Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

© Prof. Jayanth R. Varma
jrvarma@iima.ac.in

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2005
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Wed, 30 Nov 2005

Validating my RSS feeds causes old posts to reappear

Today some of my old posts reappeared as new posts in some RSS readers. This is because I have been validating my RSS feeds. While my blog has been valid XHTML for quite some time, I found yesterday that the RSS feed was not valid XML and therefore not valid RSS 2.0. I corrected the errors and have now made the feed a valid RSS feed. Because of these corrections the RSS aggregators regard the posts as different though I took care to ensure that the time stamp of the original post remains unchanged

Posted at 18:44 on Wed, 30 Nov 2005     View/Post Comments (0)     permanent link


Fri, 25 Nov 2005

Private Sector Watchdogs: Reputational Capital and Financial Capital

In my earlier posting on private sector watchdogs, I argued that these watchdogs can be sued for negligence while government regulators cannot. Commenting on my post, Dr. Ajay Shah asked whether there are many private sector watchdogs who can pay serious money in the event of a lawsuit.

My initial response was that audit firms and investment banks have often paid large amounts of money to settle lawsuits against them. But this exchange set me thinking about the capitalization of private sector watch dogs. Information about the capital and financial position of audit firms is rather scanty. But some information is available from the July 2003 report of the US General Accounting Office ( “Public Accounting Firms: Mandated Study on Consolidation and Competition”) and the July 2004 report of the UK Office of Fair Trading (“An assessment of the implications for competition of a cap on auditors’ liability”).

The US data indicates that audit fees are about 0.15% of the revenues of the firms being audited while the UK data suggests that the audit firms have capital of about 4-5 times their annual audit fee income. Combining the two suggests that capital is less than 0.75% of the revenues of the companies being audited. To my mind, this is a very low amount of capital in relation to the potential liability. The low capital might be an important reason why the audit firms have lobbied hard for a cap on auditor liability.

The low capital might also explain the extremely high degree of concentration in the audit business with the Big Four accounting for practically the entire audit business of large companies. When audit firms rely on reputational capital rather than monetary capital, this becomes a very strong barrier to entry. A different approach to auditing would involve audit firms with large amounts of financial capital. Regulatory changes would be needed to allow audit to be done by public companies rather than private firms. Regulatory changes would also be required to allow audit firms to solicit business and advertise aggressively. This would dramatically ease entry into the audit business and make it highly competitive. For example, one could imagine a Warren Buffet starting a new audit company with say $10 billion of capital and gaining business by aggressively advertising more stringent auditing standards than the existing audit firms. Many institutional investors may then put pressure on companies to use the new audit firm even if it is significantly more expensive.

There is no reason why the same strategy of relying on financial rather than reputational capital cannot be applied to credit rating agencies and other private sector watchdogs.

Posted at 18:30 on Fri, 25 Nov 2005     View/Post Comments (1)     permanent link


Thu, 24 Nov 2005

FSA's Concerns about Competitive IPOs

The Financial Services Authority of the United Kingdom has expressed its concerns about competitive Initial Public Offerings. It was in fact so worried about them that it highlighted them in a supplement to its quarterly newsletter List!. The FSA wrote that “we felt we needed to tell the market about [these issues] immediately, rather than waiting until our next full edition”.

The FSA expressed its concern about the new form of conducting Initial Public Offerings as follows.

“In a standard IPO, the lead manager and other brokers involved in the IPO are appointed at a very early stage of the process, forming a syndicate of brokers. Under competitive IPOs, the syndicate members, their roles and remuneration are not defined until late on in the process. This maintains competitive pressure on the potential syndicate members as not all the firms involved in the competitive IPO process will be appointed to the syndicate after the initial ‘beauty parade’. In a standard IPO, the lead manager and other brokers involved in the IPO are appointed at a very early stage of the process, forming a syndicate of brokers. Under competitive IPOs, the syndicate members, their roles and remuneration are not defined until late on in the process. This maintains competitive pressure on the potential syndicate members as not all the firms involved in the competitive IPO process will be appointed to the syndicate after the initial ‘beauty parade’.. This may create ‘pressure points’ and new conflicts of interest — particularly around the preparation of pre-deal research and pre-marketing activities. We understand that one of the reasons issuers favour competitive IPOs is that it gives them greater control over the IPO process and greater leverage over the firms involved.

In a competitive IPO the issuer may be able to exert pressure on the competing firms, directly or indirectly, to produce research that is favourable or which justifies a higher valuation range. This is because firms could be providing their draft research to the issuer in circumstances where the firm is still trying to win a role in the syndicate. In a competitive market, firms may find it difficult to resist such pressure. Even where individual firms have some reservations about the process, they may feel compelled to participate so they are not excluded from transactions.”

This concern of the FSA appears quite strange to me. It suggests that regulators have not learnt the right lessons from the IPO scandals that took place during the dot com boom in the United States. Those scandals showed that the investment banks were not trying to get the best possible price for the shares in the IPO. Competition between investment banks was of the non price variety. Worse, in some cases, it took the form of allotting hot stocks of other underpriced IPOs to the CEO and other key decision makers in an attempt to win the IPO mandate. An IPO process that increases competition on the basis of price is a move in the right direction.

Regulators however continue to act as if anything unfamiliar is worse than the status quo even when it is potentially better. The US SEC did the same when Google decided to auction shares instead of doing a normal IPO. The risk factors that the SEC forced Google to incorporate in its offer document showed that the SEC too had not learnt any lessons from the IPO scandals that took place under its own watch.

Posted at 12:49 on Thu, 24 Nov 2005     View/Post Comments (0)     permanent link


Fri, 04 Nov 2005

Negligence, Misfeasance and Private Sector Watchdogs

The collapse earlier this week of the misfeasance suit by the liquidators of BCCI against the Bank of England highlights the importance of private sector watchdogs. The key difference is that many private sector watchdogs can be sued for negligence, but regulators can usually be sued only for misfeasance.

In the case of Bank of Credit and Commerce International (BCCI), most observers believe that the Bank of England was negligent in the discharge of its regulatory duties. But the sovereign cannot be sued for mere negligence. The liquidators of BCCI therefore had to invoke the charge of misfeasance. Misfeasance consists essentially of an intentional misuse of public power. It required the liquidator to prove not merely that the actions of the Bank of England were improper but that they were malicious or dishonest (not necessarily in a financial sense). In most cases of regulatory failure, malice or dishonesty is very unlikely to exist. It is difficult to imagine why the officials of the Bank of England would act with malice against the depositors of BCCI. It is much easier to see why they might be negligent.

Another recent case of a failure of a misfeasance suit again in the United Kingdom was the suit by the shareholders of RailTrack against its renationalization. Here there was much greater plausibility to the claim that the sovereign acted with something approaching malice. But the claim could not be proved in court and the judge dismissed the claim completely.

If misfeasance is either unlikely or difficult to prove, then the victims of regulatory negligence are left with no recourse at all. This makes private sector watchdogs attractive. When they fail, it is possible to sue them for negligence and to recover monetary damages. It is noteworthy that in the Worldcom and other scandals in the United States, the major part of the financial recovery by investors has come from private sector gatekeepers and watchdogs.

Posted at 14:33 on Fri, 04 Nov 2005     View/Post Comments (2)     permanent link