When a prominent Houston attorney advocates exonerating a convicted Enron executive you have to believe — as I have long argued — that something is seriously wrong with the conviction.  In his excellent post, The Reeling Prosecution in the Skilling Case, Houston Attorney Tom Kirkendall explains why the U.S. Supreme Court should (and likely will) let Jeff Skilling out of jail when it hears his case.

For those with short attention spans, the bottom line is that Jeff Skilling was convicted and sent to jail for 24 years (a sentence recently set aside by the 5th Circuit Court of Appeals in a weirdly self-contradictory opinion) because a Houston jury, poisoned by months of anti-Skilling and anti-Enron propaganda, decided that Skilling exercised bad business judgment as Enron’s CEO during the company’s death spiral. The jury’s theory, doubtless buttressed by years of education and experience running companies in the complex energy derivatives markets, was apparently that any business executive dumb enough or nice enough to try to rescue the jobs and retirement plans of thousands of employees from a perfect market storm had damn-well better save the company or get ready for the guillotine.

Skilling’s conviction and draconian sentence should shock the consciences of anyone who has thoroughly studied the case.  Readers with the stomach for detail will find compelling evidence of Skilling’s innocence (and the prosecution’s guilt) in his 209-page Petition for Writ of Certiorari.

One prong of Skilling’s defense is that “honest services wire fraud,” codified at 8 U.S.C. § 1346, is chaotic nonsense that fosters politically-motivated witch hunts any time a big company’s stock plunges in value for whatever reason.  Kirkendall notes:

Inasmuch as there is now a split between Fifth Circuit decisions and several other circuit appellate courts on the scope of honest services wire-fraud, the issue is ripe for Supreme Court consideration. Indeed, Justice Antonin Scalia earlier this year urged the Supreme Court to take up the issue in his dissent from denial of certiorari in Sorich, et al v. U.S., 129 S.Ct. 1308, 1310 (2009):

“Without some coherent limiting principle to define what ‘the intangible right of honest services’ is, whence it derives, and how it is violated, this expansive phrase invites abuse by headline grabbing prosecutors in pursuit of local officials, state legislators, and corporate CEOs who engage in any manner of unappealing or ethically questionable conduct.  .   .   . Indeed, it seems to me quite irresponsible to let the current chaos prevail.”

Lest anyone wonder, I do believe that some Enron employees engaged in illegal conduct. I don’t think there’s any question that one of those was Enron CFO Andy Fastow. However, there is very little doubt in my mind that Jeff Skilling’s conviction was morally, economically and legally wrong and should be overturned.

ht: Doran Williams

With Wall Street agog over the DOJ’s biggest insider-trading sting ever and fully seven years since the Enron scandal broke, Jeff Skilling is back in the news.  The U.S. Supreme Court has agreed to hear Skilling’s appeal of his convictions in the Enron case for so-called “honest services fraud” and insider trading.  Needless to say, justice in these United States can take an excruciatingly long time to develop.

The Supreme Court’s grant of certiorari in Skilling v. United States should be good news for Americans accused of white collar fraud in the current wave of anti-Wall Street hysteria.  It is a sign that justice may at long last get its day in court, even in politically-charged cases like Skilling’s which grew out of the collapse of Enron.  I have consistently argued — see Jeff Skilling Is Innocent — that Skilling’s convictions were themselves a fraud, riddled with prosecutorial misconduct and jury bias and founded on a specious legal theory, “honest services fraud,” that criminalizes optimism essential to economic growth.

Here, for the record, are the questions to be heard by the Supreme Court:

1. Whether the federal “honest services” fraud statute, 18 U.S.C. § 1346, requires the government to prove that the defendant’s conduct was intended to achieve “private gain” rather than to advance the employer’s interests, and, if not, whether § 1346 is unconstitutionally vague.

2. When a presumption of jury prejudice arises because of the widespread community impact of the defendant’s alleged conduct and massive, inflammatory pretrial publicity, whether the government may rebut the presumption of prejudice, and, if so, whether the government must prove beyond a reasonable doubt that no juror was actually prejudiced.

Not every economic catastrophe is caused by a crime.  Markets naturally move up and down in cycles. Prosecutors and politicians should have the courage to make this clear to investors who too often expect someone else to pay every time the market turns against them.

As this story from Chinese markets shows, financial derivatives are often not what they seem.  If you plan to use derivatives to hedge risks, don’t forget the counterparty risks inherent in the derivatives themselves.

Highlighting once again the risks of doing business with state-owned Chinese companies, banks and the derivatives market took another hit on September 7 when the Chinese government encouraged state-owned airlines and shippers, including China Eastern Airlines Corp., Air China Ltd. and China Ocean Shipping (Group) Co., to legally challenge their fuel derivatives contracts with foreign banks.

The contracts were used by these companies to hedge against what they expected to be a steep rise in fuel prices.  When the prices fell — as they sometimes do in a market — the companies ended up losing millions.  The losses are premised on the assumption that the companies are legally bound by the derivative contracts. This assumption should have been questioned back in March 2009 when, according to China Daily, China’s State-owned Assets Supervision and Administration Commission (SASAC) “tightened the rules” governing State-owned enterprises’ (SOEs) use of derivatives under Chinese law.  Those who did not question then are certainly doing so now.

As the Wall Street Journal reports:

China’s government … offered public encouragement to state-owned companies challenging foreign banks over huge losses from derivative contracts …

… [The SASAC] said it supported moves by unnamed Chinese enterprises to seek recourse for their losses in structured financial derivative contracts tied to the price of oil and reserved the right to file lawsuits itself.

In early August, China Eastern Airlines Corp., Air China Ltd. and China Ocean Shipping (Group) Co. sent letters to six international investment banks warning that certain transactions “may be void, invalid or unenforceable”…

Among the banks … are Deutsche Bank AG, Goldman Sachs Group Inc., J.P. Morgan Chase & Co., Citigroup Inc. and Morgan Stanley…

The Shanghai-based [China Eastern Airlines] said in January it faced a loss of about $900 million on aviation-fuel-hedging activities. In a reminder of how volatile financial markets can be, it more recently said its position had reversed…

By stepping into oil-derivative contract disputes that have been bubbling for months, Beijing is sending a signal that its strategic interests can extend to foreign financial markets…

The SASAC highlighted in its statement that it is investigating the oil contracts in order to “safeguard state assets,” while noting the “risks and complexities” in some contracts that make them difficult to understand.

Financial policy makers in China say government leaders often don’t grasp how derivative products work and then react angrily when deals backfire… [Editorial comment: This phenomenon is not confined to Chinese government leaders.]

The article quotes Alan Wang, of Freshfields Bruckhaus Deringer LLP, for the proposition that companies entering into contracts with Chinese enterprises should “ensure that Chinese entities have necessary authorization to enter a deal, since legal challenges are often grounded in an argument that the deals weren’t permitted or were too complex [under relevant Chinese regulations].”   Wang also advises that contracts should include an international arbitration clause to ensure enforceability of awards or judgments in Chinese courts.

For a contrary view, read Dan Harris’ excellent article, China OEM Agreements. Why Ours Are In Chinese. Flat Out. Dan believes that contracts with Chinese parties should be drafted in Chinese and should direct dispute resolution to local Chinese courts.  While the derivatives contracts at issue here are not OEM agreements, it is fair to say that much of Dan’s logic crosses over.  While a non-Chinese arbitrator might uphold the derivatives contract in favor of a foreign bank, it’s far from certain that a Chinese court would enforce the arbitral award where Chinese public policy arguably demands the opposite result.

Takeaways?  Derivatives are risky whether you are hedging or speculating.  The same goes for any other kind of contract with government-owned entities — especially ones a long way from home in proudly communist countries whose cultural orientation toward “markets” has at least historically been markedly different from that of much of the rest of the world.

More details are available at the WSJ.

Earlier this year, I shared misgivings of other commentators that Mary Schapiro’s tenure at FINRA rendered her too conflicted to Chair the SEC.  Judge Rakoff’s scathing September 14 order in SEC v. Bank of America adds weight to the argument.  Judge Rakoff rejected the SEC’s settlement, ordering the parties to prepare for trial on February 1.

The judge’s order shines light on the SEC’s “prosecution” of the case.  First, the SEC actually planned to take an additional $33 million fine from Bank of America (and, therefore, its shareholders) to “punish” the Bank’s management for allegedly lying in proxy solicitations to those same shareholders about the bonuses to be paid to Merrill execs pursuant to the merger.  In other words, in SEC’s distorted view of reality, the best remedy for management theft is SEC theft.

Second, the SEC apparently violated its own policy manual in declining to prosecute the attorneys who Bank of America insists were responsible for the alleged misstatements in the first place.

This is all very strange behavior for a regulatory agency supposedly working hard to repair its reputation in the aftermath of the Madoff scandal.  I differentiate here between the scandal (that the SEC took so long to discover Madoff’s Ponzi) and the Ponzi itself. Some of the most compelling language from Rakoff’s order appears below.

In the Complaint in this case, filed August 3, 2009, the Securities and Exchange Commission (“S.E.C.”) alleges, in stark terms, that defendant Bank of America Corporation materially lied to its shareholders in the proxy statement of November 3, 2008 that solicited the shareholders’ approval of the $50 billion acquisition of Merrill Lynch & Co. (“Merrill”). The essence of the lie … was that Bank of America “represented that Merrill had agreed not to pay year-end performance bonuses or other discretionary incentive compensation to its executives prior to the closing of the merger without Bank of America’s consent [when] [i]n fact, contrary to the representation …, Bank of America had agreed that Merrill could pay up to $5.8 billion –- nearly 12% of the total consideration to be exchanged in the merger ….

Overall … the parties’ submissions … leave the distinct impression that the proposed Consent Judgment was a contrivance designed to provide the S.E.C. with the facade of enforcement and the management of the Bank with a quick resolution of an embarrassing inquiry – all at the expense of the sole alleged victims, the shareholders….

Nor is the proposed Consent Judgment reasonable. Obviously, a proposal that asks the victims to pay a fine for their having been victimized is, for all the reasons already given, as unreasonable as it is unfair. But the proposed Consent Judgment is unreasonable in numerous other respects as well. For example, the Consent Judgment would effectively close the case without the S.E.C. adequately accounting for why, in contravention of its own policy … it did not pursue charges against either Bank management or the lawyers who allegedly were responsible for the false and misleading proxy statements.

The entire order is well worth a read for those with securities-law mindset. Are the SEC’s “enforcers” so accustomed to playing this kind of game that they never expected a judge to object? In a case with this kind of profile, wouldn’t you expect Mary Schapiro to weigh in? Is Schapiro the proverbial fox guarding the hen house?

Who ruined your retirement portfolio? In his September 10, 2009 New York Times’ column, Accountants Misled Us Into Crisis , Floyd Norris points the finger at standard-setting accountants at the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB).

Norris appears convinced that if the FASB and IASB had written the “right” accounting standards the “right” way (especially to require banks to report their assets at “fair” value), banks could not have become so weak as to threaten the financial system.  If only reality were that simple.  Four factors argue against Norris’ view.

First, demands by market analysts and others for “fair value” financial statements are misplaced.  The reality of today’s internet-fueled markets is that no asset or group of assets has a single “fair value” that lasts for more than an instant. Verifiable market values, if they exist at all, often move dramatically in mere minutes or hours.  No profession — not accountants, actuaries, analysts, physicists or attorneys — can pinpoint a single, verifiable “fair value” for any financial asset.  One notorious illustration occurred only a year ago.

Fleeing from a run on Wachovia Bank, the U.S. government tried to force Wachovia to sell itself to Citigroup.  On the night of October 2, 2008, the country turned out the lights “knowing” that Wachovia’s “fair value,” as established by the terms of the Citigroup sale, was $2.16 billion. The next morning, October 3, we awoke to the news that the Wachovia’’s “fair value” had miraculously increased overnight to $15.1 billion, thanks to a bid by Wells Fargo.

Can anyone claim, today, nearly a year after the event, that they unequivocally know Wachovia’s “fair value” at the close of business on October 2, 2008?  The same uncertainty afflicts asset values across the market — commodities, stocks, bonds, mortgage-backed securities, used cars — you name it.  The most we can say about any asset’s value at any moment in time is that it falls with less than 100% reliability within some range of values.  It is fundamentally misleading to claim as “fair” any particular number within that range.   To demand that accountants lie to readers by reassuring them of the existence of a non-existent number is manifestly unfair.  Perhaps accounting rules should require less precision (which some erroneously equate to “transparency”) in valuing assets rather than more.

Second, the idea that banks would be more healthy if forced to be more transparent flies in the face of banking reality.  Our fractional banking system — as vividly illustrated by Wachovia’s near death experience last fall — is at its core a con game.  The more light you shine on it, the faster it goes out of business.  Not for nothing is the Federal Reserve fighting desperately to avoid disclosing banks’ discount-window transactions to Bloomberg News.

A bank’s survival depends on its ability to persuade (snooker?) the vast majority of depositors into believing that they can get their money out at any time when every banker knows that no more than 10 percent of deposits (and often significantly less) are actually held by the bank.   Thus, banks rely in part of lack of transparency just to survive.  One might argue that the more transparent a bank’s financial statements, the faster it will go out of business.  The FASB and IASB can hardly be faulted for declining to write accounting standards that would push most banks over the edge.

Third, public companies — including banks that are publicly traded — are already required by existing IFRS and SEC rules to provide what Norris demands and more.  Under both sets of rules, publicly traded banks must report all material information to the market in their financial statements or other required disclosure documents.

Under the  “true and fair override” of IAS 1, para. 18, if a set of financial statements prepared in accordance with detailed IFRS standards are nevertheless misleading, then an IFRS-compliant company must change the financials (in violation of the detailed rules) to ensure as much as possible that they fairly state the company’s position and results. Norris and I last debated true and fair view, in 2008, in the context of another bank-accounting controversy,  Societe Generale’s “report everything in 2007″ approach to Jerome Kerviel’s trading losses.

The SEC (though not the FASB) has a similar rule, SEC Rule 12b-20.  This rule requires that companies provide whatever additional disclosure is necessary to make misleading-yet-FASB-compliant financial statements not misleading.  Rule 12b-20 has been on the books since 1965.  Its consistent application by the SEC would make unnecessary any changes to existing financial accounting standards.  Hence, to the extent that financial reporting really had anything to do with the mess, and it’s not entirely clear that it did, it is hardly fair to pin the blame on either FASB or IASB.

Fourth, investors, analysts and institutions simply must accept some responsibility for their own decisions.  If you do not understand what you are reading in a set of financials — say, for example, that you just cannot parse the economics of those darned CDOs or mortgage-backed securities — then don’t buy the stock.  How hard is that?

Some of Bernie Madoff’s victims knew that he had to be doing something illegal but they invested anyway because they liked his “returns.”  In the broader market, a fair share of institutional investors were burned by investing in companies or products, like mortgage-backed securities, whose financial disclosures they knew they did not understand.  Investors who are so cavalier with their funds should be full responsibility for their losses.

Now a few comments focused on specific portions of Norris’ piece:

It is unfortunate that there are significant differences between the American and international rules on how to determine fair values of financial assets. That has enabled banks on both sides of the Atlantic to demand that they get the best of both worlds. Pleas for a level playing field have resonated in Washington and Brussels.

I’m not sure what to make of this paragraph. Why are “significant differences” between the two sets of standards so unfortunate? Isn’t the opposite possibly true, that the market is fortunate to have two different sets of standards running in parallel in such a way that comparative strengths and weaknesses are more clearly evident?

The banks have argued that market values can be misleading, and that their own estimates of the eventual cash flow from assets are more realistic than what they — or others — will now pay for those assets. The rules already allowed them to ignore so called “distress sales” in assessing fair value, but the banks pushed to broaden that exemption in the United States, while in Europe they got the regulators to allow them to retroactively stop calculating market value for assets they said they did not intend to sell.

Is Norris arguing that “market” values cannot be misleading? What about that October 2, 2008 value of Wachovia Bank? As any trained business valuation specialist will attest, the value of an asset absolutely depends on when the seller intends to sell and to whom, hence the notion of “control premiums” and “minority discounts.”

Behind the scenes, there is a battle pitting securities regulators — who instinctively favor disclosure — against banking regulators, who fear there are times when disclosure could make a bad situation worse.

I’m not convinced that securities regulators “instinctively favor disclosure,” but there’s no doubt that more transparent disclosure could undermine the con that we accept in our banking system.

The securities regulators argue that accounting should do its best to report the actual financial condition of a company. If the banking regulators want to allow banks to use different rules in calculating capital — rules that would not require marking down assets, for example — then they can do so without depriving investors of important information.

But that information could scare those investors, and set off the kind of panic that brought down Lehman Brothers a year ago.

While I agree that banking regulators should be able to look past the FASB rules in determining how to address capital adequacy, securities regulators, analysts and pundits need to quit pretending that the “actual financial condition” of a bank can be measured with scientific precision.   The collapse of Long Term Capital Management should have taught market watchers that the laws of physics (themselves imprecise) do not apply to financial markets.  Hence, we should always think in terms of a range of values, not a single verifiable number. To insist that bank financials conform to an arbitrary standard that produces a single “right” result is as counterproductive as producing no number at all.

It is the job of banking regulators to keep their institutions healthy, and that effort can only be helped by accounting that reveals problems early. . . .

Again, I’m not convinced that early public “revelation” of these kinds of problems will help keep banks healthy.  Perhaps the threat of such disclosure would force banks to behave more conservatively in the first place.  It’s hard to say.

The accounting rules on financial assets were, and are, a confusing mess, with the same loan getting very different accounting based on whether or not it had been packaged as part of a security. . . in the crucial area of fair value accounting, the American and international boards are not moving in tandem. The international board is delaying some issues as it rushes to get a rule out this year that will clarify when banks can ignore fair value. The American group is taking a more unified, and slower, approach. By not moving together, they run the risk of a race to the bottom, with investors the losers.

While I agree that financial assets accounting is confusing, where is the support for the assertion that FASB and IASB “not moving together” risks “a race to the bottom”?  I see the opposite: A contest between two competing regulatory systems each of which is striving to demonstrate its superiority over the other.  Having two competitors is good for the market, not bad.

The fights over bank accounting are taking place against the backdrop of the S.E.C. trying to decide whether and when to move the United States to international accounting standards, and as the two boards seek to converge on one set of accounting rules.

Mr. Ciesielski fears convergence could lead to acceptance of the weakest standards for banks. But without convergence, the S.E.C. will have no standing to oversee application of international standards, or to act as a counterweight if European politicians try to order even weaker standards to protect their banks.

Why the absence of accounting standards convergence would result in the SEC having “no standing to oversee application of international standards” or to “act as a counterweight” to EU politics is a mystery.  The SEC has jurisdiction to oversee application of IFRS standards to all companies whose shares are publicly traded here in the United States.  No one that I know of is suggesting that the SEC cede its enforcement powers to the EU.   Is Norris looking for some more expansive, extraterritorial power?

The bottom line is that too many people are expecting far too much precision out of financial statements that were never intended to convey a continuously-updated view of a company’s fair value.  At best, the financials can provide a broad, momentary glimpse of the company’s near-reality in the context of the “going concern” assumption.  Holding accountants or their standards responsible for more than this is unfair and foolish.  If anything, in this instance, financial statement readers let themselves and the accountants down, not — as Floyd Norris suggests — the other way around.

Some have asked for my views on the Honduran so-called “coup” in which the former Honduran President, Manuel Zelaya, was removed from office upon the order of the Honduran Supreme Court.   Having read the relevant documents in the original Spanish, I agree with Miguel Estrada that the removal was both legal and necessary.

For reasons set forth in more detail in Estrada’s Los Angeles Times op-ed (July 10), in the Corte’s Comunicado Especial (linked to the picture below), and in the documents supporting it, those who are full informed have every reason to applaud la Corte Suprema de Justicia Hondureña for legally and properly sending a would-be Hugo Chavez packing.

Like me (and unlike Barack Obama) Estrada speaks Spanish, actually works as an attorney and has read the Honduran Constitution and other official documents by which the Honduran Supreme Court legally ordered the removal of then-President Zelaya.  Americans (and Europeans) who think they know que pasa in Honduras would do well to read what Estrada has to say.

The basic story line is that the Honduran Supreme Court and legislature acted entirely within the bounds of the Honduran Constitution in removing Zelaya.  Zelaya had repeatedly defied the law of Honduras, acting as a sort of “community organizer,” by attempting to stage a “popular” override Honduras’ constitutional prohibition against its presidents calling for constitutional amendments by plebiscite.  He thumbed his nose at legal Supreme Court orders that he stand down and even personally led a mob that broke into an army facility to steal ballots that were legally controlled by the Honduran army.  If there was a coup in the offing in Honduras, it was Zelaya’s.

Mr. Obama’s efforts to see Manuel Zelaya return to power are 180-degrees against the interests of the Honduran people and of the United States.  We should be supporting Honduras against Zelaya and his mentor, Hugo Chavez.  That the Obama administration is supporting Zelaya makes sense only if Obama also supports Hugo Chavez in Venezuela.

Key excerpts from Estrada’s article follow:

Something clearly has gone awry with the rule of law in Honduras — but it is not necessarily what you think. Begin with Zelaya’s arrest. The Supreme Court of Honduras, as it turns out, had ordered the military to arrest Zelaya two days earlier. A second order (issued on the same day) authorized the military to enter Zelaya’s home to execute the arrest. These orders were issued at the urgent request of the country’s attorney general. All the relevant legal documents* can be accessed (in Spanish) on the Supreme Court’s website. They make for interesting reading.

What you’ll learn is that the Honduran Constitution may be amended in any way except three. No amendment can ever change (1) the country’s borders, (2) the rules that limit a president to a single four-year term and (3) the requirement that presidential administrations must “succeed one another” in a “republican form of government.”

In addition, Article 239 specifically states that any president who so much as proposes the permissibility of reelection “shall cease forthwith” in his duties, and Article 4 provides that any “infraction” of the succession rules constitutes treason. The rules are so tight because these are terribly serious issues for Honduras, which lived under decades of military rule.

As detailed in the attorney general’s complaint, Zelaya is the type of leader who could cause a country to wish for a Richard Nixon. . .

Indeed.  The Honduran Supreme Court and legislature are patriots, in my view.  Barack Obama may feel threatened by them because Obama, like Zelaya and his model Hugo Chavez, seeks more power than his country’s Constitution provides an executive.   As between Hondurans and Americans, the Hondurans are doing much better at following their own constitution than are the Americans.

Read Estrada’s full article at the LA Times.

*Los que hablan español pueden leer aqui los documentos relevantes en el website de la Corte Suprema de Justicia de la Republica de Honduras.  Pueden comenzar con El Comunicado Especial lo cual explica en forme breve las razones por las cuales remover al Sr. Zelaya fue no tan solo necesario pero también legal y correcto.  En la vista mia, la Corte Suprema de Justicia de Honduras ha hecho lo correcto al remover Sr. Zelaya.  Viva Honduras!

Ever get frustrated with attorneys who fuss over precise contract wording?  They do it for good reason:  In negotiating and drafting agreements, millions can be won or lost by the placement of commas or parentheses.   Chartbrook v. Persimmon Homes, decided July 1, 2009 by the British House of Lords,* vividly illustrates the principle that a cup or two of annoying front-end fuss can avert shipping containers full of it down the road.

Chartbrook and Persimmon Homes thought they understood each other, on October 16, 2001, the day they inked a deal to develop 100 flats totaling 50-60,000 square feet of “internal area”.   Not so.  It took eight years, untold thousands in legal fees, three courts and 40 pages of Law Lords’ verbiage to unravel what could have been resolved with a few strategic keystrokes at the drafting stage.   Did Persimmon owe Chartbrook £4,484,862 or a mere £897,051?

In their opinion reversing the trial judge and the Court of Appeals — who, in holding for Chartbrook, found the contract “clear, certain and unambiguous” with “straightforward arithmetic” — the Law Lords held for Persimmon.

While the Lords found the agreement clear on most points, to them it was  ambiguous with respect to that half of the price formula termed “Additional Residential Payment” or “ARP”.  The contract defined ARP as follows:

23.4% of the price achieved for each Residential Unit in excess of the Minimum Guaranteed Residential Unit Value [MGRUV] less the Costs and Incentives

At trial, J Briggs thought the interpretation obvious:

ARP means 23.4% of something. To the question ‘23.4% of what?’ the clear answer is the excess of the price achieved for each Residential Unit over the MGRUV, less the Costs and Incentives.

Note well that J Briggs added a comma not found in the original contract.  The Lords, on the other hand, lamented the parties’ failure to reduce the ARP definition to an algebraic expression and dismissed Briggs’ hopeful comma.  Two competing ARP formulas emerged:

1. ARP = 23.4% x (Sales Price – MGRUV – C&I), yielding £4,484,862,

or

2. ARP = [23.4% x (Sales Price - C&I)] – MGRUV, yielding £897,051.

Through deep discussion and copious amounts of ink, the Lords adopted the second formula.  Lord Hoffman articulated the rule which guided their construction of the agreement:

There is no dispute that the principles on which a contract (or any other instrument or utterance) should be interpreted are those summarised by the House of Lords in Investors Compensation Scheme Ltd v West Bromwich Building Society [1998] . . .  It is agreed that the question is what a reasonable person having all the background knowledge which would have been available to the parties would have understood them to be using the language in the contract to mean. The House emphasised that “we do not easily accept that people have made linguistic mistakes, particularly in formal documents”. . . but said that in some cases the context and background drove a court to the conclusion that “something must have gone wrong with the language”. In such a case, the law did not require a court to attribute to the parties an intention which a reasonable person would not have understood them to have had.

Applying this rule, Hoffman continued:

It is, I am afraid, not unusual that an interpretation which does not strike one person as sufficiently irrational to justify a conclusion that there has been a linguistic mistake will seem commercially absurd to another. . . The subtleties of language are such that no judicial guidelines or statements of principle can prevent it from sometimes happening. It is fortunately rare because most draftsmen of formal documents think about what they are saying and use language with care. But this appears to be an exceptional case in which the drafting was careless and no one noticed. I agree with the dissenting opinion of [appellate judge] Lawrence Collins because I think that to interpret the definition of ARP in accordance with ordinary rules of syntax makes no commercial sense.

Ouch.  Acknowledging the hindsight advantage and clear superiority of algebraic expression, the parties might still have avoided the legal battle with this simple rewording of the ARP definition:

ARP = 23.4% multiplied by the excess of the net price achieved for each Residential Unit, after deducting Costs and Incentives, over the Minimum Guaranteed Residential Unit Value [MGRUV].

What can be learned from the Chartbrook case?  First, meticulous drafting is essential where the issues or amounts involved are material to the parties.  Where the issue is monetary compensation, a clear algebraic formula may be best.

Second, it is wise to include in every contract an “integration” clause that says, in essence, “this piece of paper that we have signed revokes any prior understandings of the parties and includes their entire agreement.”  In other words, you want to discourage courts as much as possible from considering evidence outside the four corners of the agreement itself.

Third, on the chance that a court (in or out of the United States) decides to consider outside evidence to aid in contract interpretation, it would be wise to preserve contemporaneous evidence of a “consensus” on key issues.  Compensation, price and payment terms are usually front and center.  Email trails can help narrow down the ambiguity.

Fourth, if during negotiations your attorney expresses misgivings about linguistic ambiguity in the draft, listening attentively may save you from reprising Chartbrook.  No one really wins when a dispute runs on through two appeals and eight years.  As a value proposition, up-front investment in quality relationship infrastructure (i.e., a well-drafted contract) pays big dividends down the road.

Fifth, attorneys who entered the legal profession to avoid math might want to consider a course in algebra.  In this case, I have a feeling some attorneys in the U.K. are wishing they had.

* * *

* For American readers, the “Law Lords” (or Lords of Appeal) of the British House of Lords are roughly speaking the U.K. equivalent of the United States Supreme Court.

From the War on Terror to the War on Wall Street, due process violations by government agencies are proliferating like nuclear weapons. Facilitated by widespread ignorance among Americans — general public, financial professions, and the federal judiciary — the pattern of abuse threatens not only American markets but the very foundations of American life.

In April 2009, the staff of the Securities and Exchange Commission took another bite out of due process by issuing without public notice or input a “Staff Accounting Bulletin” or “SAB” for the first time since December of 2007.

I stumbled on this unhappy fact after reading, somewhat in disbelief, the following text from Footnote 17 to HSBC’s March 31, 2008 Quarterly Financial Statements:

In November 2007, the SEC issued Staff Accounting Bulletin 109. . . which supersedes SAB 105 . . . SAB 109 revises the views expressed by the staff in SAB 105 to specify that the expected net future cash flows related to the associated servicing of a loan should be included in the measurement of written loan commitments that are accounted for at fair value through earnings. SAB 109 is effective for derivative loan commitments issued or modified in fiscal quarters beginning after December 15, 2007. The adoption of SAB 109 did not have a material impact on the HUSI consolidated financial statements.

Why disbelief? HSBC’s language assumes that SAB 109 is legally binding when, in fact, it is not.  SAB 109 was written by SEC staff (not the Commission who have legal rulemaking power) without any attempt at complying with 5th Amendment due process or Administrative Procedure Act notice and comment requirements. The SEC staff openly admit that their SABs are not law with this coy disclaimer:

The statements in staff accounting bulletins are not rules or interpretations of the Commission, nor are they published as bearing the Commission’s official approval. They represent interpretations and practices followed by the Division of Corporation Finance and the Office of the Chief Accountant in administering the disclosure requirements of the Federal securities laws.

Yet, the staff nevertheless proceed to unilaterally “amend” the Code of Federal Regulations to reflect the addition of SABs with language posted at the top of the SABs like this:

Accordingly, Part 211 of Title 17 of the Code of Federal Regulations is amended by adding Staff Accounting Bulletin No. 109 to the table found in Subpart B.

Registrants are thus confronted with stealth legislation written by SEC staff on their own initiative.  The SABs have the aura of legitimacy without real authority.  The SEC and its staff should know better, but registrants and audit firms should do their part by pushing back against this abuse of due process.

HSBC is an American company, incorporated in Maryland and headquartered in New York.  Its officers — especially its attorneys — should know not to treat a mere SAB as if it were law.  SABs are not “adopted” and have no “effective dates”. They are staff opinions, nothing more.

The SEC obviously knows this but they also know that Americans have forgotten the meaning of due process and are willing, in the interests of “protecting investors,” to wink at the SEC’s illegal rule-making behavior. It knows that corporate officers — cowed by congressional anti-fraud theatrics — are reluctant to take a stand against such abuse on the part of the sacred-cow SEC.

Enter SEC Commissioner Paul S. Atkins’ Feb 8, 2008 remarks to the Practising Law Institute.  Atkins effectively dismantled SAB No. 99 with which the SEC staff attempted to define what is perhaps the most important term in the securities law lexicon: materiality.

Here are excerpts from Atkins’ speech, last paragraph copied first:

The process of issuing Staff Accounting Bulletins is organized to avoid “complications” with the Administrative Procedure Act. Is that how a full-disclosure agency should operate? The Commission never voted on the views espoused within any SAB, so it does not and cannot represent the views of the SEC. Worse yet, SEC staff developed SAB 99 without public input. Substantive policy ought not to be made by the staff in private meetings, and ought not to be made based solely on the wisdom and experiences of SEC staff. . .

. . . One of the most glaring examples of lack of predictability is determining what constitutes materiality. The crux of our federal disclosure system is that all material information must be disclosed — with an emphasis on material. Yet the age-old question is: What does it mean to be “material”?

Issuers, investors, and regulators have struggled with applying the materiality test since the enactment of the securities laws. Materiality is an objective test: the Supreme Court has said that something is material if “there is a substantial likelihood that a reasonable shareholder would consider it … as having significantly altered the ‘total mix’ of information made available.”

It is not enough that some investors may view a fact as important; rather, it must be important to the reasonable investor. In coming to this standard, the Supreme Court in 1976 in TSC Industries v. Northway, specifically overturned a test applied by the Second Circuit — that material facts include all facts that a reasonable shareholder might consider important. Can you imagine what prospectuses and proxy statements would look like if that standard had prevailed? TSC Industries is an example of the Supreme Court showing judicial restraint by not expanding the securities laws. Does this sound familiar? We have seen similar restraint in recent Supreme Court decisions this year and last in the area of securities law.

In TSC Industries, the Supreme Court clearly understood the problem of materiality. In the unanimous opinion written by Justice Thurgood Marshall, the Court observed that “[s]ome information is of such dubious significance that insistence on its disclosure may accomplish more harm than good.” The potential liability for a fraud violation can be great and, so Justice Marshall explained, “If the standard of materiality is unnecessarily low, not only may the corporation and its management be subjected to liability for insignificant omissions or misstatements, but also management’s fear of exposing itself to substantial liability may cause it simply to bury the shareholders in an avalanche of trivial information — a result that is hardly conducive to informed decisionmaking.”

The SEC allowed the waters to be muddied on the issue of materiality in 1999 with Staff Accounting Bulletin 99. Anyone who has tried to apply SAB 99 is left with little certainty. Regardless of how quantitatively tiny a disclosure might be, the answer to any materiality question seems to be “it depends.” (Of course, too often it is said to be clear later in 20/20 hindsight.) And yet that bulletin has been cited by courts, SEC staff, and lawyers as authority for materiality. As a result of SAB 99, issuers feel compelled to inundate shareholders with “an avalanche of trivial information,” which was precisely the fear of the Supreme Court almost 32 years ago. Often, when you read a 10-K, it is as if you are reading Greek. Maybe we do need Hermes, after all, to interpret the content!

Would it surprise you to learn that SAB 99 does not necessarily represent the views of the Commission? As the title implies, it is a Staff Accounting Bulletin. . . .

Little wonder that two days ago the Russian State newspaper, Pravda, published a commentary — “We the Sheeple” — ridiculing the people of the United States for so easily abandoning our Constitution and free markets in favor of a Russian-style Marxism.

It must be said, that like the breaking of a great dam, the American decent [sic] into Marxism is happening with breath taking speed, against the back drop of a passive, hapless sheeple, excuse me dear reader, I meant people.

The Russians should know.  Meanwhile, Americans should demand that the federal agency charged with protecting investors and rooting out financial fraud cease and desist from the regulatory fraud of legislation without representation.  Of all of the SEC’s regulatory failures (and there are many) this one may be the worst.

For an eloquent illustration of how accounting innovations like FAS 157’s “fair value” regime are way beyond even above-average American financial readers, try Michael Rapoport’s May 1, 2009 article entitled
New FASB Rule Aims to Clarify ‘Net Income’.

Rapoport, trying to capture the meaning of the new SFAS No. 160, stumbles over one of the most basic concepts in the accounting literature — that “minority interests” in consolidated financial statements reflect the fact that “parent” companies don’t really “own” 100 percent of the assets or income of “subsidiaries” except those they wholly own.

If Coca Cola owns only 51 percent of Coca Cola Enterprises (it doesn’t, but let’s pretend that it does), Coca Cola’s consolidated net income should not include the 49 percent of CCE it doesn not own.   Sounds simple, doesn’t it?

Rapoport is no financial dummy.  No one who authors articles like this one on derivatives accounting could be.  So if a  guy like Rapoport is confused by SFAS No. 160, just imagine what SFAS No. 157 and 133 do to the average investor!  Against such a backdrop, why bother writing more standards?

Lenders have been hammered by the pathologically procyclical impact of FAS 157’s mark-to-market regime.  Hardly surprising, therefore, that banks and credit unions came out in force to support the latest FASB “clarification” of FAS 157.  Some other commenters, mostly from the “analyst” community, emphatically disagree.

Yesterday, the Financial Accounting Standards Board’s comment period closed on yet another proposed FASB Staff Position — denominated FSP FAS 157e — clarifying FASB Statement 157, the highly contentious standard on fair value measurement and disclosure.

Between its March 17 issuance and April 2 at 7:30 eastern time, FAS 157e garnered 367 comment letters (counting mine transmitted near midnight on April 1), more than triple the 102 comments posted last October on FAS it’s immediate predecessor, FSP FAS 157d.  The single largest bloc of commenters were banks and credit unions nearly unanimous in their support of the proposal, with some modifications.

The proposal has, however, come in for withering criticism from some quarters, mostly financial analysts and valuation “professionals,” whose lifestyles are heavily subsidized by FAS 157’s arcane, risk-metric-rich framework.  Others, like the New York Times’ Floyd Norris, view any liberalization of fair value standards as undermining the “integrity” of financial accounting.

As my comment letter explains, I disagree with Norris & Co. on several points including the notion that financial accounting and the FASB had any integrity to lose in the first place.  Individually, yes.  Institutionally, not.

The FASB has always been dominated — as the current FASB members’ bios demonstrate — by big-firm and big-academy politics.  In a professional sense, they are congenitally disconnected from the market they dominate with only spasmodic oversight by Congress.

I’ve been in the financial reporting business for nearly 30 years as a CPA, attorney, consultant, author and college professor.  I can say with authority that financial standards and statements are like sausage and pickles: once you’ve seen them made, you’ll find it hard to trust them ever again.

Financial statements are only as trustworthy as the management who prepares them while their luck holds and market conditions remain static.  The idea that accounting, valuation or risk management practitioners can provide reliable “forward-looking information” that magically invests financial statements with predictive capacity is nonsense.  By their very nature, financial statements are historical and always will be.  Anyone who still believes otherwise — including, apparently, all current FASB members — needs to read Nassim Taleb’s The Black Swan.