Fisher Investments Editorial Staff

Looking Beyond the Crimea—Policy Edition

By, 03/05/2014
Ratings263.192308


The Supreme Court is hearing a case about class action lawsuits this week. Photo by Win McNamee/Getty Images.

Tuesday, headlines fixated again on the Crimea and Ukraine—this time, relieved after Russian strongman Vladimir Putin struck a somewhat conciliatory tone in a highly bizarre press conference, markets surged. But while nearly every eyeball has turned toward the Crimea, global markets and economies haven’t stopped. This week we’ve seen several under-the-radar issues being discussed by policymakers and high courts. Over time, these issues likely mean more for markets and investors than the current situation in the Crimea.

In Europe, Financials have encountered a few bumps. EU regulators announced plans to close apparent loopholes in the banker bonus cap that took effect in January. Under the new rules, bonuses are capped at 100% of one year’s salary (or 200%, if shareholders approve). To get around this, banks have started adding “extra allowances” to top bankers’ salaries, beefing up bonus potential and shielding performance-based income from the cap. Regulators are crying foul, saying it hampers the rule’s ability to fight “reckless risk-taking,” which they see as the culprit in 2008. To “fix” matters, the European Commission plans to designate certain traders and bankers as “material risk takers” and be extra-vigilant in monitoring their compliance.

On the one hand, this adds some clarity—banks have admitted confusion over who the cap applies to. But it’s based on the flawed premise that bonuses incentivize risky behavior and thus threaten financial stability—a big stretch, in our view. Performance-based pay introduces accountability. A higher emphasis on salary removes incentives to perform and behave well. So we’d suggest not expecting the rule to ensure the permanent health of EU banking. Rather, it gives banks and bankers an incentive to go elsewhere—a negative—and creates some (albeit well-known by now) headwinds for eurozone Financials.

Bonuses were a hot topic across the Channel as well, with the Bank of England’s regulatory committee investigating whether and how to implement the Parliamentary Commission on Banking Standards’ recommendations for a compensation clampdown. In lieu of a bonus cap, which Chancellor George Osborne is presently fighting in EU courts, regulators are investigating stricter clawback rules and longer deferral periods.

Clawbacks are fine in principle—the threat of losing part of a bonus is an incentive to behave—but the UK’s application may be going a wee bit too far. Under current rules, bankers’ bonuses can be reclaimed three to five years after they were paid, an effort to ensure a bonus wasn’t earned based on reckless (or fraudulent), short-term focused behavior. But the Parliamentary Committee thinks the period should be longer—10 years. Consider: Maybe you’re a banker who helped underwrite a Washington Mutual bond issue in 1998. In theory, the bank’s failure in 2008 could make your bonus go bye-bye. While the implementation of the most extreme proposals wouldn’t be a great development for UK financials, nothing has been decided yet—it’s a story worth following. 

Speaking of potential rule changes, the Supreme Court began hearing arguments in Halliburton vs. Erica P. John Fund this week. At stake: “Fraud on the market” rules that underpin most shareholder class action lawsuits. Should the justices disallow fraud on the market, the number and scope of securities class action suits could be greatly reduced. 

Fraud on the market, articulated by the Court in its 1988 Basic Inc. v. Levinson ruling, spares investors from having to prove they personally heard and employed erroneous or fraudulent information issued by a public company. All they have to prove is they owned shares of a company found to have issued any errant information during a certain period of time (the class period). This has led to an explosion in the number of class action lawsuits.

Our interest in this case is singular—has that increase in litigation benefited shareholders? Some view class action lawsuits as a necessary check on corporate misbehavior—forcing companies to be held accountable to shareholders, or suffer the costly consequences. Since 2000, class actions cost public firms about $39 billion a year—certainly something public company leadership would want to avoid. However, companies do tend to insure for such events, and they staff up compliance departments and litigation funds as a hedge. Finally, when you consider issuing fraudulent information is illegal—and executives could see prison as a result—we’re not so sure this disincentive is the key motivator proponents claim. 

For the shareholders who do participate in a suit, payouts are typically meager. Pennies on the dollar. If you still own the stock, consider that you’re basically suing yourself. Stocks are just a slice of ownership in a business, after all. And your company buys insurance against, potentially, your suit. And they heavily fund compliance, accounting and litigation funds for the same reason. Is this the best way for a business to deploy capital to benefit shareholders?

Regulatory changes like these might not make the front page, but they matter. Absent conflict in the Crimea going global, it’s likely their aftereffects will linger long after folks have forgotten Putin’s putsch.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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