the public interest.

But we don't mean to pick on SunTrust. NorthernTrust (NTRI) put out a press release yesterday to announce its $1.5 billion infusion because it "fully supports the U.S. government's efforts to strengthen our nation's financial system." There's also this one from Valley National (VLY): "Although Valley is a well-capitalized organization, we believe such a program provides an excellent opportunity for healthy strong banks like Valley to participate in and support the recovery of the U.S. economy". Even relatively small banks seem to be on message, like First Niagara (FNFG) which said in its press release yesterday, "We are supportive of the Treasury Department's efforts and remain strongly committed to supporting the economy in Upstate New York.

How patriotic of these banks! How selfless! It almost makes you want to burst into the Star Spangled Banner or go out and buy Liberty Bonds or something.

(Editor's Note: This post comes to us from Lauren Cohen and Christopher Malloy of the Harvard Business School, and Andrea Frazzini of the Graduate School of Business at the University of Chicago)

In our recent working paper entitled Hiring Cheerleaders: Board Appointments Of "Independent" Directors, we test the hypothesis that boards appoint independent directors who, while technically independent according to regulatory definitions, nonetheless may be overly sympathetic to management. Rather than adopting the typical approach in the literature, which seeks to relate measures of board independence (e.g., increases in the number of independent directors on a board) to future performance of the firm, we investigate a subset of independent directors for whom we have detailed, micro-level data on their views regarding the firm prior to being appointed to the board. We use these track records to compare the roles of optimism (i.e., hiring a cheerleader for management) versus skill (i.e., hiring an objective and able observer) in the board appointment process.

The agents we examine are former sell-side analysts who end up serving on the board of companies they previously covered. Unlike former CEOs or other senior executives who sometimes end up on corporate boards, for whom past performance attribution is complicated by the fact that firm performance is difficult to disentangle from individual performance, sell-side analysts can be easily assessed. We can explicitly compute measures of skill/ability and optimism by examining the composition and stock return performance of analysts' past buy/sell recommendations, coupled with the accuracy of their earnings forecasts. In doing so we find evidence that boards appoint overly optimistic analysts who exhibit little in the way of skill in terms of evaluating the firm itself, other firms within the firm's industry, or other firms in general. In particular, board-appointed analysts issue significantly more positive recommendations on companies for whom they end up on the board of directors; both relative to the other stocks they cover, and relative to other analysts covering these stocks. The magnitude of this result is large: 80.4% of these recommendations are strong-buy or buy recommendations, compared to 56.9% for all other analyst recommendations. By contrast, we find little evidence that board-appointed analysts' recommendations are more profitable, or that their earnings forecasts are more accurate. Finally, when predicting the probability of a board appointment, optimism on the firm is a strong predictor of appointment while accuracy is not. Taken together, these results challenge the conventional view that appointing independent directors necessarily adds objectivity to the board of a firm.

The full paper is available for download here.

I've been saying for a long time (see, e.g., my Corporate Crime and Enron archives) that the wave of corporate crime prosecutions following Enron, and particularly the Enron prosecution itself, were unfair, ineffective and counterproductive. The criminal law is wholly inappropriate for disciplining managerial agency costs, including disclosure violations. We're likely to end up with some very close cases, pursued at enormous direct costs, and the even larger indirect cost of precluding a constructive effort to figure out what happened.

Dennis Berman makes these points in today's WSJ:

Those looking for retribution against the executives of failed companies will quickly see that prosecutions won't come easy. The law gives executives wide latitude to run their business, no matter how terrible their decisions. And even convictions would seem an incomplete conclusion given that a system political and regulatory also failed the public.

Berman reviews potential criminal cases involving Lehman. As he quotes me in the article:

These are necessarily going to be very close cases," said University of Illinois law professor Larry Ribstein, a critic of some Enron prosecutions. Should Mr. Fuld "err on the side of panic, or state the risk pessimistically, he's got a full-scale bank run. If he gets optimistic, it's bordering on fraud."

Berman concludes:

It has been just 2,282 days since Sarbanes-Oxley was signed into law. Today, "we need to figure out root causes and get at them," Mr. Ribstein said. "We could go through all this and have no assurance the same thing won't happen again."

The question now: have we learned anything from Enron?

It's always nice to take a counterintuitive approach. Doing so will often attract attention and may sometimes even be right. With that in mind, we noticed the editorial by Charles Calomiris, a professor at the Columbia Business School, who contends that in fact, repealing Glass Steagall was, according to an editorial in the WSJ, a good thing. According to his rational:

Wasn't the ability for commercial and investment banks to merge (the result of the 1999 Gramm-Leach-Bliley Act, which repealed part of the 1933 Glass-Steagall Act) a major stabilizer to the financial system this past year? Indeed, it allowed Bear Stearns and Merrill Lynch to be acquired by J.P. Morgan Chase and Bank of America, and allowed Goldman Sachs and Morgan Stanley to convert to bank holding companies to help shore up their positions during the mid-September bear runs on their stocks.

The comment is accurate as far as it goes. But isn't it like saying that we should build ships from Styrofoam so that when they sink, drowing passengers will have something to hold onto? Repealing Glass-Steagall, as we have noted (The "Great Fall": The Consequences of Repealing the Glass-Steagall Act), spelled the death knell for independent investment banking firms, something that will ultimately harm US financial markets. Moreover, in the interim, the repeal did nothing to help stabilize the industry during a period of financial turmoil, as the last few months have shown. No matter how you spin it, the legislation repealing Glass Steagall was a mistake.

The First Circuit Court of Appeals affirmed a grant of summary judgment in favor of the SEC in a fraud action based on market timing in SEC v. Ficken, Case No. 07-2532 (1st Cir. Oct. 20, 2008). The Commission's complaint claimed that Justin Ficken, a registered representative in the Boston branch office of Prudential Securities, Inc., intentionally and fraudulently concealed his identity and that of his clients while trading in and out of mutual fund shares in order to mislead the fund companies so they would process trades that they otherwise would not have allowed under their established policies.

The District Court granted summary judgment in favor of the Commission. That ruling was based on the SEC's evidence which demonstrated that Mr. Ficken sought to circumvent fund policies prohibiting market timing by using multiple financial advisor numbers which identify the broker placing the trade and multiple client numbers so that the funds would not discover his identity and would process the trades.

On appeal Mr. Ficken did not dispute the fact that the SEC had substantial evidence. Rather, he argued that there was a dispute of material fact which precluded granting summary judgment under Fed. Civ. R. 56. The First Circuit rejected this argument and affirmed the district court.

The Court began its opinion by acknowledging that "[a]lthough it is unusual to grant summary judgment on scienter, summary judgment on this issue is sometimes appropriate." Here the Commission submitted substantial evidence to support its claim of scienter and deception as defendant acknowledged. This evidence included e-mails from defendant to his clients which noted that he was trying to evade fund policies on market timing through the use of multiple FA and client numbers.

In considering Mr. Ficken's evidence, the Court acknowledged that it "might raise a genuine issue as to scienter with respect to the FA numbers . " but declined to consider it for two reasons. First, the Court rejected Mr. Ficken's reliance on his testimony before the SEC during its investigation. In that testimony he stated that multiple FA numbers were used to facilitate splitting commissions with other brokers. The court refused to consider this testimony in evaluating the merits of the summary judgment motion because in the district court it was only offered to explain the reason defendant declined to give a deposition in the district court, not to oppose summary judgment. Since Federal Rule 56(e) and Local Rule 56.1 require a party opposing summary judgment to refer to specific parts of the record to raise a genuine issue of material fact, the Court declined to consider the testimony.

The Court also declined to consider segments from defendant's testimony before the NASD. In that testimony Mr. Ficken answered some questions but not others about blocked accounts, invoking his Fifth Amendment privilege. The Court concluded that this testimony could not be considered because it is inadmissible hearsay. According it failed to meet the requirements of Fed. Civ. R 56(a)(1) which requires that supporting affidavits set out facts which would be admissible in evidence. And, in any event, "Ficken's testimony would not be admissible because his assertion of his Fifth Amendment privilege or his refusal to answer questions prevented development of his testimony on closely related issues."