September 28, 2007
The Fed, The Market and The Consumer
Several years ago I wrote on this blog that I thought we were heading into a market correction of 10% or so. That market correction has yet to come and I have taken some friendly and not so friendly advice to stay with legal analysis and stay away from future market predictions. My projection ast the time was based on data that Americans, for the second year consecutive year, were spending more than they earned (in other words, that they were spending their savings or the equivalent, the equity in their house, for example). They last time Americans had done this was some time in the 30s. I thought the following -- the American consumer is holding up not only our stock market but the world's stock markets and he/she is running out of money. Well, I underestimated the American consumer; he/she continues to spend more that he/she earns and has not run out of money nor has he/she decided to economize. I can come up this three possible explanations: First, the earnings numbers are low (the gray (or black) market or exchange economy is much larger than the numbers reflect); Second, Americans have more savings to burn than I anticipated; Or three, Americans will spend until someone says they cannot (they fall off the cliff). In any event, do not follow any market advice I may offer, now or in the future.
Shareholder Activism and the SEC
There has been a lively debate in the editorial pages of our financial newspapers on whether the shareholder activism practiced by modern private equity funds, hedge funds, and public pension plans is healthy for American business. On one side are the traditional republicans (with a small "r") that believe shareholders should delegate management details to their boards of directors and then let them do their work. Shareholders who are displeased should replace the poorly performing managers or sell their shares. On the other side are investors that believe the board should listen to their specific strategies to increase stock value. Many of the strategies include leverage (stock buy-backs or extraordinary dividends) or unbundling the business (spin-offs or bust-up buyouts). The debate is complicated by a side-bar debate (the activism debate does not inherently depend on the side-bar debate) on the shareholder primacy principle. Those who are not comfortable with shareholder value as the primary concern of a board of directors are new-found republicans; a board with maximum discretion can favor non-shareholder constituencies.
The SEC in a very unusual move, promulgated two mutually contradictory rules on shareholder voting (one re-affirming the traditional view and one giving major shareholders access to the firm's board nomination procedure), to see what public comment it would generate. I doubt either side is correct or, if one side is correct, that it will be correct for very long. Firms should be able to choose their internal structure (a division of power between shareholders and firms included), publicize it to the markets, and suffer or enjoy the consequences of their choices. Those firms that choose well will lower their costs of capital and have a competitive advantage. In other words, the danger is for the SEC to attempt to try and pick a winner in the debate. The best position for the SEC is an enabling position: the proxy machinery regulated by the SEC should act in furtherance of whatever state law allows. Far-sighted states (and/or exchanges) should enable firms to opt into various internal control systems, no one system is mandatory. Let the investment market, not the political (or academic) market, decide on optimal firm governance procedure.
The refusal of a private equity group to proceed with its buyout of Sallie Mae and the refusal of Finish Line to close its merger deal with Genesco both pose the same question. Can a buyer walk away from a buyout agreement when the buyer's financing dries up (or becomes much more expensive)? The buyer will assert multiple breaches of the acquisition agreement by the seller but most claims come down to two: First, a failure of the seller to disclosure accurately something about the seller's business; And second, a material adverse change that triggers a MAC clause out. Courts, in deciding both issues, will know that the buyer wants out because it financing has become more expensive and it looking for justifications. Since financing problems are traditionally considered to be the buyer's and not the seller's problem, courts start with a presumption against the buyer's claims. Buyers can convince a court however that the seller's breaches or the adverse changes are real and justify a refusal to close. Tie the disclosure breach or the material change to the reason for the financing to increase in cost and the buyer has a chance. General market downturns are not enough here however; the buyer must show that the the disclosure breach was calculated and material or the material adverse change was unexpected and material. In the Sallie Mae case, the collapse of the CDO market (collateral debt obligation financing) on which Sallie Mae depends for is operating revenue would seem to qualify as unexpected and material. In the Genesco deal, the deepening losses posted by both firms on the eve of the closing may not, without more, justify walking away from the deal. In both deals, however, I am surprised at the parties reliance on overly general terms. It would be easy to trigger a walk condition on specific market conditions in the credit markets or in operating revenues. Why do more acquisition agreements not do this?