Crooks and Scandals: Punish One at a Time

In my previous blog I suggested that business regulation is about a decade behind the times for financial services, citing AIG as an example of a company that failed when it overinvested in non-insurance assets. We got into this situation when the Gramm-Leach-Bliley Act of 1999 deregulated financial services but the government structure of oversight failed to change. There is nothing wrong with regulation as long as it reflects the current strategy of an industry. The problem is that Congress has not really adjusted the regulatory responsibilities since the passage of the three securities acts (1933, 1934 and 1940) and the banking acts (1864 and 1913); there never has been federal oversight of the insurance industry.

What we need to do once the dust settles is to refocus on the functions of these industries in the 21st century and not of one, two or even three generations earlier. As I wrote in my book, Is U.S. Business Overregulated? (York House Press, 2008), we need the appropriate level of consolidated regulation, probably by categories of risk. First, each type of investor should receive a directed form of regulation by risk category.

For institutional investors, management of financial services businesses in terms of such risk categories as-

  • Insurance risk for the safety of customer funds that are on deposit with a financial services firm. This would include the segregation of customer funds and administration of account insurance (like the Federal Deposit Insurance Corporation).
  • Business risk to protect the integrity of the intermediation process used by all financial services companies. This would include assurance that adequate collateral exists for loans, that appropriate due diligence has occurred in deciding whether to establish and continue relationships with customers, and that necessary documentation exists to support financial transactions.
  • Systemic risk for the security of the financial system. This would involve uniform capital requirements, payment system regulation, and the monitoring of financial system liquidity.

For individual investors, depositors and consumers, protection for those who are too weak, uninformed and scattered to defend themselves. The securities industry has long recognized that institutions and other sophisticated market participants do not need the same regulatory protections as unsophisticated investors. Financial services for retail customers would be subject to regulation and the protections afforded such investors, policyholders and depositors across product lines. This would include the prevention of deceptive sales practices, credit counseling prior to the acceptance of a loan, and prosecution against the “churning” of securities and of fraudulent profit claims.

The single regulator approach permits financial regulation from the larger perspective of the strategic objectives and decisions of a financial services organization, rather than of specific product lines and operations. The model would be the Financial Service Authority of the U.K. British regulators have learned from long experience that, while there will always be scandals and failures, each should be dealt with accordingly and with remedies specific to the circumstances. This is in sharp contrast to the current American approach to business regulation: that fraud and the misappropriation of company funds can only be prevented by severe civil and criminal penalties. In my next blog, I will discuss some related issues to the current financial situation.


Bad Regulation: AIG and When Chickens Come Home to Roost

Just how out-of-date is our regulatory system? Given the current economic crisis, we are finally hearing calls for fixes to the government oversight of banks and other financial institutions. If we start with the deregulation of financial services companies that was accomplished in the Gramm-Leach-Bliley Act of 1999, we’re about a decade behind in terms of financial regulation. Why? Because the old structure was retained, with the Federal Reserve System and the Comptroller of the Currency regulating the commercial banks, the Securities and Exchange Commission overseeing the securities industry, and state insurance commissions responsible for the insurance industry.

Meanwhile, financial companies could enter any financial business in the search for profits and market share. That’s what got AIG (the American International Group) into trouble. It established an investment bank behind its rather dull but competently managed insurance businesses, which managed to eventually lose more than $18 billion (the reports for the most recent three quarters of operations). This AIG unit wrote credit-default swaps (CDS), a guarantee against default, with an exposure based on the notional (face or stated) value of nearly one-half trillion dollars! A CDS is a contract between two counterparties – that is, buyers and sellers – in which the buyer makes regular payments to the seller in exchange for the right to compensation if there is a default or “credit event” in respect of a third party (sometimes called a “reference entity”).

As poor credits including subprime securities began to fail, AIG hit the wall. The company couldn’t pledge enough collateral with its counterparties, prompting credit rating downgrades and more calls for margin. The New York State Insurance Commission actually did a fine job in regulating the insurance groups of AIG, and it appears unlikely that any loss will occur in those businesses. It is the investment bank – not subject to the insurance regulators – that was the culprit, and the cause of the requirement for an $85 billion credit facility bailout from the Federal Reserve.

This is the time for Americans to reconsider our approach to financial regulation, and indeed, to all business regulation. For the financial industry, we need the appropriate level of consolidated governmental oversight, probably by categories of risk. In my next blog, I will discuss a more thoughtful approach to regulation and suggest appropriate organizational ideas.

If, “It’s the Economy, Stupid!” Where’s the Plan?

Is U.S. Business Overregulated?There is no more critical issue facing America than its ability to compete in the global economy. The loss of manufacturing jobs to countries with five to twenty times lower labor costs may be the most important economic problem of our times. The U.S. has become a service economy that is heavily dependent on the goodwill of two classes of market participants:

• Foreign holders of dollars who keep buying our stocks, bonds, real estate, and other assets

U.S. consumers whose spending drives some 70 percent of our gross domestic product


So, what do our Presidential candidates suggest? What structural changes would their administrations propose? Unfortunately, one of the problems in following the candidates’ economics positions is that they don’t have any specific long-term plan. The composite position is some kind of short-term economic stimulus package totaling about $100 billion. While economists never agree on much of anything, there seems to be a consensus that a $100 billion stimulus applied to a $13 trillion economy will accomplish almost nothing. (It would take a $130 billion stimulus just to equal one percent of the size of the U.S. Gross Domestic Product [GDP]!)


We need some real discussion among the candidates about the long-term: changing laws, eliminating regulations, stimulating job growth, reducing corporate tax rates, etc. The closest to this probably has been Mitt Romney in Michigan who promised to revitalize the auto industry and restore jobs … although, to no one’s, surprise … the details are vague. (Hint to Mitt: Those auto jobs are now in Japan, South Korea and other countries, and they aren’t coming back.)


The U.S. has to change its vision of the 21st century economy. We have to consider repealing laws that seemed reasonable as long ago more than 100 years ago (for example the Sherman Act of 1890 concerning antitrust), and as recently as 6 years ago (the Sarbanes-Oxley Act of 2002 concerning corporate governance). America has never developed a comprehensive public policy toward global competition. In fact, the Department of Commerce, the agency charged with the promotion of international business, did not begin to emphasize sales to foreign markets until the 1970s, some 300 years after countries like Great Britain and Holland were actively developing world trade relationships.

<>If foreign holders of dollars and/or U.S. consumers ever falter in their support, the result could be a decade-long recession. This is no idle threat; by 2007, housing was in a slump with prices likely to be down for the years 2007 – 2009. And in recent years housing “wealth” was what sustained the consumer and supported all those trips to Wal-Mart <>and to Orlando or Las Vegas. Although there are no quick fixes, the argument of my new book Is U.S. Business Overregulated? (York House Press, 2008) is for a new look at our regulation of business to level the playing field against foreign competitors. We may well be our own worst enemy in limiting America’s ability to compete in the global economy!

The theme of this book is that there are “positive” regulations … and “negative” regulations, where government officials substitute their judgment for that of the market in situations when such substitution is inappropriate and may result in the suboptimal allocation of the factors of production….society cannot survive without laws to protect individuals and the environment against the corrupt or criminal actions of business.


Whatever Happened to the “Giant Sucking Sound”?

Is U.S. Business Overregulated?The 2008 Presidential campaign has been underway for months (some say years), but economics and global trade are not getting the top headlines and sound bites. Although it takes some digging to discern the candidates’ positions, the Democrats have generally supported free trade and fiscal responsibility, although the campaign of John Edwards has somewhat strangely attacked free trade agreements while Hillary Clinton, Barack Obama and the leading Republican candidates seem to support them. On October 27, Mr. Edwards issued a very critical statement on the proposed bilateral free trade agreement with Peru (which is similar to the North American Free Trade Agreement or NAFTA); however, it was approved a week later by the House Ways and Means Committee.

Free trade has been kicked around in the Americas since debate began on NAFTA well before it came into operation on January 1, 1994. Some of you may remember 1992 Presidential third-party candidate Ross Perot’s prediction of a “giant sucking sound” of jobs leaving the U.S. for Mexico, where the labor cost has been significantly lower. Although Perot clearly touched a nerve (he received 18.9% of the popular vote but no electoral votes), his forecast of massive job losses were wrong. In fact, trade and employment has increased significantly among the three participating countries (the U.S., Mexico and Canada), although specific industries have lost jobs (e.g., textile, apparel). The debate about free trade in the Americas is now fairly quiet, and the Clinton and G.W. Bush Administrations have strongly urged the extension of NAFTA to other developed countries such as Chile, Brazil and perhaps, Argentina.

Because of Mexico’s unwillingness to extend NAFTA until progress is made on normalizing immigration, the U.S. has developed bilateral trade agreements with Western Hemisphere countries, including Chile, Colombia and Panama, as well as the Peruvian agreement noted above. (Note: the U.S. has also entered into such arrangements with Australia, Bahrain, Israel, Jordan, Malaysia, Morocco, Malaysia, Singapore and the UAE.) The jobs issue that became a centerpiece of the 1992 election seems to have vanished. As a nation, we are at full employment (typically 4.5% of American workers are unemployed in any reporting period but currently 4.7%), with nearly 5% annualized growth in workers’ output per hour and a five quarter record of positive growth in real wages (that is, inflation adjusted).

No candidate has made American competitiveness and global trade major campaign issues. Regardless, we need to hear about these concerns and what the next President will be doing to change the regulatory system that is strangling American business.

Churning is for Butter, not for Business Managers

An essential element in managing an organization is continuity: the idea that the same people will function in their jobs for an extended period of time so that their corporate responsibilities are conducted efficiently and effectively. Naturally, any business experiences some turnover, whether from new opportunities, departures or other events. However, this process should proceed with the minimum of disruption to the conduct of the company’s affairs. The regulatory environment has become so difficult for many managers that even 6-figure salaries are insufficient compensation to motivate them to stay in their current positions.

A recent survey by Liberum Research reports that the trend of recent years in finance continues to show high levels of management change. For example, more than 2,300 chief financial officer (CFO) positions turned over in 2006, with fastest rates of “churn” in businesses with $1 billion or more in revenues. The average time in position was 30 months, about one-half of the 5 year tenure in 2002. A major cause reported by Liberum is stress from such sources as regulation and global competition.

Stress has always been a component of any job, but current pressures far exceed past demands for profits and growth. The Sarbanes-Oxley Act of 2002 (Sarbox), passed in response to such fraud cases as Enron, WorldCom and Tyco International, establishes a large body of mandatory actions by public companies. Sarbox broke new ground by mandating that U.S. publicly-traded corporations regularly assess their processes to ensure transparency and protect shareholder value. The law was enacted to restore investor confidence by requiring actions concerning financial reporting, conflicts of interest, corporate ethics and accounting oversight. Heavy fines for senior managers and their corporations, and even imprisonment, are available remedies under Sarbox; the idea was to construct a strong enough incentive for business executives to be good citizens.

Sarbox makes new law in several important areas, some of which may create havoc for corporate managers, accountants and regulators. As one example, chief executive officers are now required to certify that a periodic financial report “fairly represents, in all material respects, the financial condition and results of operation of the issuer.” A knowingly false certification can result in a fine of up to $5 million and imprisonment of up to 20 years. Although Sarbox does not contain any clarification for this process, many public companies are requiring finance managers to “sub-certify” the sections of the financial reports for which they are responsible. One survey noted the following areas as the most common areas where financial professionals were being asked to sub-certify, leaving them with unresolved issues of liability:

· disclosures in management’s discussion and analysis or in footnotes

· specific account balances in banks

· compliance with company policies and procedures

· adequacy of internal controls in their department or business function

· compliance with company code of conduct

The answer to the fraudulent actions of a few very bad actors is not to pass expensive and overly punitive legislation. This solution contributes to the enormous cost of operating business and stresses managers to the point of their leaving their positions after only a short term of service. Sarbox should be repealed and other existing law used when fraud is detected. Incidentally, this was how the chief executives of Enron – Ken Lay and Jeffrey Skilling – were successfully prosecuted.

We Have to be Economic Pragmatists — Like the Founding Fathers

    This blog is about economics, trade and global business. In deciding the best course of action for the U.S., we should recall how our Constitution – the document that has guided our government since ratification – came into existence. The leading causes of the decision to meet in convention in Philadelphia in 1787 were the political and economic weaknesses of the Articles of Confederation. Evidence of the political problems was the inability of Congress to support the new government and to raise funds for the Continental Army during the Revolutionary War. This powerlessness continued after the war and threatened the security of the U.S. in the form of Shay’s Rebellion and the presence of foreign powers and Indian tribes at America’s Western and Southern borders.

The essential economic problem facing the colonists after the war was continuing quarrels over commerce and the inability of the federal government to manage interstate and international trade. The framers came to recognize that, because of their own self-interests, individual states would not bring themselves to conduct their affairs in the manner outlined in the Articles of Confederation, to “… enter into a firm league of friendship … on account of …trade…” The new federal government needed to be assigned the responsibility to protect commerce from the interference of any state.

Such measures took various forms, including taxes, laws on trade, and fees at ports of entry. Alexander Hamilton, James Madison and John Jay wrote 85 Federalist Papers to explain the intentions of the framers. Federalist comments on these matters appear in Nos. 6 (Hamilton), 7 (Hamilton), 10 (Madison), 11 (Hamilton), 22 (Hamilton) and 42 (Madison). For example, states with access to navigable ports taxed goods shipped from their neighbors, which resulted in retaliation and attempts at special trade arrangements with foreign governments. This is no particular surprise given the divergence of regional economic interests: shipping and fishing in New England; small farming, manufacturing and finance in the Mid-Atlantic States; and slave-based agriculture in the South. As the result, the South depended on exports and free trade, while the Northern states needed import tariffs to protect their infant industry.

Compromise was required to get to Philadelphia and then to reach consensus. During the period before the Constitutional Convention, there were at least four separate pragmatic actions that leading founding fathers used to move the process along.

· George Mason (a Virginian) negotiated with a delegation from Maryland over navigation rights on the Potomac River, even though he had not received formal instructions on his duties from his governor (Patrick Henry).

· George Washington invited these delegations from Maryland and Virginia to his home (Mt. Vernon) to conclude the Potomac River compact, ignoring clear restrictions on such actions without Congressional authorization.

· The two delegations agreed that the river would be a “common highway” allowing free access, despite the wording of the 1632 charter issued by King Charles I that ownership belonged to Maryland.

· The success of this agreement led to proposals to call a convention, the excuse for which was New Jersey’s instructions to its delegates to an Annapolis MD meeting of the States in 1786 to address commerce “and other important matters.”

Not one of these events was consistent with the rule of law (such as it was in 1785 – 1786), and any one, if voided by appropriate authority, could have prevented the Convention from ever meeting. We’ll talk more about “revolutionary” changes in future blogs. However, it is a given that we must be similarly pragmatic in the beginning of the 21st century in fixing our restrictive laws and regulation on business activities.

Let’s Talk Free Trade

The business environment and free trade. It’s a topic certain to be on the minds of several candidates and many voters in the coming Presidential campaign. Economists universally agree that open and unrestricted competition helps nearly everyone by raising living standards, easing the differential between the “haves” and “have nots.” However, some worry that American jobs will be exported to other countries where the cost of labor and other factors of production is much less than in the U.S.

The solution to making America competitive is not to build trade barriers; we tried that in 1930 when Congress passed the Smoot-Hawley Act that raised tariffs on more than 20,000 items. The result was a decline in world trade from $5.7 billion in 1929 to $1.9 billion in 1932 due to retaliatory tariffs by our trading partners. The Great Depression and totalitarian governments followed. Since World War II, the nations of the world have reduced trade barriers through the World Trade Organization (and its predecessor, the General Agreement on Tariffs and Trade).

The fall of communism has allowed capitalism to become the economic system of choice in much of the world. We cannot become isolationist again in terms of politics and economics; as a country, we must become competitive and undertake those actions that will reduce restrictions on American business. My new book, “Is U.S. Business Overregulated? How Government Destroys our Ability to Compete in the Global Economy”* (by James S. Sagner), forthcoming from York House Press, discusses a very significant area of competition: the laws and regulations that unnecessarily restrict our global competitiveness.

All Americans feel the toll as manufacturing and other jobs pour out of the nation, lost to countries with 5 to 20 times lower labor costs. Increasingly a service economy, the U.S. has become heavily dependent on the goodwill of foreign holders of dollars to buy its financial and hard assets and on our hometown consumers to keep spending. Seemingly informed solutions offered to the crisis range from balanced budgets; to higher interest rates; to taxes to improve our economic situation; to a value-added tax to suppress consumption; to better education to ensure that American high-school graduates can read and write on a par with workers in other countries and to a return to some form of the gold standard to force our leaders to stop printing money.

Is there a practical answer to the ever deepening problem? Yes. And it is one that can quickly and effectively level the global playing field and put U.S. business back in the game: eliminate the laws and regulations that hamper business from performing in the world marketplace against less regulated, overseas competitors. In my new book, I analyze, summarize and explain in simple terms, understandable to all readers, the complex rules that restrict American business, such as the antitrust, corporate governance, and regulations on specific industries. Next, the now informed reader is led to what appears as an obvious, innovative and brilliant solution—widespread deregulation of business in competition with other businesses–sure to benefit American business and all Americans.

This blog will discuss many of the issues regarding our political and economic development as a country. We were once competitive and we can get there again.

*Available as a pre-order at major booksellers or at