By Dimitri Lascaris.
In 2002, following the bursting of the technology bubble and the collapse of a massively fraudulent Enron Corporation, President George W. Bush signed into law the Sarbanes-Oxley Act of 2002, or “SOX.”
SOX was designed to restore investor confidence in the disgraced U.S. capital markets. It set new and enhanced standards for all U.S. public companies. It stiffened penalties for fraudulent conduct, imposed additional responsibilities on the boards of directors and senior officers of public companies, and created a new quasi-public agency, the Public Company Accounting Oversight Board, to supervise, regulate, inspect and discipline accounting firms in their roles as auditors of such companies.
In the aftermath of the Enron scandal, so determined was the U.S. political class to distance itself from the politically connected but now toxic CEO of Enron, Kenneth Lay, that the House of Representatives approved SOX by 423 yes votes, 3 no votes and 8 abstentions, while the Senate approved SOX with 99 yes votes and one abstention. President Bush, arguably the prime beneficiary of Kenneth Lay’s electoral largess, hailed SOX as a historic achievement, declaring that SOX included “the most far-reaching reforms of American business practices since the time of Franklin D. Roosevelt. The era of low standards and false profits,” Bush crowed, “is over, no boardroom in America is above or beyond the law. “
Virtually from the moment that SOX was enacted, however, the U.S. business elite launched a campaign to persuade voters that SOX was encumbering America’s entrepreneurial spirit, and that its allegedly excessive burdens threatened America’s status as the great bastion of global capitalism. As the U.S. economy emerged from the recession of 2001, and rapidly expanded through what we know now to have been a mortgage-debt binge of stunning proportions, Wall Street’s campaign to reverse the modest achievements of SOX became ever bolder.
One of the first politicians to sign on to this campaign was New York’s Democratic Senator, Chuck Schumer. Ignoring his 2002 vote in favor of SOX, Schumer joined forces with New York City’s billionaire mayor, Michael Bloomberg, to commission a study from McKinsey & Company and the New York City Economic Development Corporation (NYCEDC). The purported objective of the study was to educate U.S. policy-makers as to the means by which New York City could maintain its status as the world’s leading financial center.
To justify the study, Schumer and Bloomberg raised the specter of New York City being supplanted as the center of global capitalism by other financial centers, particularly London, which by then had begun to attract ever larger amounts of capital due in no small part to the extraordinary laxity of its regulatory regime. Not only did the U.K. lack anything approximating SOX, but its securities regulator constituted little more than a token supervisor of the capital markets, and its civil liability regime offered few if any meaningful remedies to defrauded investors.
In January 2007, Schumer and Bloomberg announced the completion and issuance of the McKinsey/NYCEDC report. With patriotic solemnity, they proclaimed:
Dear Fellow Americans:
The 20th Century was the American century in no small part because of our economic dominance in the financial services industry, which has always been centered in New York. Today, Wall Street is booming, and our nation’s short-term economic outlook is strong. But to maintain our success over the long run, we must address a real and growing concern: in today’s ultra-competitive global marketplace, more and more nations are challenging our position as the world’s financial capital.
Traditionally, London was our chief competitor in the financial services industry. But as technology has virtually eliminated barriers to the flow of capital, it now freely flows to the most efficient markets, in all corners of the globe. Today, in addition to London, we’re increasingly competing with cities like Dubai, Hong Kong, and Tokyo…
The report provides detailed analyses of market conditions here and abroad, informed by interviews with more than 50 respected leaders drawn from the financial services industry, consumer groups, and other stakeholders. The findings are quite clear: First, our regulatory framework is a thicket of complicated rules, rather than a streamlined set of commonly understood principles, as is the case in the United Kingdom and elsewhere. The flawed implementation of the 2002 Sarbanes-Oxley Act (SOX), which produced far heavier costs than expected, has only aggravated the situation, as has the continued requirement that foreign companies conform to U.S. accounting standards rather than the widely accepted – many would say superior – international standards. The time has come not only to re-examine implementation of SOX, but
also to undertake broader reforms, using a principles based approach to eliminate duplication and inefficiencies in our regulatory system. And we must do both while ensuring that we maintain our strong protections for investors and consumers.
Second, the legal environments in other nations, including Great Britain, far more effectively discourage frivolous litigation. While nobody should attempt to discourage suits with merit, the prevalence of meritless securities lawsuits and settlements in the U.S. has driven up the apparent and actual cost of business – and driven away potential investors. In addition, the highly complex and fragmented nature of our legal system has led to a perception that penalties are arbitrary and unfair, a reputation that may be overblown, but nonetheless diminishes our attractiveness to international companies. To address this, we must consider legal reforms that will reduce spurious and meritless litigation and eliminate the perception of arbitrary justice, without eliminating meritorious actions…
In the weeks and months ahead, we will work together to implement the state and local reforms necessary to strengthen New York City’s position as the world’s financial capital. At the same time, we will work with Congress, the Administration, regulators industry leaders, and other stakeholders to take the necessary steps to ensure that America retains its dominant position in the financial services industry in the 21st Century. It is our hope that this report will call attention to the challenges we face in meeting this goal, and serve as a call to action for members of both political parties, and for leaders of every branch of government. [Emphasis added.]
Less than one year later, the United States entered one of the worst recessions it has experienced since the Great Depression. Within two years of the report’s publication, most of Wall Street’s leading investment banks had either failed or had been taken over in eleventh- hour bids to save the American banking system from collapse.
As the scale of Wall Street’s vast mortgage-bond chicanery became increasingly apparent to the investing public, Schumer and Bloomberg quietly shelved their initiative to persuade their fellow Americans that London’s laissez-faire model of financial regulation was superior to the American SOX regime. In other words, Schumer and Bloomberg had the good sense to shut up. Unfortunately, the same cannot be said of British Prime Minister David Cameron. As 2011 drew to a close, it was now Europe that teetered on the brink of financial Armageddon. Confronted by the prospect of the collapse of Europe’s banking system, Europe’s leaders agreed to convene a decisive meeting on December 9, 2011.
Weeks before the meeting, MF Global, a major U.S.-based derivatives broker, failed, and in the course of its failure, appeared to have ‘lost’ well in excess of $1 billion of client funds. MF Global clients and many other investors were stunned, because they rightly expected their funds to remain segregated from the trading capital of the firm in whose custody they had placed those funds. The disappearance of so much client money raised deeply troubling questions about the efficacy of the regulatory regime to which MF Global was subject. As the date for the decisive meeting of Europe’s leaders approached, no one offered remotely satisfactory answers to those questions, particularly the question of what happened to over $1 billion in MF Global client money. Then, on December 7, 2011, just two days before the critical meeting of EU leaders, Thomson Reuters Business Law Currents published an article by Christopher Elias entitled “MF Global and the great Wall St re-hypothecation scandal.” In the article, Elias revealed:
A legal loophole in international brokerage regulations means that few, if any, clients of MF Global are likely to get their money back. Although details of the drama are still unfolding, it appears that MF Global and some of its Wall Street counterparts have been actively and aggressively circumventing U.S. securities rules at the expense (quite literally) of their clients.
MF Global’s bankruptcy revelations concerning missing client money suggest that funds were not inadvertently misplaced or gobbled up in MF’s dying hours, but were instead appropriated as part of a mass Wall St manipulation of brokerage rules that allowed for the wholesale acquisition and sale of client funds through re-hypothecation. A loophole appears to have allowed MF Global, and many others, to use its own clients’ funds to finance an enormous $6.2 billion Eurozone repo bet…
In investment banking, assets deposited with a broker will be hypothecated such that a broker may sell securities if an investor fails to keep up credit payments or if the securities drop in value and the investor fails to respond to a margin call (a request for more capital).
Re-hypothecation occurs when a bank or broker re-uses collateral posted by clients, such as hedge funds, to back the broker’s own trades and borrowings. The practice of re-hypothecation runs into the trillions of dollars and is perfectly legal. It is justified by brokers on the basis that it is a capital efficient way of financing their operations much to the chagrin of hedge funds.
U.S. RULES
Under the U.S. Federal Reserve Board’s Regulation T and SEC Rule 15c3-3, a prime broker may re-hypothecate assets to the value of 140% of the client’s liability to the prime broker. For example, assume a customer has deposited $500 in securities and has a debt deficit of $200, resulting in net equity of $300. The broker-dealer can re- hypothecate up to $280 (140 per cent. x $200) of these assets.
But in the UK, there is absolutely no statutory limit on the amount that can be re- hypothecated. In fact, brokers are free to re-hypothecate all and even more than the assets deposited by clients. Instead it is up to clients to negotiate a limit or prohibition on re-hypothecation. On the above example a UK broker could, and frequently would, re-hypothecate 100% of the pledged securities ($500).
This asymmetry of rules makes exploiting the more lax UK regime incredibly attractive to international brokerage firms such as MF Global or Lehman Brothers which can use European subsidiaries to create pools of funding for their U.S. operations, without the bother of complying with U.S. restrictions.
In fact, by 2007, re-hypothecation had grown so large that it accounted for half of the activity of the shadow banking system. Prior to Lehman Brothers collapse, the International Monetary Fund (IMF) calculated that U.S. banks were receiving $4 trillion worth of funding by re-hypothecation, much of which was sourced from the UK. With assets being re-hypothecated many times over (known as “churn”), the original collateral being used may have been as little as $1 trillion – a quarter of the financial footprint created through re-hypothecation.
BEWARE THE BRITS: CIRCUMVENTING U.S. RULES
Keen to get in on the action, U.S. prime brokers have been making judicious use of European subsidiaries. Because re-hypothecation is so profitable for prime brokers, many prime brokerage agreements provide for a U.S. client’s assets to be transferred to the prime broker’s UK subsidiary to circumvent U.S. rehypothecation rules.
Under subtle brokerage contractual provisions, U.S. investors can find that their assets vanish from the U.S. and appear instead in the UK, despite contact with an ostensibly American organisation.
Potentially as simple as having MF Global UK Limited, an English subsidiary, enter into a prime brokerage agreement with a customer, a U.S. based prime broker can immediately take advantage of the UK’s unrestricted re-hypothecation rules… If anyone on Downing Street was listening to Elias, you wouldn’t have known it from David Cameron’s negotiating posture during the meetings of December 9, 2011.
As the date of the meeting approached, representatives of the French and German governments let it be known that they expected EU member states to support treaty changes that effectively would deprive EU members of the discretion to exceed conservative levels of deficit spending. For at least one key reason, the Cameron government ought to have supported the Franco-German initiative: that initiative envisioned a mechanism whereby austerity could be imposed on ‘profligate’ EU members, and the Cameron government was and remained, even in the face of severe economic contraction, an avid fan of brutal austerity. Yet, Cameron elected to veto the Franco-German initiative.
Cameron’s motivation was by no means the preservation of Britain’s freedom to engage in ‘profligate’ behavior. Rather, Cameron unsuccessfully demanded assurances from fellow EU members that future EU financial services regulations would not be imposed on Britain against its will. As Cameron stated upon his return to London from the December 9 meetings, he had vetoed the proposed treaty changes because he was unable to secure “sufficient safeguards” on financial regulation.
In other words, Cameron was prepared to isolate Britain from the rest of the EU in order to preserve the very regulatory model which had resulted in the collapse of MF Global. In the face of such an appalling disconnect from reality, one may well ask: on what lonely planet does David Cameron reside?
Wherever that planet may be, Cameron will soon be joined there by 62 million Britons.
Dimitri Lascaris is a a lawyer called to practice in the State of New York and the Province of Ontario, Canada. He currently represents investors in numerous securities class actions against public companies in Canada and the United States, and specializes in cases of financial fraud. Before becoming a plaintiffs’ class actions lawyer, Dimitri was a securities lawyer in the New York and Paris, France offices of a major Wall Street law firm.
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