Knee Jerk Regulation’s Unintended Consequences

Audiences loved the knife-fight scene in Butch Cassidy and the Sundance Kid (1969, Campanile Productions). Smooth-talking Butch Cassidy faces huge, ugly Harvey Logan, who holds a gigantic Bowie knife. Butch says the fight cannot start until he and Harvey agree on the rules. Confused, Harvey barks that there are no rules in a knife fight, but before he can finish his sentence Butch kicks him hard between the legs. Harvey drops to his knees. “Well, if there ain’t going to be any rules, let's get the fight started. Someone count. 1,2,3 go,” says Butch. The Sundance Kid quickly complies, and Butch slams stunned Harvey in the head, knocking him out and ending the fight.

This is a pretty good example of using “rules” to alter outcomes rather than to ensure a fair competition, and a pretty good example of how regulators and politicians have been approaching financial markets. We support regulations that ensure a level playing field, and we are sympathetic toward those who have been harmed economically, but we feel that regulators and politicians consistently overreact to economic hardship.

Interventionist regulations almost always have unintended consequences, sometimes creating problems more serious and more complex than those they are meant to correct. They also cross the line from market maintenance to market manipulation. To paraphrase a more contemporary popular film, The Dark Knight (2008, Warner Bros.), the crusader either dies a hero or lives long enough to become the villain.

Short Sighted on Short Selling

The crusader approach to financial regulation usually appears in knee-jerk responses to spectacular “scandals,” such as the Enron/Worldcom failures or the recent financial sector meltdown. Responses include legislation like the 2002 Sarbanes-Oxley bill and the SEC’s July 29^th emergency order mandating that all short sales of shares in 19 financial services firms be subject to a “pre-borrow” requirement. Yes that’s right; the SEC took special action to protect a select group of companies from market forces. While the rule was largely symbolic – savvy players were unaffected – the unprecedented behavior of the SEC was also symbolic – symbolic of interference in the market.

Former SEC Chairman Arthur Levitt wrote in the August 5^th Wall Street Journal,

…the Fed’s duty is to prevent bank failures and bank runs, to protect the banks. The SEC’s duty is to investors, protecting investor’s cash and securities, and working to prevent securities fraud.

The SEC’s emergency action protected some investors of some companies, but at the expense of all investors, because such ad hoc rules degrade the integrity of the market. Who wants to play a game – for high stakes – if the rules could change at any moment?

As Michael Lewitt of Hegemony Capital Management wrote in his article, Survival of the Unfittest, “By engaging in selective protectionism of a few favored companies rather than re-imposing the uptick rule and treating all companies equally, the SEC furthered the appearance of favored treatment for large institutions that raises serious moral hazard concerns and dampens confidence in U.S. financial markets.”

In our January 2008 issue, we noted that not every failure is a scandal or a crisis. Companies make mistakes, investors bet wrong, and “stuff” happens. Investors take risks, and often face unpleasant consequences. Here’s what we said about short selling:

One of the most significant contributors to recent market volatility is an arcane and little reported rule change enacted last July by the Securities and Exchange Commission. After what seemed like thorough testing and reasonable debate, the SEC repealed a rule that placed limits on the practice of short selling (selling borrowed stock in a bet that the price will drop and one can then buy the stock for less than the price at which it sold).

Short-sellers are not well loved by long-term investors, in part because they do not have to show their hand the way other investors do (through SEC filings), but also because their machinations can increase other’s losses. Under the old rule’s so-called “tic-test,” short-sellers were required to wait to sell until the price increased in the most recent transaction. In other words, short-sellers could only sell on an up-tic, not a down-tic. Presumably, this prevented short-sellers from taking an active role in driving a stock price down.

….The short-sell rule, just like most of the post crash regulations, was designed to reduce volatility in the market place; in this case regulators wished to prevent a snowball-to-avalanche effect of short-sellers crashing the market.

But as soon as the rule was repealed, vigilant investors noticed that the market, always a harsh mistress, was now viciously punishing stocks based on the flimsiest of pretenses. By August, bits of news that previously cost a stock two percent of its value could lop off eight percent, based not on the value of the company but on the gamesmanship of the short-sellers. As former Chicago Board Options Exchange Chairman Gary Lahey told the Wall Street Journal, “You’re going to get more volatility because it’s easier to whack a stock.” Other systems and regulations may help avert market crashes, but it stands to reason that repealing a rule designed to reduce volatility will likely lead to increased volatility.

 

We repeat this lengthy explanation because we believe the effect of this rule change has been devastating. Entrepreneurial investors may like volatility, but the public, the press and politicians do not.  Increased volatility damages confidence in the market, which leads to additional rule tinkering, which further degrades confidence, particularly when the rules are unfair or inconsistently enforced.

Pump & Dump or Distort and Short?

20 years ago, with the rise of electronic day trading and instant web-based communications, the SEC turned its attention to so-called “pump & dump” schemes, wherein a shareholder buys a stock cheap, mass-promotes it to drive the price up, then sells at a profit and lets the chips fall where they may for others. Policing pump & dump schemes calls for careful oversight: that’s why articles like this one must be cleared by our firm’s compliance officer before they can be published.

Unfortunately, short selling is governed by a different set of rules, so the SEC must now turn its attention to “distort & short” schemes, wherein short sellers actively undermine confidence in a company whose decline would profit them. The SEC imposed a rule against naked shorting (the practice of short selling without actually borrowing stock to sell), but the practice is still quite common, not least because the fines for noncompliance pale next to the potential profits. We like the advice of 19^th century speculator Daniel Drew, as quoted by Spencer Jakab for the Dow Jones Newswire: “He who sells what isn’t his’n must buy it back or go to pris’n.”

The emergency rule protecting selected financial services companies (which was more or less a threat to enforce existing rules!) expired on August 12 and it appears to have had little effect, but we imagine the commission must be crafting new rules to deal with abuses of short selling. Like a computer company issuing software patches and firmware updates, regulators cannot always see how each individual fix might combine to damage overall system performance.

According to Levitt,

Financial Markets are not the place to practice field surgery and experimental medicine, because they are too important to the vitality of the world economy. Rather, regulators should stick to the basics – those things that are at the core of what has made U.S. financial markets strong: disclosure, transparency, fairness and accountability.

 

We agree, and wonder whether subjecting short sellers to the same disclosure requirements applied to other investors would eliminate the misuses of short selling far better than an ever-changing patchwork of ad hoc rules.

Sarbanes-Oxley – Vilified but Valuable

The 2002 Sarbanes-Oxley [SOX] bill provides a good example of regulatory legislation that succeeds to some extent because it is grounded in the basics described by Levitt: disclosure, transparency, fairness and accountability. Although vilified by business because of its onerous reporting and auditing requirements, SOX is believed by many to add value by improving investor confidence in companies complying with its strict standards.  We find it hard to believe that a CEO can knowledgably sign off on every tiny piece of a large, complex business, but the PR value sometimes outweighs the practical implementation.

According to a 2006 article on CFO.com,

Foreign issuers that list in the United States see as much as a 30 percent higher valuation than companies that list only in their home markets.

Investors are willing to pay extra for the peace of mind offered by America’s rules. Theoretically, compliance should also lead to a reduced cost of capital.

But compliance is a double-edged sword. CFO.com observes that companies that discovered and corrected financial control problems through the SOX audit process saw their cost of capital drop by 1.3%, but companies that got a consistently clean bill of health lowered their cost of capital by only .58%. We call this “the prodigal son’s responsible brother syndrome.” Those who misbehave but return to the fold get a lot of attention and a big party. Those who have behaved responsibly get ignored.

Higher valuations and a lower cost of capital should be benefits of the SOX legislation, but these are difficult to isolate and quantify. The costs of compliance, however, are obvious and onerous. One of the unintended consequences of the legislation was the windfall for auditors, the only clear beneficiaries of the bill.

Small companies in particular feel disadvantaged by SOX. Consider an oil exploration and development company like Contango (AMEX: MCF). With only six full-time employees, the burden of compliance weighs heavily. Christy Wood, a senior investment officer at pension giant Calpers, told CFO.com she had little sympathy for small companies threatened by SOX costs: “I would say to them that maybe the private markets are better suited to them.”

Perhaps, but this reduces the public’s access to ownership in many highly efficient companies. Many feel that the ultimate negative effect of SOX has been the loss of investment opportunity as companies opt for private equity or foreign exchanges rather than U.S. public markets.

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A Level Playing Field

We applaud the intent of Sarbanes-Oxley, because we agree with its aim: better transparency and accountability that allows free markets to behave naturally. Of course, enforcing rules established after the market crash of 1929 may have accomplished the same goal with fewer costs.

Likewise, subjecting short sellers to existing rules and treating all investors – and companies – equally would go a long way toward restoring the market’s health. Regulator inconsistency counteracts their primary responsibility: ensuring market integrity and investor confidence.

The moral hazard of interventionist regulation is that people will take ever-greater risks when they believe that the government will swoop in and rescue them at the last minute. As mentioned above, such rescues assure the “survival of the unfittest.”

Do we outlaw the forward pass because we don’t like the football score at halftime? Certainly not. Nor do we eliminate helmets just because no one has suffered a concussion in the first half. The rules exist for the good of the game and the safety of the players, not to influence the outcome. The same should be true in our public markets. 

 

Comments

[woodsey:]

Right on!

2008 Aug 22 02:27 PM