The emergency measure meant to protect shares of 19 financial companies from abusive short-selling is set to expire tomorrow. The SEC has said that it will not extend the rule. Instead, it plans to propose a new rules on short-selling that will apply across all US equities markets. But that rule could be months in the offing.

It’s not clear what effect the emergency rule had. Some market participants say the requirement that short sellers manually locate and pre-borrow shares slowed down short trading. Others say that shares in every one of the 19 protected companies—including mortgage giants Fannie Mae and Freddie Mac and Lehman Brothers—were widely available for borrowing, and that any slow down was minimal.

The new rules could take a variety of forms. A reintroduction of the old uptick rule, which required short sellers to wait for stocks to move higher before they added a short position, is unlikely. But some say a modified uptick rule, essentially a circuit breaker that would prohibit shorts if a stock was rapidly declining, may be introduced. Other possibilities include mandatory disclosure of short positions and the application of some version of the emergency rule to all shares traded on US exchanges.

One dark-horse possibility emerged recently in Pakistan, where some investors recently urged that a ban on all stock declines be adopted. Freddie Mac chief executive Richard Syron could not be reached for comment.

Is the staff of the Securities and Exchange Commission pursuing its own activist agenda without adequate supervision by agency heads?

Many SEC observers were caught off guard yesterday when the New York Times broke the news that the SEC has been requiring major US corporations to include shareholder proposals supporting universal healthcare in official proxy materials. This seemed to be a departure from many recent decisions by the SEC’s commissioners restraining or rejecting innovative regulations favored by special interest shareholder groups. Why had the SEC suddenly embraced this radical rule favoring proposals on political issues only indirectly tied to corporate governance?

The answer may lie in the disarray at the top ranks of the SEC.

More on the SEC staff’s activist lark after the jump.

As Opening Bell mentioned this morning, shareholder democracy took a turn for the weird recently when the Securities and Exchange Commission began telling major public corporations that they would have to subsidize shareholder proposals urging the company to take a lobbying position in favor of universal health care. Boeing, General Motors, United Technologies, Wendy’s International and Xcel Energy have all received word from the SEC that they’ll have to include these shareholder proposals in the official proxy materials, according to the New York Times.

After the jump, we explain why these proposals are useless, at best, unduly costly and possibly dangerous. Also: a law professor explains better ways to handle these things.

President Bush nominated Washington University Law School professor Troy Paredes to the Securities and Exchange Commission yesterday. If confirmed by the Senate, Paredes would replace DealBreaker’s favorite SEC commissioner Paul Atkins. We’d feared that the loss of Atkins, who’s been a consistent critic excessive financial regulation, would be a blow to the SEC. But Paredes looks like a strong successor to Atkins.

Paredes, who is 37 years old, teaches classes on corporations, securities regulation, corporate finance, and the theory of the firm at the St. Louis school. His published work has focused on the political and psychological causes of excessive financial market regulation, as well as the psychology of corporate decision making. The choice has been endorsed by Larry Ribstein, a professor at the University of Illinois College of Law and the author of the Ideoblog.

Paredes has written that the SEC’s decision to require hedge fund managers to register with the commission—a policy which was later struck down by the federal courts—may have been a reaction to the accounting scandals of the late nineties. The commission “did not want to get caught flat-footed and criticized again” after taking a beating from following the collapse of Enron and WorldCom. In an era when everyone seems to have their own pet plan of new regulations following the subprime disaster, this sounds like exactly the kind of approach we need on the SEC.

We fully expect that Paredes will come into criticism from people whose tacit assumption is that only enthusiasts for regulatory growth should be placed in positions of power at regulatory agencies. Bush is right to ignore this question begging approach by appointing an insightful critic.

Bush Nominates Law Professor Troy Paredes To SEC [Dow Jones Newswires]

The Securities and Exchange Commission is on a three case losing streak in its attempts to sue hedge-fund managers who close out short positions with stock bought through private placements.

Bloomberg reports:

Since October, judges in three cases rejected the U.S. Securities and Exchange Commission’s argument that closing out short positions with shares bought in private offerings is illegal. The SEC sued hedge-fund managers that engaged in the transactions.

“If the SEC losses are ultimately upheld, they’re going to result in funds’ being able to short more easily,” said Steven Siesser, a partner at law firm Lowenstein Sandler in New York who counsels placement agents and investors in sales of “private investment in public equity,” or PIPEs.

The federal agency also argues in the three cases that the managers violated insider-trading laws by shorting stock before a private sale was announced. Prosecutors make a similar claim in a criminal case.

It’s vaguely reassuring to see courts discovering that there may actually be limits to insider trading laws.

SEC Struggles to Pin Insider Trading on Fund Sales [Bloomberg]

Implementing the “internal controls” provisions of Sarbanes-Oxley has been immensely costly for publicly held businesses in the United States while the concrete evidence of it’s benefits has been scant. By some estimates, the direct costs of implementation are as high as $35 billion each year. And the real costs might be even higher. Nonetheless, because non-compliance with Section 404 can be disastrous for a public company due to regulatory sanctions and massive stock declines, companies continue to spend and spend to implement Section 404.

It’s clear the regulation is broken but we’re unlikely to be rid of it any time soon. The regulation’s defenders insist the regulation is helping us avoid the kind of accounting scandals we saw in the late nineties, and that government enforcement of the regulation is necessary because the market can’t be trusted to regulate itself. There’s some truth in this argument: the market won’t necessarily price internal controls over financial accounting at the price regulators think is appropriate, much less at some level that optimizes efficiency over the long term.

But it’s a half truth because it rests on a double standard. It insists we focus on the reality of imperfect markets but not notice the reality of imperfect government. There’s no evidence that the government has arrived at the right level of internal controls, or that it can efficiently police this regulation.

Yesterday we got a reminder of the reality of imperfect government when the General Accounting Office declared that the Securities and Exchange Commission had a material weakness in the internal controls over its own financial reporting. This is a serious blow to the SEC’s credibility, which avoided getting tagged with the “material weakness” finding last year only by promising to improve things. But things haven’t improved. Indeed, they may now be worse.

Fortunately for the SEC, there is no market accountability for government agencies. You can’t short the SEC, and lawmakers are unlikely to penalize the commission by denying it authority or funds. Indeed, we expect that this GAO finding will somehow become an argument for the SEC to get more funding. That’s the way it works in our nation’s capital: failure is only evidence of the need to get more of the people’s treasure.

And for those of you who miss the irony of this we’ll make it clear: the SEC is the agency charged with enforcing Section 404 on public companies. Of course, no government agency has ever let the glass facades of its own house prevent it from throwing stones.

SEC Flunks Internal Controls Audit [CFO.com]

The myth of shareholder democracy holds a powerful sway over public opinion. The comments we’ve received on our two articles on the proxy access rules now up for comment at the Securities and Exchange Commission demonstrate that people continue to be bedeviled by the misguided analogy with democratic political regimes.

One of the mental levers the mythologists of shareholder democracy use to make their case is a kind of demonology of corporate managers. Although corporate insiders, especially chief executives, have demonstrably lost power in recent years to shareholders and independent directors while the risks of running a public company have increased, the continued climb of executive pay seems to have convinced many that executives are somehow fleecing shareholders. The evidence for this is underwhelming, however. While bad characters exist in executive suites and board rooms, they hardly justify enacting wide-ranging corporate governance reforms. Bad CEOs make bad law.

It’s important to remember that our system of corporate governance has generated enormous wealth for shareholders and workers over the years, bringing us unprecedented prosperity. We should exercise caution when seeking major reforms, especially when the costs of those reforms will be difficult to measure and the reforms will be next to impossible to reverse. By creating a uniform, national rule for proxy access, the proposed reforms would shut off jurisdictional competition and experimentation between the states. Worse, the proxy access reform is clearly viewed by many of its proponents as a first step in what they view as a revolution in corporate governance. There will be more to come. The proxy access reforms are precedent not a final resting place.

Some of the most thoughtful criticism of our first essay came from Beth Young, who I believe is the author of the Shareholder Proposal Handbook and a senior research associate at the Corporate Library.

We rough up Young’s objections to our articles after the jump.

Sometime in the next few weeks, Securities and Exchange Commission chairman Chris Cox will likely have to decide how he will vote on a pair of competing rules on shareholder access. One “proxy access” rule would shift power from boards of directors to cliques of outside shareholders by permitting certain shareholders and groups of shareholders to include in company proxy materials proposals for amendments to bylaws that would mandate procedures to allow shareholders to nominate board of director candidates. The other preserves longstanding rules that make it difficult and costly to for dissidents to mount proxy fights.

The SEC’s commissioners are evenly divided along partisan lines on the question. The Democratic commissioners favor increased proxy access. The Republicans favor the status quo. Cox holds the deciding vote. Which way will Cox vote? We’re not in the predictions game. But if we take Cox at his word about his own agenda at the SEC, it seems clear that he should vote against the new proxy access rules.

After the jump, we look at how the new proxy access rule hurts ordinary investors.

Securities and Exchange Commission Chairman Chris Cox holds the swing vote in one of the most important questions of corporate control currently being considered by the government. Sometime soon he’ll have to decide whether to support the proxy access proposals put forward by the Democratic commissioners or cast his lot with Republican proposals to maintain the status quo.

As is so often the case, at the heart of the matter is a confused concept. In particular, the concept of shareholder democracy seems to have broken out of its academic box and run rampant through the minds of some otherwise sensible people. Fortunately, the proxy access proposals are the subject of two of the most important articles published today—one from law professor Lynn Stout in today’s Wall Street Journal and the other from Larry Ribstein on Ideoblog.

Stout takes the argument for shareholder democracy head on, arguing that the “proposed proxy access rule is driven by the emotional claim, unsupported by evidence, that American corporations benefit from ‘shareholder democracy.’” Current shareholders, who are only temporary owners with easy entrance and exit strategies, have incentives to exploit and loot a company for immediate gains—which is exactly what some well-known activist shareholders have been urging on public companies. A stronger shareholder franchise will only acerbate the problem, Stout says.

What makes US companies function so well is the fact that they are managed by strong central boards and run by powerful managers. “Successful corporations are not, and never have been, democratic institutions. Since the public corporation first evolved over a century ago, U.S law has discouraged shareholders from taking an active role in corporate governance, and this ‘hands off’ approach has proven a recipe for tremendous success,” Stout writes.

Ribstein is less enthusiastic about traditional models of corporate governance. In fact, he thinks that the traditional public corporation may be on its way out—or at least in for some real evolution. But he agrees with Stout that attempts to force change on corporations through a new national regulation on proxy access are a very bad idea. “[T]he reason why the SEC should keep its hands-off here has more to do with the appropriate limits of SEC power than with the substance of the proposal. This is a matter of internal corporate governance which should be for the states,” Ribstein writes. “There is no justification for making this a federal matter unless you buy in to the shareholder democracy myth.”

What neither Ribstein nor Stout touch on today is the actual mechanism for the disfunction of shareholder democracy. Both understand that it won’t work as promised but they don’t spell out the reasons why. But fortunately you read DealBreaker, so you are about to learn why.

Clearing up the puzzle of shareholder democracy after the jump.

Filing annual reports and auditing financial statements according to US GAAP standards is excruciating for all public companies but for NEC electronics, it’s become a debilitating factor in their American depository receipts trading on our exchange.

The company formerly known as Nippon Electronic Company’s ADRs will no longer be traded on the Nasdaq as of today. Not only are they unable to file their Form 20-F for the fiscal year rounding up in March ’06, they announced their US filings dating back to 1999 are unreliable.

According to a report by CNN Money, the NEC said a restatement (of their annual report) “is not practicable” because of the complexities involved in determining the necessary adjustments. We previously reported that the Europeans are also taking issue with our accounting principles and filing standards and realize we’re seeing a trend here.

Are our accounting standards REALLY that difficult? Is this our problem or theirs? Have our accounting rules become so arcane they’re driving companies away from us? A bunch of you have your CFA designation – tell us what’s going on here.

Nasdaq Takes Step to Delist NEC Corp. [Wall Street Journal]

NEC Will Not File Fiscal 2006 Report [CNNMoney.com]

Ever the persistent bunch, the Europeans will stop at nothing to get a slice of that delectable American pie. If it’s not attempting to rename the simple hot dog into something called a Frankfurters, it’s our wallets they are after. Now it seems they want the SEC to confirm to their dodgy accounting principles. The New York Times reported today, “In a letter released yesterday, the European Association of Listed Companies said the Securities and Exchange Commission should allow the use of international accounting standards but should not insist that companies follow all the standards. Instead, the group said, the S.E.C. should accept modifications imposed by the European Commission.

Such a change, if approved by the S.E.C., would reduce the power of the International Accounting Standards Board, which is based in London and sets rules now used in many countries.

Currently, companies whose securities are registered in the United States must either prepare their financial statements in accordance with American rules (known as generally accepted accounting principles, or GAAP), or reconcile them to those rules. The proposed S.E.C. rule would eliminate that requirement starting next year.”

Sure, sure. It would probably help our exchanges out by making it easier for foreign companies to list on US exchanges. And there are some advantages to those fancy European principals based accounting standards. But we’re still suspicious of letting the E.U. start issuing instructions to the SEC.

Just keep your mayonnaise off our freedom fries you Belgian busy-bodies!

A Plan to Let S.E.C. Accept Foreign Rules Is Opposed [New York Times]

The SEC implied yesterday afternoon that Dwight “Sean” Jones, former defensive lineman for the Raiders, Oilers, and Packers blocked regulators from examining the business records of his investment advisory firm, Amaroq. Jones allegedly evaded requests for information, and then told the SEC that the records were no longer available, because

(There’s nothing else to add, because this story is hilarious as is. But maybe just don’t give your money to football players-cum-money managers, with the exception of OJ Simpson. He got away with murder. Investing should be easy, by comparison.)

Former NFL Star Sacked By Feds [New York Post]

Last month, the SEC put up links on its website to every company filing that mentions business conducted with the U.S. designated “State Sponsors of Terrorism,” or Cuba, Iran, North Korea, Sudan and Syria. We covered it here. The most common “offenders” were banks, consumer products companies, natural resource companies and Nokia.

There were even five companies linked to business in North Korea: Biotech Holdings Ltd, China Yuchai International Ltd, Credit Suisse Group Ltd, HSBC Holdings PLC and Siemens Aktiengesellschaft (Gesundheit).

Last week, Barney Frank, Chair of the House Committee on Financial Services dissed the SEC Terror Tool, and SEC Chairman Chris Cox took the thing down on Friday. Here’s an overview of the official SEC statement, from the AAO Weblog:

On Friday, the SEC took the tool away from investors [you can take the tool out of the investor, but you can’t take the investor out of the tool]. According to a statement by Chairman Christopher Cox, it will return [more powerful than you can ever imagine] with more up-to-date information [and a different colored light saber]. That carries the implication that the tool will corral information [and livestock] from 10-Qs as well as 10-Ks. (The original tool extracted data from only 10-Ks.) Cox also hinted that [he might be going commando] the tool might evolve into an XBRL project [the bonobo of projects] - and that “the Commission staff will also consider whether to recommend a Concept Release on the question of how best to make public company disclosure of activities in terrorist states more accessible [a new thrill ride]. The release would solicit public comment in a formal way [leave a card in the SEC comment box on the way out], so that the Commission could ensure that all legitimate concerns can be met [if Applebees and IHOP merge, do the terrorists win?] while providing better access to company disclosures on these topics [the last three sentences don’t mean anything].”

Basically, in a mess of gloriously fuzzy obfuscation, the tool has been shelved. It doesn’t make much sense that the existing site had to be completely eliminated on an interim basis. Even if Frank thought that the site was inaccurate, it did point to the actual segments of company filings that mentioned the designated countries. We’re thinking maybe a simple disclaimer would have sufficed - “Just because Nokia is the mobile carrier of choice for terrorists doesn’t mean that you shouldn’t buy a new Nokia N75.”

The SEC Pulls Its “Terrorism Tool” [The AAO Weblog]

We got so caught up in the excitement over the board of directors, Bancroft family, Rupert Murdoch, News Corp drama that we’d totally forgotten about the insider trading angle to this story. But fortunately we have the Securities and Exchange Commission to remind us that prior to the public learning of the deal, a Hong Kong couple with ties to Dow Board member David Li, chief executive and chairman of the Bank of East Asia, allegedly engaged in insider trading.

According to published reports, the SEC has issued a Wells Notice to Li, informing him that it plans on filing civil charges against him.

For those of you who have never gotten one—a Wells notice is a sort of like a bill from the utility company stamped Final Notice. Except that instead of shutting off your electricity, if you don’t respond to the notice you wind up getting sued by the SEC. It’s basically your last chance to convince them that they shouldn’t file a lawsuit against you. Or, as a friend of ours once put it, it’s a notice that it’s time to move your funds off-shore, get out of the country and hire some very good lawyers.

SEC to File Civil Charges Against Dow Jones Director [Wall Street Journal]

If you think insider trading in the U.S. is bad, where 41% of deals show signs of “suspicious” pre-announcement trading, take a look at some other countries. The Dutch are just as dodgy, Deal Journal reports. Dutch authorities are looking into the 11% spike in Numico shares before the announcement of a $17 billion bid for the company and the NYSE is investigating trading of ABN Amro share before the announcement of Barclay’s bid.

One of the worst industrialized nations in terms of insider trading is Brazil. A Bloomberg expose on the Brazilian market reports that nearly every one of the 145 M&A deals in Brazil this year leaked early and showed signs of rampant insider trading. We’re not talking subtle share price bumps but massive spikes like the 550% surge in the price of Tele Norte Leste Participacoes SA before an April 10 buyout announcement. This hasn’t exactly created a crises of confidence, as the Bovespa benchmark index in Brazil has climbed 189% (in dollar terms) in the past 2 years, helped along by the slowest inflation in a decade. At least the incredibly corrupt old boys in the system are finally making real relative gains.

If you thought the SEC was toothless, it’s a virtual piranha compared to the gummy geriatric nibbles of enforcement provided by the Comissao de Valores Mobiliarios (the Brazilian SEC), run by Macelo Trindade. In theory insider trading is a crime in Brazil, carrying a penalty of one to five years in prison (and we’re taking one to five in Brazilian prison years), but no one has ever been sent to jail for it. Prison sentences for illegal trading have been issued in the country, but get overturned on appeal (and upheld by the Brazilian Supreme Court), like the famous Naji Nahas case in 1994.

The only people in finance we know in Brazil, Merrill Lynch banker Renato Malzoni and his girlfriend Daniela Cicarelli (pictured above), could not be reached for comment. (By popular demand, we’ve reduced her picture to a headshot. Click on the picture for a larger image of Cicarelli in beachwear.)

Insider Trading Goes Global [Deal Journal]
Insider Trading Infects Brazil Stocks as Almost All Deals Leak [Bloomberg]

The SEC has added links on its website to the pertinent portion of every company filing that mentions business conducted with U.S. designated “State Sponsors of Terrorism.” The five winning countries are Cuba, Iran, North Korea, Sudan and Syria. The companies are mostly banks, financial services or natural resource companies, with a sprinkling of some consumer products companies and biotech.

The only recognizable outliers are Xerox (in the Sudan, as all good genocidal propaganda, or at least “missing” posters need mass production), the Four Seasons (in Syria, for power lunch) and Nokia is the mobile carrier of choice for terrorists (with business in Iran, Sudan and Syria).

Remarkably, there are five companies that mention business in North Korea: Biotech Holdings Ltd, China Yuchai International Ltd, Credit Suisse Group Ltd, HSBC Holdings PLC and Siemens Aktiengesellschaft (Gesundheit).

Here’s an excerpt from Credit Suisse’s 20-F:

As part of its continuing evaluation of risk, in the first quarter of 2006, the Group determined to limit the amount of business with counterparties in, or directly relating to, Cuba, Iran, Myanmar, North Korea, Sudan and Syria. The Group has decided that it will not enter into new relationships with clients from these countries and will end all existing relationships with corporate clients and most private banking clients in these countries. Some designated relationships with private banking clients in these countries will be maintained subject to restrictions, including the centralization of the private banking relationship within Credit Suisse in Switzerland.

Translation: No more Swiss bank accounts for new or up and coming terrorists, although the really rich established ones can stick around, and have free checking.

Here, a nugget from HSBC’s 20-F:

HSBC takes its obligations to prevent money laundering and terrorist financing very seriously. HSBC has policies, procedures and training intended to ensure that its employees know and understand HSBC’s criteria for when a client relationship or business should be evaluated as higher risk. As part of its continuing evaluation of risk, HSBC monitors activities relating to Cuba, Iran, Myanmar, North Korea, Sudan and Syria. HSBC’s business activities include correspondent banking services to banks located in some of these countries and private banking services for nationals of, and clients domiciled in, some of the above countries. The Group has a small representative office in Tehran, Iran.

Translation: If we see anything, we’ll call you (quick Zarqawi, the back door is this way). We monitor this stuff we swear (are we still liable if we don’t know about our client’s activities?).

Then there’s China Yuchai International’s 20-F, which, I’m paraphrasing, says that the SEC sent us a letter and…um…yeah…we’ll get right on that.

SEC Adds Software Tool for Investors Seeking Information on Companies’ Activities in Countries Known to Sponsor Terrorism [SEC]

The Securities & Exchange Commission has opened up a preliminary inquiry into the near collapse of a highly levered hedge fund it managed, Business Week’s Matthew Goldstein is reporting. Apparently regulators would like to know how the investment firm went from telling investors that April’s losses were below 7% only to restate them at 18.97%.

This morning DealBreaker reported that the headline making troubles of two Bear Stearns funds were attracting the attention of two Capitol Hill lawmakers.

Bear’s Big Loss Arouses SEC Interest [BusinessWeek]

IBM settled with the SEC, without admitting any wrongdoing, over charges that it deliberately used a misleading chart (pictured) in a 2005 earnings call. The IBM chart in question portrayed the impact of expensing employee stock options on EPS in 2005. IBM said in the chart that the negative impact of expensing employee stock options would be 14 cents a share in Q1 and 55 cents in 2005, despite internal estimates that EPS would dip by only 10 cents a share in Q1 and 39 cents a share in 2005.

IBM produced the bogus numbers because it didn’t want analysts to increase the company’s expected growth rate, in a partial attempt to offset an increased pension cost. No IBM executives were named in the complaint and the company was not fined. IBM did agree to not do anything wrong in the future. Let that be a warning to companies that want to make up numbers. The SEC’s teeth are awfully sharp.

Did IBM Show Analysts a Phony Chart? [CFO.com]

It is apparently still news to some that the Securities and Exchange commission is very deferential to the securities industry. This morning the Wall Street Journal reported that “the agency has been publicly and noisily pressured by a congressman, a union leader and a Democratic presidential candidate, amid increasing consternation the agency is favoring business interests in its decision making.”

The focal point for the attention is a Supreme Court case that will decide on whether shareholders can sue investment banks for the fraudulent activities of their clients. The question is whether the SEC will file a brief with the court supporting the plaintiffs position that investment banks can be held liable. Prominent (some would say, notorious) plaintiff’s lawyer Bill Lerach is lobbying the SEC to take the side arguing that banks can be sued. Merrill Lynch, which is a defendant in a class-action lawsuit filed by lawyers representing former Enron shareholders, asked the SEC to take the opposite side.

Both sides, of course, claim that their position best protects investors. The plaintiff bar claims that holding banks liable will make banks better police their clients and avoid aiding or even looking the other way when companies engage in fraud. The banks see this opening the flood gates to a torrent of lawsuits.

Who’s right? That’s probably entirely besides the point. These things are rarely, if ever, decided on the basis of wise policy.

[After the jump, we pull back the curtains on what really decides these kind of public policy issues. Hint: it’s not a great and all-knowing wizard.]

It is apparently still news to some that the Securities and Exchange commission is very deferential to the securities industry. This morning the Wall Street Journal reported that “the agency has been publicly and noisily pressured by a congressman, a union leader and a Democratic presidential candidate, amid increasing consternation the agency is favoring business interests in its decision making.”

The focal point for the attention is a Supreme Court case that will decide on whether shareholders can sue investment banks for the fraudulent activities of their clients. The question is whether the SEC will file a brief with the court supporting the plaintiffs position that investment banks can be held liable. Prominent (some would say, notorious) plaintiff’s lawyer Bill Lerach is lobbying the SEC to take the side arguing that banks can be sued. Merrill Lynch, which is a defendant in a class-action lawsuit filed by lawyers representing former Enron shareholders, asked the SEC to take the opposite side.

Both sides, of course, claim that their position best protects investors. The plaintiff bar claims that holding banks liable will make banks better police their clients and avoid aiding or even looking the other way when companies engage in fraud. The banks see this opening the flood gates to a torrent of lawsuits.

Who’s right? That’s probably entirely besides the point. These things are rarely, if ever, decided on the basis of wise policy.

[After the jump, we pull back the curtains on what really decides these kind of public policy issues. Hint: it’s not a great and all-knowing wizard.]