Business Law Prof Blog

The Liquidity Crunch Hits Talbots & Sears

Dale's post below brought to mind an example of the liquidity crunch and banks wanting to stay on the sidelines.  Here's the report from the AP:

According to a filing with the Securities and Exchange Commission, Talbots said HSBC will phase out its $135 million line of credit over several months, while Bank of America canceled its $130 million credit line.

Oppenheimer & Co. analyst Roxanne Meyer said this news means that Talbots will have a tough time finding a new form of financing.

"With two major banks walking away, it won't be easy and financing will not be cheap," Meyer wrote in a client note.

Talbots, a relatively upscale retailer, has been in hard times for a while; nonetheless, the banks are under pressure of their own to shore up their balance sheets. 

In a similar move, B of A has decided not to renew Sears' $1B line of credit.

Posted by Paul Rose

It's the Liquidity, Stupid!

Many in the market claim that we are in a "credit crunch."  In other words, folks are not loaning each other each money.  They are partially right.  There is much money on the sidelines waiting to get in; it is scared. Why?  Because of the real problem -- the liquidity crunch.  Many in the market invested in illiquid investment instruments -- these are investment instruments in thin markets that rely on good times to stay open. We are not in good times.  Once the thin markets shut down, folks holding the instruments take huge losses -- they cannot unload them and cannot even value them.  People with cash to lend stay on the sidelines until the mess clears up.  Credit swaps, asset based securities, and auction-rate securities are the current examples of illiquid investment instruments.  Holders assumed (or were misled to assume) that the thin markets in these securities would survive.  The took for granted liquidity, which occurs in boom markets but disappears when times get tough.  We are in a liquidity crisis which has spawned a credit crisis.

The Zell Deal for Control of Tribune

I am still somewhat flummoxed about the details of Sam Zell's successful deal for operating control of the Tribune Corporation.  In the first step of the transaction, the Zell Entity invests $250 million in Tribune for (1) 1,470,588 shares and (2) a promissory note of the company equaling $200 million, exchangeable at Tribune's option into 5,882,353 shares of common stock (equivalent $34/share).  Zell's entire first stage investment is cashed out in the second stage and replaced by another.  Presumably, the first stage was a combination stock lock up to discourage other bidders and an immediate cash infusion in the company that did not have to wait for the closing.  Also in the first stage is an ESOP's purchase of 9 million plus shares at $28 a share, which is a toe-hold purchase at $4 less a share than the closing price.

The guts of the deal for Zell is in the second part of the transaction.  Tribune borrows a bucket of cash ($2.105B incremental term loan & $2.1B senior unsecured bridge and the remainder long-term loans), and lends it to the ESOP to buy up the (126,000,000 outstanding) shares of Tribune at $34/share. The new ESOP-owned Tribune would have roughly $13.4 billion in debt after the deal, up from about $5 billion before it.  Zell provides subordinated financing ($325 million) to Tribune to help make this happen, and receives a warrant to purchase 40.3% of the company (43,378,261 shares) for $500 million (plus he pays the $90 million to purchase the warrant). Zell also gets the benefit of an Investors Rights Contract that gives him two seats on the board and veto power over major corporate decisions.

The return for Zell is in the warrant.  It is deep in the money.  If the true value of the company is $8.2 billion (at $34/share) and Zell exercises the warrant for a $3.2 billion interest in Tribune he will pay around $615 million. If the value of the company falls to $13 a share, less than half, he still makes a small amount money on the option.  How does he get such a great deal???   Who takes the hit???  The employees.  If the company does well and is worth more than $34 a share, the employees get the benefit.  If the company does not do well and is worth only $13 a share, the employees lose dollar for dollar while Zell stills brakes even.  What are the company's prospects?  Miserable.  The newspapers are showing dramatic declines in revenue.  The employees have, in essence, bet that the Cubs and the company's real estate is undervalued and can be sold for a huge gain over carried values.  Why did the employees go for this?  They put their pension plan on the line, not their wage package. 

To make matters worse for the employees, the company's creditors can force bankruptcy even if the company continues to have positive earnings.  The creditors have demanded debt coverage conditions (nine times revenue)  that, if triggered, would accelerate principle repayments and would trigger bankruptcy.  So even if the company continues to stagger along making smaller and smaller profits, the new creditors can pull the plug on the deal and the employees could be the big losers. 

GE's Problems Continue

Ex-CEO John Welch has publicly criticized the current CEO Jeffry R. Immelt for not being correct in Immelt's projections of earnings.  It is a very rare public moment.  The problem is, of course, deeper.  GE's stock has slumbered since Immelt's appointment.  GE is simply too large; it's returns cannot beat the market, it is the market.  Yet the company, through management missteps, can have returns that fall behind the market.  GE needs to bust itself up.  A bust-up, once announced, would immediately drive up the stock price and reflect a board and a CEO that care about investors, not the management perquisites of size.   

Obama and Investment Taxes

The Dublin Intrade market has Senator Obama as the prohibitive favorite in the Democratic primary and as the favorite for President of the United States in the general election in November.  So we ought to pay careful attention to what he would do with taxes once in office.  As far as I can make it out he would 1) raise the top income tax rate to 39.5%, 2) lift the cap on payroll taxes for higher incomes that, added to 1) would increase the top marginal tax rate to around 52%, 3) increase dividend taxes to 39.5% from 15%, 4) increase capital gains taxes to 28% from 15%, and 4) increase the top estate tax rates to 55% from 45%.  Added together it would be one of the largest tax increases (by rate or by application) in American history.  This in the teeth of an economic slowdown and in the teeth of new competition from very capable and determined international opponents (the EU, China, India).  Particularly distressing in this package is an increase in what I call the investment tax -- those who choose to invest in United States industries will pay much higher taxes on those returns.  States are desperate to attract capital -- to the point of offering absurd tax rebates to those who offer to invest in a local factory or office -- and Sen. Obama is set to penalize those same investors who invest in the United States.  We cannot have it both ways folks. Penalties on investment will drive marginal investment offshore or limit it in other way (drive it into munis).  This is a potentially crippling gaff.      

The Expanding Role of the "Financial Stability Forum"

A perhaps underreported aspect of the credit crunch is the growing role of internation regulatory efforts such as the Financial Stability Forum (FSF).  The FSF, as described by Treasury Undersecretary David McCormick, "brings together supervisors, central banks, finance ministries, the International Monetary Fund and the World Bank, and other international regulators. Together, the members of the FSF assess international financial system vulnerabilities and identify needed actions among responsible authorities. This provides critical coordination between globally integrated capital markets and national regulatory agencies." 

The FSF reported to the G-7 with recommendations for an international response to the market turmoil:

Prudential oversight: Firms need to strengthen their risk management practices, liquidity buffers and capital. The Basel Committee should raise capital requirements for complex securities and off-balance sheet vehicles.  . . .

Transparency and valuation: Firms need to fully disclose their risk exposures and fair value estimates for complex securities. . . . The International Accounting Standards Board should urgently act to improve standards for off-balance sheet entities and improve guidance for fair value accounting.

Credit ratings: Investors should improve their due diligence efforts, reducing their reliance on credit ratings. Credit rating agencies need to clearly differentiate the ratings for structured products, improve their disclosures, and reassess the quality of the information they use to determine ratings for structured products.

Authorities' responsiveness to risksDealing with stress in the financial system: Supervisors and central banks need to increase their cooperation and information exchanges, including assessments of financial stability risks.

Dealing with stress in the financial system: Central banks need to effectively provide liquidity when the financial system is under stress. In addition, authorities should strengthen arrangements for dealing with weak and failing banks, domestically and across borders.

As has been demonstrated by the sub-prime crisis, international markets have not decoupled from the U.S.--on the contrary, securitization spread risk and reward internationally.  Many of the financial institutions most affected by the sub-prime mess are multinational, and better regulatory coordination among the nations at interest should be welcome.  Still, another layer of regulation means more bureaucracy.  Paulson's efforts to clear (or at least rearrange) the deck with respect to some U.S. financial regulation is perhaps in recognition of the fact that international or supranational regulation will take on greater prominence with globalization--the result is not so much a net decrease in regulation (not for most larger public companies, at least), but a relative increase in international regulation and (hopefully) a slight decrease in overlapping domestic regulation.

UPDATE:  The Basel Committe has also just come out with proposals for tighter regulations on banks; see report here.

Posted by: Paul Rose

New "Best Practices" Guidelines for Hedge Funds

A group of hedge fund managers, backed by treasury Secretary Hank Paulson, have just published a "Best Practices Guide" of hedge funds.  The Guide contains the expected -- more transparency and better internal valuation of assets.  Although the Guide is voluntary it could soon be part of the contractual obligations of the industry as hedge fund clients and counterparties may demand that the Guide's directors be included in their contracts.  One should not that the present economic crisis has hit the brokerage houses and investment banks much harder than hedge funds.  Given all the caterwauling about hedge fund risk taking in the past year or so, it should be well noted that it is not hedge funds that have proven to be the most vulnerable to the credit crunch. 

Another Large Airline Merger

On Monday, Delta Air Lines reached an agreement to take over Northwest Airlines.  Delta said the combined airline will have an enterprise value of $17.7 billion and over $30 billion in revenue placing it ahead of Fort Worth, Texas-based American Airlines for the top spot in the U.S.  Headquarters will be in Atlanta, and Delta CEO Richard Anderson will lead the combined company.  The parties will have to convince the Justice Department that the merger, creating one of the world's largest airlines, is not ant-competitive.  Arguments may include a dual  "failing company" defense -- each of us would fail if left alone.  How two struggling companies can combine to make a healthy one is always a question.  I suppose two drunken sailors could lean against each other and hold each other up.

Sorkin's Interview with Stephen A. Feinberg

Sorkin, noted business columnist for the New York Times, has ripped Stephen A. Feinberg, founder of Cerberus Capital Management, for being "cold and ruthless."  So, Feinberg, following the dictates of modern public relations specialists, did penance and invited Sorkin in for a rare media interview.  Feinberg's offense?  He noted that returns for investors did not necessarily mean Chrysler would survive in its present form -- that he his task was not to be a "hero."  Well how cruel and heartless.  In any event, Feinberg called in Sorkin and fell on his sword.  He noted his "national responsibility" for "American manufacturing" and that he was uncomfortable as a student at Princeton ("I should have gone to a public school").  Sorking loved it of course.  If I was an investor in Cerberus, which I am not, I would have hated it --- either he does not mean what he says or he does -- both are a problem. 

Israel, Founder of Bayou Group, a Hedge Fund, Goes to Jail

Samuel Israel, III, the co-founder of a hedge fund, Bayou Group, was sentenced to 20 years in prison two days ago.  His Connecticut based hedge fund took $400 from investors and lied to them about profits and losses.  They fabricated financial statements and siphoned money off in a phone brokerage operation.  Co-founder James G. Marquez was sentenced to four years and three months in prison.  The failure of Bayou in 2005 was one of the events fueling an outcry among commentators and academics for more regulation of hedge fund operations.  Seems like a 20 year prison sentence ought to be sobering enough.

Turn-Around Funds: Apollo and Appalossa's Woes

Turnaround private equity funds that purchased struggling companies in good times, with leverage, have found that their turnaround plans and suffering the with economy.  Plans that may have worked in good times have no chance in bad.  Apollo Management is an example.  Apollo's turnaround plans for Linen 'n Things may be unreveling and Apollo may be "throwing good money after bad" in continuing to prop up the company's debt.  Another turnaround hedge fund, Appalossa Management, has lost 17 percent last quarter.  Hopeful that Appalossa can turn it around it Carnegie Mellon that has put Appalossa's manager's name, Tepper, on its business school in exchange for $55 million.

A Race Between Court in the Clear Channel Busted Buyout

There is a race between two judges in the litigation over the busted Clear Channel buyout.  A state court in Texas is racing to beat a court in New York.  Clear Channel is based in San Antonio and is attempting to force the buyer's financial bankers to finance the deal.  The Texas judge, anticipated to favor closing the deal, is way ahead.  Judge Brown has already imposed, in succession, a very quick TRO, a temporary injunction, and a fast track trial date.  The New York court, more sympathetic perhaps to the financing banks, has a summary judgment hearing scheduled for April 24th.  This reminds me of the railroad wars at the turn of the century than included a fight between the courts of Pennsylvania and New Jersey.  Plenty more to come.

Questions on KPMG's Audit of New Century

The surprise failure of New Century Financial, one of the country's largest subprime mortgage lenders, has led to an all too familiar question -- how could the auditors have given the company a clean bill of health right up until the collapse?   KPMG has some explaining to do.  The Sarbanes Oxley Act of 2002 was largely pointed at auditors whose roles in the collapse of Enron and WorldCom drew the ire of Congress.  The Act increased auditor liability for inadequate performance, created a new auditor watchdog agency, and added procedural requirements intended to protect auditor independence and enhance auditor quality.  Yet -- the same old story -- a firm with a clean audit collapses and the auditor's for the firm disclaim any and all fault.  The audit industry mess reflects an inherent conflict of interest -- managers who select and pay auditors are those whom the auditor's audit.  We would not let football coaches pay game referees after each quarter, but we allow managers to pay auditors after each quarter.  Auditors should report to shareholder or investor groups not managers.  Until the basic conflict is cleaned up the salves, such as those in Sarbanes Oxley, will provide only temporary and partial relief.

Cadbury Schweppes Shows GE the Way

On Apr. 11, Cadbury Schweppes shareholders voted to spin off the company's U.S. drinks division. The newly independent chocolate, candy, and gum business is to be listed on the London Stock Exchange on May 2.  The new U.S. drinks business—which will be named Dr. Pepper Snapple Group (DPSG) and is set to be listed on the NYSE on May 7.  General Electric, an unwieldy conglomerate of the 60s, should follow Cadbury's example and spin off several of its under performing units (or it few well-performing units) to separate the cash cows from the dogs.