If I Were President Part II: Protecting Our Capital Markets

Posted by Keith on July 28, 2007 at 6:07 pm  

Don’t worry. I have no expectation of being drafted to actually run for President. But I hope that by putting this series in the first person I will more effectively emphasize the specific real-world actions our next President, in my opinion, must take.

Why They Matter

Our capital markets matter to every man woman and child in America and throughout the world. These markets are where money meets opportunity, where reward meets risk, where jobs are created, and where mortgages and new cars are financed. Our capital markets are more mature, more sophisticated, and until recently were more desirable than similar markets around the world. They create better jobs and greater prosperity for us all.

But they do something even more important: They protect our freedom – and the burgeoning freedom, both economic and political, throughout the world.

Our capital markets are America’s – and the world’s – greatest bulwark in defense of freedom because they provide the economic foundation upon which we stand in its defense.

Just as China’s armies stood for centuries on the Great Wall to defend it against invaders, our capital markets are the Great Wall upon which we stand; and they will – if we let them – play an essential role in protecting us and the world from dominance by governments far less protective of the fundamental freedoms we cherish, and for which we – and millions of Americans past – have paid so high a price.

We are the most powerful nation on earth – for now – thanks to our capital markets, which make possible our vast consumer-based economy, our far-reaching political influence, and the tax revenues we spend on, among many other things, a military that so admirably defends freedom around the globe.

Yet, we are not nearly the largest country in the world. Not demographically. Not geographically. In fact we constitute less than five percent of the world’s population; and our geographic size and even our natural resources, while significant, are modest compared to other emerging powers such as China or Russia.

As other nations emerge economically must we inevitably witness the decline of America’s preeminence on the world stage? Hardly. If we remain the world’s stockbroker, the world’s bond dealer, the world’s bank, the world’s source for the highest and best technical and commercial innovations – by protecting our capital markets — America’s Great Wall, as China’s, can last for centuries.

Attack from Within – Death by a Thousand Cuts

But America is quickly losing – if it has not lost already – its preeminent role as the world’s largest source of capital and opportunity. This is occurring not because of invading armies from without, but because of invading regulation, monetary mismanagement, taxation, and special interests from within.

Should we care? For all its missteps abroad, America, as world leader, has been history’s finest Shepard of democracy and free enterprise. Were our intentions malevolent, were we truly interested in world hegemony, as other preeminent powers before us have been, our planet would be a far different place indeed.

I have written many times that our greatest export is freedom. I grew up in a world of presumed parity between our might and the might of the U.S.S.R., during a cold war of nuclear proportions.

Do we really wish to return to a world of military or political parity with the governments of China or of the “new” Russia, or with a coalition of other non-democratic governments?

How We Are Destroying our “Great Wall”

Business leaders, financial institutions, and even the sovereign investment funds of other nations have looked at our new too-strict corporate liability laws, at our shriveling dollar, at the litigiousness driven by America’s runaway Bar, at our arcane and increasingly non-competitive tax code, and at the increasingly shrill (in this election year) Washington rhetoric that demonizes profits; and the world has said, “No thank you.”

How has this happened? Not by a masterstroke of destruction, but by often small well-intentioned assaults at the fringes – and sometimes at the heart — of our economic system. For example, we passed the eminently well-intentioned Sarbanes-Oxley Act in response to a slew of isolated corporate scandals. Yet this law has done more in the space of two short years to reduce capital inflows to America than virtually all other factors (except perhaps our tax code) within the past fifty years.

This is not to say that increased corporate transparency is not a good thing, or that some reforms were needed, or that reforms will not always be needed as a small few find new ways to exploit others.

But it is to say that we went too far when, for example, under Sarbanes-Oxley we failed to establish a much higher intent-to-harm-or-deceive threshold for civil and criminal liability of well-intentioned corporate directors and officers. Why would the officers and directors of any multinational subject themselves directly, and their shareholders indirectly, to an unrealistic and costly standard of liability? If you had a choice of capital markets, would you?

And while most world markets generally attempt to emulate our markets’ transparency – and while we should use our clout to insist on transparency elsewhere as a condition for access to America’s consumers — the world’s verdict on the damage we’ve done to ourselves by imposing unrealistic standards of liability upon corporate officers and boards could not be more clearly illustrated than with this simple fact: In the last year alone, both London and Hong Kong have surpassed the U.S., by dollar volume, in initial public offerings (IPO’s). America, the land where new and growing businesses have historically found abundant capitalization is now in third place in the IPO arena, and we continue to lose ground.

The Integrated Reforms We Must Undertake

But it is not just the existence of one over-zealous law that threatens our markets. It is a combination of attacks – all set in motion from within – that imperil us. These related factors are:

* Excessive corporate regulation and statutory liability-creation. This attack is driven by Congress, state legislatures, and state attorneys general;
* Excessive private litigation against corporations, their directors and officers. This attack is driven by utterly irresponsible members of the Trial Bar, and by the Bar itself when it blindly defends them;
* Our tax code;
* Poor monetary policy; and
* A rising tide of “anti-profit” rhetoric.

Finally, although our current President has been loathe to use his Constitutional authority when dealing with Congress, or even to use his position as a bully pulpit, a President does have tremendous direct and indirect influence over the legislative process. Congress can be constructively driven on these issues – whether directly, indirectly, willingly — or kicking and screaming.

Therefore, if I were President:

Principals of Sanity: How I Would End Excessive Corporate Regulation and Statutory Liability Creation; and How I Would End Excessive Private Commercial Litigation

Because statutes and regulations can facilitate (or can potentially end) excessive litigation; because the “excessive litigation industry ” so deeply and disproportionately influences the legislative and regulatory process; and because our legislative, regulatory, and litigation systems must work in tandem if we are to reconstitute our capital markets, these issues must be addressed collectively.

I believe it is best to do so by reaffirming and applying a short list of fundamental principals.

There are endless examples of where these principals could be applied: By amending Sarbanes-Oxley or other regulatory schemes to reasonably raise thresholds of liability; by requiring in class actions the participation as lead plaintiffs of shareholders representing at least ten percent of outstanding shares in a corporation (thus requiring their affirmative consent in advance); by imposing career-ending disbarment against state Attorneys General who bring claims that fail to withstand motions to dismiss; by imposing loser-pays liability personally on attorneys who bring frivolous actions; or by limiting the reach of the SEC and NASD to the dissemination and enforcement of regulations that promote meaningful transparency without infringing upon free commercial speech either in the promotion and sale of investment products, or “aspirational speech” by corporate leaders.

With these as just a few examples, here are the principles I would aggressively apply whenever and wherever as President I could find the Constitutional purchase for doing so. Some may seem arcane, but if you study them I think you will see they go to the heart of why our markets are losing their competitive edge, and how we can regain that edge immediately:

1. Immediately raise corporate liability thresholds as follows:

a. In all civil or regulatory proceedings against businesses, whether brought by regulators, or shareholders or consumers individually or as a class, we must require clear and convincing evidence of an officer’s specific intent to steal, defraud or harm for financial gain the specific plaintiffs bringing the action, or class being protected as a condition of liability. In criminal prosecutions and in regulatory reviews where regulators have enforcement authority, a “beyond a reasonable doubt” standard must be applied. Competence should not go on trial. While a corporate official’s competence may be the subject of great interest to shareholders, neither incompetence nor stupidity is a criminal offense. If it were, at one time or another we’d all find ourselves in jail.

b. In order to withstand an immediate motion to dismiss, all such claims must be accompanied by substantial prima facia evidence sufficient to convince a skeptical court that a substantial likelihood of liability exists. In the case of regulatory investigations, corporations doing business in more than one state should have the immediate right to require federal judicial review of whether this requirement has been met. This threshold must be met prior to discovery, as it is during the discovery process where most litigation expenses are often incurred. Otherwise, companies will continue to be forced to evaluate settling even frivolous claims or misguided regulatory actions based on cost-of-defense formulas.

c. No shareholder class action should be permitted against a company or its officers or directors unless shareholders representing ownership of at least ten percent of the outstanding shares agree in writing in advance of the litigation to participate as lead plaintiffs and are certified by the court as such; or unless the defendant company, faced with a myriad of similar claims, requests a merger of those claims into one dispositive class action.

d. Absolve aspirational speech such as the projection of earnings or sales, speeches about a company’s future goals or objectives, or common puffery about products or services, unless the above requirements are met. The market will sort out who can be trusted.

e. Prohibit the application of common law or statutory fraud statutes (which allow the award of damages without a specific showing of harm to the named plaintiffs) unless evidence attached to the complaint meets the above prima facia requirements, and where all the evidence ultimately proves beyond a reasonable doubt the existence of an actual corporate conspiracy to defraud – a conspiracy intended to benefit the corporation itself — not just a conspiracy of some rogue company officials who can be held accountable individually. Merge standards of proof for criminal or civil fraud claims, as currently a civil fraud verdict, even absent a showing of criminal intent, can be potentially ruinous to a company.

f. To eliminate outrageous demands for damages, plaintiffs who fail to obtain a verdict equal to at least 51 percent of the compensation they demand in their initial complaint should pay all costs of defense, unless the court finds extraordinary circumstances. Where the plaintiff is unable to pay, the attorney who brought the claim should be held liable for the amount, at the discretion of the court. During litigation, plaintiffs should be free to amend their demand amounts upward; but should not be free to avoid this requirement by amending their initial demand downward. Parties should remain free to settle claims without prejudice as to fees.

g. To eliminate outrageous punitive damage awards I would limit such awards to three times the compensatory damages received; but in the case of wrongful death to no more than either twenty times the decedent’s actual annual income, or to one million dollars, whichever is greater. I would index this latter amount for inflation.

h. Finally, the SEC and the NASD need to get out of the business of protecting investors from themselves. Instead they must concentrate on the business of ensuring that investors receive meaningful disclosure information. They are not in charge of what investors do (or don’t do) with that information once they receive it. These agencies should also stop exercising prior restraint on commercial speech such as the creation and dissemination of investment product sales literature, presentations, and marketing materials, provided those things are accompanied by meaningful and simple standardized disclosure information.

How I would Reform Our Federal Business Tax Code

1. Recognizing that reform of our income tax code for individuals deserves its own installment in this series, I would reform our federal business tax code to reflect this fundamental principle: That government can and should receive a smaller piece of a much larger economic pie. I would pursue this economic principle as follows:

a. Reduce corporate tax rates to no more than 20 percent. Our current 36 percent federal tax rate is among the highest in the world among first-world economies. The median national corporate tax rate in Europe is 28 percent, and rates in many emerging countries, including China, and in financial capitals such as Hong Kong and Singapore are far less than that. Only the most static and brainless of economic models could ignore the capital this would attract and the increased economic activity, American jobs, and tax revenues this would generate.

b. Eliminate the double taxation of dividends. Corporate profits distributed to shareholders in the year they are earned should not be taxed at the corporate level. They should only be taxed at the shareholder level – at the current 15 percent rate to encourage capital investment. Currently, once compelled to pay taxes on their profits, corporations have no tax incentive to distribute their profits. Instead many have accumulated huge fortunes in cash. This fuels incessant mergers and acquisitions, and “empire building”, often with little or no benefit to shareholders. When corporations are encouraged to distribute a greater share of their profits, shareholders will be empowered to make millions of independent decisions regarding where best to spend or invest the money. This spurs the sort of productive economic activity that builds our economy – and our tax revenues.

c. I would apply this same principal to profits generated by closely held small businesses, whether sole proprietorships, LLC’s or Sub-S corporations after requiring only that deductible fair-market wage-based compensation to principals active in the business be claimed and taxed first as ordinary income.

d. I would reform our system of depreciating capital assets. Few laws are more rife with special interest exceptions and mathematical contortions. Our current system distorts capital expenditures and penalizes small businesses not only with higher taxes but also with disproportionate compliance costs. I would eliminate all this as follows:

i. Allow all businesses to deduct up to one million dollars per year for capital expenditures, whether the capital asset is purchased with cash or financed.

ii. Allow for the current deduction of all capital assets purchased with cash. Where the purchase of capital assets are financed, require straight-line depreciation of the asset for the life of the loan. If a purchaser prepays a loan it would be entitled to deduct the balance of the expenditure in the year the loan is repaid. Where corporate borrowing occurs in the year of purchase, but is not tied directly to the purchase of assets, or secured by them, then permit the deduction of that portion of the assets that exceed the amount borrowed. Depreciate the remainder over the average life of whatever loans were taken. Therefore, if corporate borrowing that year exceeds capital expenditures the capital assets must be depreciated over the average life of those loans. This will encourage companies to place cash into productive use; and will discourage the over-leveraging of capital asset purchases. In short, the market and not special interests will determine the depreciable life of assets.

One Additional Individual Income Tax Reform

1. While I promised to address the reform of individual income taxation in a separate installment, one such reform is so linked to our capital markets that it should be mentioned here. Therefore, if I were President:

a. I would tax interest earned –whether in savings accounts, or in notes or bonds — at 15 percent. This will encourage savings and the formation of capital. There is no earthly reason why savers should not receive the same favorable treatment on interest earned as investors receive from dividends. Both empower our capital markets, create jobs, and spur economic growth.

Can the Government Afford These Tax Reforms?

Our government cannot afford not to implement these reforms. Ultimately the competitive position of our capital markets will determine the extent of federal revenues. There is simply no reason to believe that these capital market reforms will do anything but increase tax revenues.

Congress can either continue to snipe at our slowly growing economy, and watch it eclipse into a non-competitive sideline player on the world stage, or it can accept a smaller piece of an economy that grows for generations to come even more dynamically than the world around us.

Within two years of its implementation this productive, disciplined approach will increase government revenues beyond the wildest dreams of even a Beltway Democrat.

How I Would Reform Our Monetary Policy

The world is awash in cheap dollars. The dollar has lost twenty percent of its value against the Euro and other major currencies in the past twelve months. Investors are leaving the U.S. to put their money into non-U.S.-denominated bonds and stocks, where their purchasing power seems sure to grow against a weakening dollar.

Private investors and sovereigns such as China, which holds more than a trillion U.S. dollars, are heading for the door.

And who can blame them? Why invest in a depreciating asset such as the dollar when so many appreciating currencies and other assets are available.

With so many market-driven methods of debt financing now available, it can be argued that the Federal Reserve Board has much less power these days – as it raises and lowers its overnight discount rate to member banks – upon financial markets. Meanwhile the Fed is – and should remain — an independent agency.

Nevertheless, through appointments to the Board, and by public and private persuasion from the Presidential pulpit, an active President can – and also should – exert significant influence on monetary policy.

Therefore, if I were President:

I Would Narrow the Cost-of-Funds-Earnings-Yield Gap

An explosion of cheap credit is ruining the dollar.

Consistent with the Fed’s anti-inflation goals, I would encourage the Board to narrow the gap between the net cost of corporate borrowing through the Federal Reserve System and the average earnings/price yield on Wall Street. They must recognize the obvious: That the artificial expansion of credit is inherently inflationary.

The current flurry of often-pointless asset-consuming mergers and acquisitions is being funded by this gap. The net cost of corporate borrowing, after corporations deduct interest expense on their tax returns, is below four percent. The average earnings/price yield on the S&P is about six percent. It does not take a rocket scientist to understand that if you borrow money at four percent to buy something that pays six percent you’ll make a profit – as long as the company you buy continues to yield more than your cost of funds.

When people invest directly in these deals, without borrowing the money to do so, it is harmless enough. A dollar moves from a less productive investment to, one would hope, a more productive investment.

But when banks, as members of our Federal Reserve System, loan the money for these deals, and because they may lend a multiple of their deposits, their loans essentially create more dollars in the marketplace. They expand the credit markets.

When we create more dollars in this way, we reduce the value of dollars relative to other currencies where credit expansion is more expensive, and therefore slower. Our dollars become less desirable compared to those currencies. The result: Investors catch the train for Higherinterestville.

While a weaker dollar helps our exports, credit expansion is really a very expensive way to subsidize those exports. A weaker dollar might help, for example, Tyson sell more chickens in China, but we will all pay more for the goods and services we purchase in the U.S. since so many of those products are either made, or contain components produced, in other countries.

Actually, I’ve already proposed a partial solution to this runaway credit expansion. By lowering corporate tax rates to 20 percent from their current 36 percent, the government will only be subsidizing a fifth of a company’s borrowing cost when the company deducts interest expense on its tax return. This will increase companies’ net-after-tax-cost of borrowing, and should slow down credit expansion to some extent. This is in contrast to the current regimen where the government is subsidizing more than a third of that expense due to higher tax rates.

However, a second step is in order: The Fed needs to push up the Prime Rate (the interest rate paid by the most credit-worthy borrowers) by increasing the discount rate to member banks. And they should continue to do so until the net cost of borrowing funds (from within the Federal Reserve system at least) reaches parity with the prevailing earnings yield on Wall Street. The interest-earnings-yield gap should become an even more significant consideration by the Fed than the CPI. The CPI measures the inflationary result of credit expansion. But credit expansion creates inflation in the first place.

The bond market would likely follow this lead closely. Mergers and acquisitions would still occur. But they would slow, and would be undertaken not because money is artificially cheap, but because they make inherent economic sense.

Meanwhile as we take this important step to protect our capital markets by strengthening the dollar investors will return to dollar-denominated assets and to our capital markets.

More Aggressively Defend Our Capital Markets

It’s an election year. John Edwards is playing the class warfare card by claiming there are “two America’s”, and others are negatively spinning what, by all objective measures, is a reasonably successful economy.

For all real or imagined problems they will again blame “the rich.” They will attempt to mobilize the masses and their colleagues in Congress around the clarion call “to do something” about the “income gap” in America, the disparity in wages from the “Board Room to the Shop Room,” etc., etc., ad nauseum. We recognize this for what it is: A call to increase taxes while increasing restraints on business. A call to do further damage to our capital markets and to the jobs and opportunities they create.

Actually, John Edwards is (sort of) correct! There are two Americas: The rich and the not yet rich.

Therefore, if I were President, I would, with the eloquence of Homer (the philosopher, not the cartoon character) relentlessly make and repeat these truths:

* America’s income gap is growing not because more people are poor; but because more people are rich – very rich;
* The great majority of wealthy Americans were not born rich. They got that way by working hard, risking their own money, making mistakes, and by trying again and again until they got it right. This is America. You can do it too.
* Poor people don’t create jobs. Rich people do.
* Corporations don’t pay taxes. They collect taxes — from you. For every dollar of taxes they send to the government, you pay a dollar more for what you buy.
* Our capital markets – as in capitalism — (banks, stocks, bonds, mutual funds, etc.) are where money meets opportunity. One way or another, they help create every single job in America. When you protect those markets you protect your family, your job, your home and your future.



1 Comment so far

  1. J. Jannarone on July 30, 2007 5:52 pm

    You get my vote. I would enjoy your thoughts on taxes for the weathly (and those working to become). Specifically small to medium business owners and the Fed/State taxation of them, loss of working capital and choke hold the current tax system places on them. Obviously President Keith’s suggestions to correct are a joy to hear.

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