Trickle-Down Retribution

Congress is close to passing a 2,300-page financial services bill. Despite media spin, this legislative muddle is bad news for the American public. The only victory can be claimed by the special-interest groups--in particular, plaintiffs' lawyers--that inserted provisions to advance ulterior motives but have little to do with the stated goals of the legislation.

This poorly drafted hodgepodge--most provisions have nothing to do with the true causes of the financial crisis--will drastically expand the power of the federal government, create new bureaucracies staffed with thousands, and do little to help the struggling American citizen. Ambiguous language will result in frivolous and unnecessary litigation, further stifling economic growth. The additional costs will weigh on consumers, raise barriers to entry for entrepreneurs and destroy jobs. What a great way to get an economy up and running.

Aside from a few provisions, most of the bill has not been fully debated in Congressional hearings, but is the product of a series of marathon, late-night, closed-door negotiations. As Sen. Christopher Dodd, D-Conn., remarked at the end of an all-night session leading to the final draft, "No one will know until this is actually in place how it works."

By upping the ante on liability and leaving unresolved bureaucratic turf issues between regulatory agencies, the bill guarantees that these instruments will become more expensive and hedging risk will become less certain.

Largely unnoticed and undebated are the ways in which the bill could further expand the ambit of the plaintiffs' bar. Chief among these are the whistle-blower provisions. The bill provides that the Commodity Futures Trading Commission and Securities and Exchange Commission may award whistle-blowers from 10% to 30% of monetary sanctions collected in enforcement actions. Two special funds of $300 million and $100 million are set up for the SEC and CFTC, respectively, to ensure payment of whistle-blowers. The bill provides that whistle-blowing employees can hire attorneys and that they must hire an attorney if they wish to remain anonymous. One can imagine what percentage of the 10%- 30% take the lawyers will demand from the whistle-blower.

The drafters of the bill clearly are aiming to encourage whistle-blowers and ease their fears of retaliation, ostracism and reputational damage for future employment--all authentic concerns for legitimate protesters. But the unintended consequences of unfounded charges from employees with ulterior motives will be devastating for shareholders.

Already, a company must hire attorneys and accountants to investigate almost any purported complaint, with strict policies and procedures to ensure due process. The injection of plaintiffs' attorneys into the mix increases the potential for specious claims to get traction and win a settlement, especially if the complainant is anonymous. Congress has skewed the delicate balance between good policy and over-indulgence of accusations.

In another example, the bill imports class-action lawyers' favorite tool, section 10(b) of the Securities Exchange Act, explicitly into the law governing securities-related derivatives and swaps. Section 10(b) is the hunting license for trial lawyers to bring class-action lawsuits for sometimes frivolous reasons. While itself not necessarily earth-shaking considering the current state of the law, the change's real-world effect could be troubling when combined with the bill's new regime regarding transparency and clearing of derivatives, which will make pricing information public for the first time. Because private plaintiffs must show causation under section 10(b), plaintiffs' lawyers simply point to drops in stocks as evidence of causation.

With stocks, frivolous lawsuits may be dismissed on causation grounds by the judge. However, derivatives often fluctuate for a variety of complicated reasons, so judges simply may avoid the difficult decision of dismissing a frivolous complaint on the merits and leave matters to a jury to sort out. Since the bill's exceptions from liability are very narrow, plaintiffs' lawyers will find the $1.5 trillion over-the-counter U.S. securities derivatives market a tantalizing prospect for lawsuits.

These securities-related derivatives are important tools in basic corporate finance, mergers and acquisitions, and hedging transactions. By upping the ante on liability and leaving unresolved bureaucratic turf issues between regulatory agencies, the bill guarantees that these instruments will become more expensive and hedging risk will become less certain. It does not take a financial genius to predict that the writing and trading of these instruments will migrate to London, Singapore and perhaps Toronto.

Other special-interest groups are celebrating. The bill gives the newly politicized SEC authority to let certain large shareholders, acting in coordination in a non-transparent manner, nominate directors directly--mainly unions, state pension funds and activist shareholders pushing special agendas. The interests of these groups often differ from the interests of individual shareholders. By tipping the scale further in the favor of them, the net effect will be to politicize the proxy process, overrule well-established state law, undermine company management and confer on opaque proxy advisory firms, "activist shareholders," unions and other often-allied interest groups additional back-room clout to influence corporate affairs for their own benefit. Who loses? The average shareholder.

What started out as a bill to "get" Wall Street has morphed into a bill that sticks it to everyone--Wall Street, Main Street, consumers, entrepreneurs, shareholders and taxpayers alike. The financial markets are critically important to America. They raise capital for businesses producing goods and services. They create jobs, fund ideas and increase wealth for all Americans. When Americans save and invest, they are putting their capital to work, building their nest egg and that of others too. We need a more thoughtful, balanced plan to make sure that that nest egg is as safe as it can be, but also to ensure that we are not killing the proverbial, golden egg-laying goose. Senators should reject this unhealthy bill.

Paul Atkins is a visiting scholar at AEI.

Photo credit: iStockphoto/Brandon Rose

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