U.C.L.A. law professor Stephen Bainbridge is one of America’s leading experts in the area of corporate and securities law, and he has long been generous in sharing his expertise on those subjects and others on his popular ProfessorBainbride.com weblog. Professor Bainbridge is also a formidable writer who is particularly gifted in breaking down complex legal issues in a simple and straightforward manner.
In this TCS Central op-ed (his blog post on the article is here), Professor Bainbridge takes dead aim at the dubious governmental policy of criminalizing business interests through the prosecution of agency costs, which are essentially the costs of poor corporate governance. The entire op-ed is a must read, and here is the money quote:

[S]hareholders deserve protection from theft, but not from risk taking, even when the risk in question is how much to pay an executive. Unfortunately, it’s not clear that prosecutors know the difference — or even care.

During the recent trial of former Tyco CEO Dennis Kozlowski, I noted here and here that the cross-examination of Mr. Kozlowski did not go well for the defense.
Consistent with that theme, this Wall Street Journal ($) article reports today that Mr. Kozlowski — who essentially was convicted of embezzling excess compensation from Tyco — wrote this letter several years ago to a Houston assistant district attorney in which he requests that the prosecutor seek the maximum prison term for a former executive of a Tyco unit who had been found guilty in a Houston state court for — you guessed it — embezzlement.
In his letter, Mr. Kozlowski wrote that the former Tyco unit executive’s crime “cannot be condoned in any manner” and that “not only did he steal from the stockholders … but he breached the fiduciary duty placed in him.” In advocating the “maximum term,” Mr. Kozlowski noted that the court needed to send a message that “wrongdoing of this nature against society is considered a grave matter.”
The former Tyco unit executive got 20 years, although he was paroled after four.

U.S. District Judge Karon O. Bowdre today appointed an alternate juror to replace a male juror suffering from “recurring health problems” during jury deliberations in the corporate-fraud trial of former HealthSouth Corp. CEO Richard M. Scrushy (a previous post on the trial is here). With that move, the judge proceeded to instruct the jury that it would have to start over in its deliberations toward a verdict on the 36 criminal counts against Mr. Scrushy.
This development probably went over about as well as the proverbial turd in the punchbowl with the Scrushy jurors, who have been deliberating on the case since May 19 after enduring a trial that began on January 25.
The 36 counts against Mr. Scrushy include conspiracy, fraud, false statements and one count of false certification under the Sarbanes-Oxley Act. Mr. Scrushy used the “honest idiot” defense during the trial, contending that the finance executives at the company who engineered the fraud hid it from him.

Two columns in today’s Wall Street Journal address one of the too little-discussed effects of this post-Enron era’s criminalization of business — that is, the chilling of beneficial risk-taking.

In his weekly WSJ ($) column, Alan Murray examines the motives of former AIG chairman and CEO Maurice “Hank” Greenberg to arrange the structured finance “finite risk” insurance transation that is at the heart of Eliot Spitzer’s lawsuit and public allegations that Mr. Greenberg engaged in fraud while at AIG.

According to Mr. Spitzer’s theory of the case, the deal allegedly involved a phony, risk-free swap of insurance assets that allowed AIG to boost short-term reserves and assuage the concerns of analysts, who had been fretting that AIG was drawing down its loss reserves to boost profits. In return, the company paid Berkshire Hathaway’s General Reinsurance Corp. unit a fee of $5 million.

Mr. Murray’s column dismisses Mr. Spitzer’s contention that Mr. Greenberg’s arrangement of the questionable transaction was motivated purely by the Mr. Greenberg’s greed in propping up the value of his extensive AIG equity holdings. Rather, Mr. Murray focuses more on Mr. Greenberg’s obsession with short-term results over taking a longer term view of AIG’s financial health.

However, the more interesting question is whether it makes any sense for the government to criminalize taking the risk of financial transactions that may push the edge of the envelope of applicable accounting rules, but that may nevertheless lead to preservation or creation of wealth for equity owners?

Despite the government’s bludgeoning of various AIG and General Re executives into plea deals and the AIG’s board acquiescence to Mr. Spitzer and other governmental investigators, it still has not been proven that the transaction in question in AIG’s case was even accounted for improperly, much less illegal. Should not the government wait to address possible criminality (and its corresponding negative effect on value) until at least the underlying transaction has been proven to be violative of applicable accounting rules?

Meanwhile, in his WSJ ($) column, Holman Jenkins examines how the government’s criminalization of structured finance transactions almost scuttled a market that has turned out to be perfectly legitimate and hugely beneficial for consumers of life insurance — i.e., the business of buying and selling “used” life insurance policies where the buyer of the unwanted insurance policies (such as AIG) buys a life insurance policy from a seller, keeps up the premiums until the seller of the policy dies, and then collects the death benefit. As a result, owners of life insurance now have a legitimate market in which they can liquify their life insurance policy before the insured’s death.

Whether you consider that market ghoulish or not, the market serves a legitimate financial demand of owners of life insurance policies. Nevertheless, as Mr. Jenkins reports, part of Mr. Spitzer’s lawsuit against AIG attempts to penalize the company for its accounting of its investment in that market, and discovery in the lawsuit has already revealed that Mr. Greenberg wrote in a memo that adverse public relations emanating from an investment in the market may outweigh its financial benefit for AIG.

But as Mr. Jenkins points out, Mr. Spitzer’s assault on AIG’s involvement in the market risks damaging a market that is valuable for ordinary citizens and actually a market that government should be encouraging:

Gone are the days when insurance companies were the sole market for policyholders who wanted something to show for decades of paying premiums without having to die first.

Once, these policies might have been allowed to lapse or returned to the company for a minuscule “surrender” payment. But — here’s the peculiar calculation — where the covered person has suffered a health reverse that reduces his or her life expectancy, the real economic value of the death benefit may be far greater than the surrender value, even after the premiums that would have to be paid until he or she finally dies.

Now that institutional investors are buying and selling hundreds of policies at a time, vanished is the specter of an investor seeking to hasten his payoff with a blunt object. Pricing will improve too, as securitization takes advantage of the law of large numbers to remove much of the risk from mortality estimates.

The new securities are expected to appeal particularly to pension funds, always looking for ways to match the maturities of their investments with the timing of their payouts. Thus the recycling of life insurance by older Americans will become, twice over, a way for them to finance their own retirements.

Indeed, Mr. Spitzer’s assault on the “used” life insurance policy market is taking place at the same time as he is hammering the sub-prime mortgage market, another market that benefits ordinary citizens.

Thus, in the wake of the morality plays of Mr. Spitzer and governmental prosecutions involving structured finance transactions that the prosecutors either mischaracterize or do not understand, legitimate and productive business transactions are unfairly and incorrectly portrayed as complex business frauds. The misguided nature of the government and the Enron bankruptcy examiner’s criminalization of many of Enron’s valid structured finance transactions has already been well-chronicled by University of Chicago structured finance expert Christopher Culp and others in the recent books, Corporate Aftershock (Cato 2003) and Risk Transfer (Wiley 2004).

Mr. Spitzer and his minions are eminently capable of misusing the power of the state to deprive citizens of other valuable markets when what they really ought to be doing is encouraging the type of risk-taking that creates valuable markets for citizens such as the one that Mr. Jenkins describes.

This Wall Street Journal ($) article picks up on the theme of this post from late last year — i.e., that the government’s regulation of accounting firms through criminalization of their services is contributing to the shortage of accounting firms that have sufficient resources to provide the specialized services that big companies need:

Intel Corp. is one of the many big companies now bumping up against the limitations. After using Ernst & Young LLP as its auditor for more than three decades, the semiconductor maker considered switching recently for a fresh look at its financials. But it stuck with Ernst after receiving proposals from the other Big Four firms: Deloitte & Touche LLP, KPMG and PricewaterhouseCoopers LLP. That is because federal regulations bar the three other firms from serving as Intel’s independent auditor unless they give up valuation, computer-software and other work they do for Intel.
Worries about the shrinking number of top-tier auditing firms began mounting with the collapse of Arthur Andersen LLP in 2002, after its conviction for obstruction of justice tied to its audits of Enron Corp. (The conviction was reversed last month by the Supreme Court.) The Sarbanes-Oxley corporate-governance act, passed by Congress in response to the accounting scandals at Enron and elsewhere, has complicated the situation, as well, by forbidding auditors from providing certain nonaudit-related services to audit clients. The restrictions, aimed at enhancing the independence of auditors, have led some companies to distribute nonaudit work to the other Big Four firms. But that puts these companies in a bind if they want to switch auditors.

Meanwhile, KPMG is learning that playing nice with the Justice Department may not be all that it’s cracked up to be. As noted here last week, the threat of an indictment has KPMG pursuing a settlement of the government’s criminal investigation into its promotion of tax shelters under a deferred-prosecution agreement. As a part of that effort, KPMG issued a well-publicized admission of wrongdoing and public apology last week regarding its involvement in the tax shelters.
However, as a result KPMG’s public admission, this NY Times article reports KPMG is now a sitting duck for damages in the myriad of civil lawsuits involving the tax shelters and even unrelated accounting issues, and that KPMG’s co-defendants in the tax shelter civil cases are furious over the financial implications to them of KPMG’s public admission of wrongdoing.
All of this is having a devastating effect on KPMG financially. KPMG reported earlier this year that it had revenue of $4.1 billion last fiscal year, but that “practice protection costs” — i.e., insurance, legal fees and litigation settlements — were running at the staggering amount of more than $400 million annually, or more than 10 percent of the firm’s revenue.
Thus, the cost of avoiding an indictment might just cause KPMG to meltdown anyway. At very least, the cost of cooperation will cause substantial financial damage to the firm, resulting in job loss and less competition for audit services for big companies. And let me get this right — this is a “business-friendly” Republican Administration pursuing these policies?