Friday, 1 February 2008

O Judgment!

That in the midst of the current market mayhem my first post on this blog is about a Supreme Court case could reveal a thing or two about me. So consider this a self introduction.

The case in point is the just decided STONERIDGE INVESTMENT v. SCIENTIFIC-ATLANTA. The editors in The New York Times and Financial Times gave it prominent coverage, so I reckon they understood its importance. But I have not seen any commentary and the case cries out for a commentary.

The facts are not in dispute. I quote from the ruling:
Charter, a cable operator, engaged in a variety of fraudulent practices so its quarterly reports would meet Wall Street expectations ... The fraud included misclassification of its customer base; delayed reporting of terminated customers; improper capitalization of costs that should have been shown as expenses; and manipulation of the company’s billing cutoff dates to inflate reported revenues.

In other words, you name it, they did it. As for details:
In late 2000, Charter executives realized that ...the company would miss projected operating cash flow numbers by $15 to $20 million. To help meet the shortfall, Charter decided to alter its existing arrangements with respondents, Scientific-Atlanta and Motorola. … Respondents supplied Charter with the digital cable converters … Charter arranged to overpay respondents $20 for each set top box it purchased until the end of the year, with the understanding that respondents would return the overpayment by purchasing advertising from Charter. Charter would then record the advertising purchases as revenue and capitalize its purchase of the set top boxes … The new … agreements [to formalize the scheme] were backdated to make it appear that they were negotiated a month before the advertising agreements. The backdating was important to convey the impression that the negotiations were unconnected, a point Arthur Andersen [Charter's accountant] considered necessary for separate treatment of the transactions. Charter recorded the advertising payments to inflate revenue and operating cash flow by approximately $17 million.

So that is what we have here: fraud, pure and simple.

Stoneridge, which was holding Charter's stock, suffered losses. Consequently, in addition to Charter, it sued Charter's suppliers Scientific-Atlanta and Motorola under Section 10(b) of Securities Exchange Act which makes it unlawful to employ "manipulative and deceptive devices in contravention of rules ... prescribed for the protection of investors."

The Court framed the case thus: whether Scientific-Atlanta and Motorola could be held liable for aiding and abetting the fraud under 10(b).

It found that they could not. Because:
[A]rrangement [i.e., the fraud]... took place in the marketplace for goods and services, not in the investment sphere ... The petitioner invokes...§10(b) and seeks to apply it beyond the securities markets—the realm of financing business—to purchase and supply contracts—the realm of ordinary business operations.

What the above reasoning means is this, that 10(b) under the Securities Exchange Act governs securities only. The fraud in the case took place outside the realm of securities and in the realm of the "ordinary business," as the justices called it. As such, 10(b) did not apply. They found for the defendant.

The most critical aspect of the ruling is that, by extension, it could also apply to Charter's accountant, Arthur Andersen, which, although not a party to the lawsuit, played a similar role as Scientific-Atlanta and Motorola. Imagine a post Enron, post WorldCom world in which independent auditors could escape accountability for aiding and abetting a fraud.

The ground from which such ruling springs is the confusion over the meaning of "security." The Securities Acts do not properly and authoritatively defines a security – because they could not. Defining a security requires and presupposes knowing the meaning of finance and its relation with the "real economy." In Vol. 2 of Speculative Capital, I wrote:
The Supreme Court has tackled the question of “What is a security?” at least nine times. In all cases, it reversed the ruling of the lower courts. Lower courts have been similarly inconsistent. Contrasting rulings by various courts have piled up on top of one another, providing an arsenal of supporting footnotes to widely divergent views. One unfortunate victim of this muddying of the legal waters has been the small investor, whose protection was the central purpose of the Securities Acts. [emphasis added]

The Court's ruling once again highlighted the relevance of the emphatic sentence above.

In justifying the ruling, the justices resorted to the Court's customary one-two punch. At the macro level they brought in the flag and patriotism:
The practical consequences of an expansion, which the Court has considered appropriate to examine in circumstances like these … provide a further reason to reject petitioner’s approach … contracting parties might find it necessary to protect against these threats, raising the costs of doing business … Overseas firms with no other exposure to our securities laws could be deterred from doing business here … This, in turn, may raise the cost of being a publicly traded company under our law and shift securities offerings away from domestic capital markets.

All this is drivel. It is a regurgitation of the "arguments" that some corporate executives and their friends in the stock market have been making in order to render toothless already mild provision of the Sarbanes-Oxley Act. To raise capital, companies go where capital is. If the dollar amount of IPOs in London and Shanghai surpasses the offerings in New York that is because more capital is available in UK and China. Laws mandating corporate governance and responsibility no more hinder securities offerings that traffic laws hinder driving.

The ruling was further justified at the micro level by the citation of benumbingly long list of incestuous cases. This tactic creates a phony sense of erudition that is meant to silence and discourage dissent. It also manages – and this is a particularly important point – to strike from the psyche any picture of the case as a whole and the overall meaning of the facts as they were presented.

(An egregious case of this missing the forest for the tree – shrub, really – is manifest in another securities law case, DUNN v CFTC. The central point of the case was whether options in foreign currency were "transactions in foreign currency." The justices consulted Black's Law Dictionary for the meaning of the word "in." After establishing that it meant "in regard to," "respecting," [and] "with respect to," they rendered their ponderous opinion – in error, naturally. The ruling put foreign currency options outside the reach of CFTC enforcement. Fraud in the FX options market immediately increased many-fold.)

We have seen this tactic in the discussions about the legality of torture: what level of pain, what kind of bruise and what type of organ failure constitutes torture.

Employed thus, the tactic evidences a rot. It violates and offends our sense of humanity; in one case, it offends our spontaneous conscious, in the other, our spontaneous sense of justice.