Business Law Prof Blog

Italian and Russian Response to Market Decline: Close the Markets!

They are consistent.  Berluscone (Italy) and Putin (Russia) want to close the markets to stop the market decline.  That, in light of oft-repeated history, has proven to be a disaster.   But we you think you can control things,  you do not let history stand in the way.

The Difficulties of the Government's Decision to Buy Bank Stock

We now have the government "thinking" of buying bank stock to recapitalize the banks. Economists are grouping around the solution as well.  The UK has already said it will do so.  Solution?  No. Economists need to talk to some lawyers. 

If the government buys stock, there are two major decisions it must make.  First, at what price?  Second, what rights does the government receive?

Take the first problem:  Does the government play Warren Buffett and demand special preferred stock (which it did in AIG for just a loan, not a grant of money) that dilutes the outstanding common and preferred?  Does the government pay over fair value, fair value or under fair value (Buffett's strategy).  There are policy arguments for each position.  By the way, the stockholders of the banks would like to know so they can price their securities.

The second problem:  Does the government demand voting rights? Protective covenants which provide veto power over management decisions?  If so, who in the government exercises the authority?  How?  These are no small questions.  The answer distinguishes socialism from capitalism and we are talking about the nation's banking system here.

When you put problems one and two together you get a much more sobering appreciate to the problems than the theoretical economists seem to have.  You get a "legal process" recommendation that we should not buy bank stock at all.  We should reorganize banks, using our, in place reorganization processes (Chapter 11 for non commercial banks, and FDIC seizure and liquidation for all others).

The Government's Roll in a Crisis

Jonathan Macey writes in today's Wall Street Journal that "The Government is Contributing to the Panic."  He makes two salient points and leaves one out.  First, he notes that the government should not retard or otherwise or hinder trading market mechanisms in a crisis when we need the markets to clear as fast as is possible.  We should not, therefore, stop-short selling or [I would add]change accuracy in disclosure rules (mark-to market rules).  Second, he notes that we should not reward bad behavior and make suckers out of those that behaved well.  We should not give free deposit insurance to investment banks when commercial banks have, for years, be made to pay for it or [I would add] bail out AIG when other insurance companies we more careful with writing counterparty credit default swaps.  But he missed a third point, as important as the other two, and the third point leads to a fourth, which he does note.  The government must be predictable; otherwise the acts of the government, the biggest market player at any one time, cannot be priced in the securities.  If you cannot price one of the largest risks, you do not trade, lend, or borrow -- you sit on your cash.  If you sit on your cash, the buyers disappear and the markets cannot clear or balance.  By bailing out Bear Stearns and not Lehman, the government taught traders that the government's actions could not be predicted.  Whether the government should have bailed out both, or refused to bail out both (I am here), the argument is really less important than the argument that the government should be consistent -- do one or the other, not what it did.   This point leads to a fourth point: the government should acknowledge that it has limits in what it can do.  Tell the markets what it will do, given conditions, and let the markets do the rest.  Then we do not get Paulsen promising solutions, which he has done on numerous occasions (remember his statements after the first $170 billion stimulus package??), and looking very foolish when his projections do not come true.

Bernanke Disappoints, Abandoning Principle

When Bush appointed Bernanke, I applauded, mainly because he had publicly and repeatedly taken the position that the Fed had to be "predictable" for the markets to function well.  He has even suggested a "algorithm" for all Fed interest rate cuts, publicly known.  He knew and still knows that government uncertainty adds to market confusions and makes it difficult for the market to price, and clear, securities.  Now we see a totally unpredictable response to crisis.  We wait for Bernanke and Paulson to make their latest policy lurch and the markets cannot price the uncertainty.  What a disappointment --  the academic who leaves his conviction behind in a crisis.   

On a Lighter Note: Bird Watching Passion

We all need a little chuckle now and again.  My latest edition of Wild Birds had three letters/articles:

1) A women in Colorado saw an unusual oriole at her feeder, took a quick picture and put it on-line to her Colorado birding club, and when to work on a stormy spring day.  She returned to find that the club had identified the bird as a "Streaked Oriole", very rare in Colorado and never seen that early in the spring in the state.  She was soon visited by 450 birdwatchers who wanted a glimpse of the bird.

2) Birdwatchers keep lists of bird's sighted and many bird species are seen only over deep ocean water, pelagic water.  A group of watchers, seeking "life sightings" of such birds chartered a fishing boat and headed out to deep water.  Most were violently sea sick.  Puking over the rail until someone would shout "flesh-footed shearwater, 10 o'clock." they would all appear, green, with cameras and binoculars, check their lists, and then return to puking.  Once in port they were all happy with the sightings and happy to have gone; the writer ruined his binoculars with salt water and broke his glasses -- no matter -- he had sighted an albatross and 13 other "life birds" in one day. 

3) Birdwatchers have come close to blows over a riveting ethical issue:  Can a birdwatcher pish a bird by playing its song from an ipod to induce the bird to come from cover (to fight the intruder?)?  There are deep and nuanced arguments to this issue.   Is it fair to claim the sighting?  Can it injure the birds. scaring them off nests?  The debate got emotional when a watcher claimed to have induced a song bird out of cover only to have the bird snatched by a copper's hawk.

Stock watchers, step aside for birdwatchers.

Who Will Be the Next Secretary of the Treasury?

In the latest presidential debate both candidates were asked about who they would appoint to be the next Secretary of the Treasury.  The question bored many listeners:  "Who cares? Ask about the next Supreme Court appointee!"  And the question was truly novel.  I have never heard a debate question like it before.  But it is hugely important.  Paulson now has the power to buy over $700 billion in assets and he is struggling to get the program in place.  He also is running the country's largest insurance company, AIG, and the country's largest mortgage purchaser/guarantors, Fannie and Freddie.  He may soon have substantial voting power in the country's largest commercial banks.  He will begin buying assets and exercising most of his management power after the election is over and just in time to turn over his office to the next holder.  Right now we have a 35 year old, six years out of business school, and another Goldman Sachs employee designed processes that will be subject to intense inside lobbying by, well, everybody (some will be based on raw power moves) as government auctions always have winners and losers.  The S&L bailout, as its leader, Seldman, reminds us, had real winners as well as losers and the lobbying was intense.

Who will he turn this power over to?  We want to know.  Will the new office holder be less concerned with Wall Street institutions  and more with the "middle class"?

The candidates answers were pathetic.  McCain suggest Warren Buffett -- an Obama supporter, someone in favor of tax increases, and very unlikely to leave a one-man company that he runs (and that would tank on the news) and would have to divest himself of to avoid conflicts.  Obama said that Buffett would be "alright" (translation - not my pick) but that there were "others."  Well who???   

Governments May Be the Next To Fall

California, a state in which the housing price bubble started first, was the most severe, and burst first, is now insolvent and seeking federal government money.  Iceland, a country with a population the size of Columbus, Ohio and a capital city, controlling the finances, the size of Boulder, Colorado  has nationalized two of its largest three banks (its only privately held banks of any size at all), pegged and de-pegged its currency as its currency has plumetted, and is now begging for Russian, Uk, and Swiss money to capitalize its remaining banks.  Iceland's bank's mirrored the S&L Bank scandal;  they offered high rates to short term lenders in order to lend, with little or no capital cushion, to long term borrowers and higher rates. 

McCain's Garbled New "Mortgage Purchase" Plan

In the debate, Senator McCain offers a "new" solution.  "Buy mortgages from citizens."  Whattttt?  Citizens do not own mortgages; they own houses.  You cannot buy a mortgage from someone who does not own it.  He can mean one of two things.  1) Buy houses that people cannot pay for and sell them back to the occupants (with some new financing) or 2) buy mortgages from people that hold them on houses owned by people and forgive some of the terms.  Either way he is talking about modifying mortgage terms for people that cannot make payments.  Either way it is an administrative nightmare. I think he is talking about 1) but I am not sure.  2) is what the government is currently doing with the conservatorship of Fannie and Freddie and the $700 billion asset purchase plan (so it is not "new").  Has he totally lost it? 

Moreover, over 93 percent of the people who owe on mortgages pay them on time, should they stop to try to get in on the program?  For the 7 percent (or soon 100 percent) that are not paying, the government will have to hold hearings on their reasons to decide whether they merit some forgiveness and how much.  Did the owner speculate on  12 condos and just over-invest? Are they living in the house? Have the lost jobs?  So each forgiveness is a hearing -- which is what our foreclosures court proceedings are currently doing.

AIG in the News Again

The government loans AIG $85 billion less than two weeks ago.  The company draws is down almost immediately and Ed Liddy took his executive staff to a spa.  Congress goes nuts and then the Treasury announces, after markets close today, that the company will get another $37.5 billion loan.  We are waiting on the details [will the goverment buy get more stock?].  I still do not know who the "trustee" is that runs the trust for the government that controls 79.9 percent of the stock.  Who is the guy???

AIG Bailout Details: What a Legal Mess

It seems like the AIG bailout is now old history, but the disclosed loan documents reveal some startling news to AIG shareholders and show problems inherent in our government owning controlling equity positions in major American companies.

1)  First, there is substantial confusion over the essence of the deal.  AIG is getting a one-time loan and, in exchange, is 1) paying LIBOR plus 8.50 percent on money used (11 percent or so) and 8.50 on money not used but committed and 2) granting a government "Trust" 100,000 senior preferred shares.  the senior preferred shares vote with the common and participate in common dividends, casting 79.9% (adjusted for dilution) of the votes and taking 79.9 percent of the dividends.  The preferred is convertible into common but, why bother, the preferred has the rights of as converted common when not converted.  Many readers thought that the senior preferred was "just collateral" and would be returned once the loan was fully paid off.  No.  When the loan is fully paid, the government still controls 79.9 percent of the voting power of AIG.  I assume that once the loan is paid, the government will be under pressure to negotiate a sale of AIG to someone or run its own public offering to sell the stock to the markets.  Again, the government does not have to and may choose not to.

2)  With the government controlling 79.9 percent of shareholder voting power, the government elects the CEO and the board of directors.  How is this done and who are they?  It is done through a "Equity Trust."   A trust is formed with the government as the beneficiary.  The trustee, in essence, nominates and elects the AIG CEO and board of directors.  Who is the trustee?? I cannot find out.  I assume that it is an appointee of the Treasury Secretary.  I would like to see the trust document to understand the trustee's terms (who fires the trustee?).  Taxpayers pay and we elect the President who appoints the Secretary of Treasury who appoints the trustee who appoints the CEO of AIG. 

3) How is it that our new government appointee CEO took all his executives to a spa after the bailout documents were signed?  Can taxpayers sue for breach of fiduciary duty?? No. Taxpayers, unlike shareholders, will not have standing to sue the CEO of AIG.  This is a very diluted string of accountability.  Can the trustee sue?  Yes, he could get the money back.  Will he?  Who is he?

4) Moreover, will minority shareholders, who have standing to sue the AIG CEO under state law, have standing to sue (for fiduciary breaches) the CEO or the trustee or the Treasury Secretary or the President, all government appointees, or be blocked under the doctrines of governmental immunity.

Answers to Some Blunt Questions

I live in two worlds, a law professor world dominated by those lean left and a blue collar world dominated by those who lean right.  People on both sides have asked some very blunt questions about the bailout.

1) Where Does the Government Get the Money For Bailouts?  Answer: Government officials hope that it will be paid back.  If so, it is a loan that is paid back with a small interest rate.  If you do not believe it will be paid back (and most do not) then the answer changes depending on government choice.  The government can choose to get the money from taxpayers or from those who hold money or its equivalent.   The government taps taxpayers buy either selling more Treasuries to raise cash (taxpayers must pay the interest) or by raising taxes.  The governments takes money from those who hold dollars (or are owned dollars) by simply printing more money and inflating the currency.  The government is more likely to choose the former than the latter.  If the government sees $700 billion in treasuries, the most likely choice, it will have to add one-third to the current annual deficit projections in the form of interest payments, that will also be due each year thereafter until the treasuries are retired.   

2) Will the executives of the bailed out companies have to pay?  Yes, but it will take three to five years for the prosecutions and civil actions to be complete.  By then we will be on to the next crisis.  The executives are criminally and civilly liable if it can be proven in court that they misstated their company's financial condition on the eve of a bailout.

3) What was the root cause of the crisis?  A bubble in the housing market.  Prices were too high and must come down.  On the way down, those that took leveraged bets in favor of more appreciation in housing prices will lose their money and will hurt those with whom they do business.  The government cannot stop the prices from coming down, it can only soften the impact of the business reversals cause by the price decline.  Any effort to stop the prices from failing is doomed to failure and will cause deeper and longer lasting problems.  See Japan in 1990.

4)Is capitalism at fault? Or, Is Deregulation in a capitalist economy at fault?  Yes and no.  People trying to make money took advantage of cracks in the legal regulation of the mortgage industry.  People bought houses they could not afford because they were cajoled into contracts by people who passed on the mortgage paper to GSEs or GSE guaranteed entities.  The GSEs, government sponsored and heavily regulated entities, wanted more people to own homes.  One could claim we need more regulation of already heavily regulated entities, the GSEs (deregulation is at fault) or that the heavy regulation did not work and we should not have created the GSEs in the first place (regulation is at fault).  You pick.   

The Lesson from Hexion's Loss in the Huntsman case: "It's the Contract Language, Stupid."

Hexion attempted to bust a buyout deal with Huntsman and the Delaware Chancery Court held that Hexion had itself intentionally breached the buyout agreement.  Hexion does not have to close the deal but is liable for damages, which are not capped by the reverse termination fee of $325 million.  The lessons from the case are clear: 1) A "material adverse change" claim puts the burden on the buyer to show that a change is "material";  2) A good faith obligation to get financing or government approval is just that; foot dragging to stop a deal is actionable; and 3) contract language counts.  Both sides lost because contract language was ambiguous.  The MAE clause was too general and could have, but did not, rest on changes from forecasts.  The specific enforcement clause was a mess and cost Huntsman the ability to force the deal to close.  Why deal lawyers are content to use these general clauses in these big money deals continues to be a mystery. 

Fuld's Testimony

A House Sub-Committee had fun yesterday; it's members had Fuld, the CEO of now bankrupt Lehman Bros., answer its questions.  The press covered the hearing will glee, knowing that it would make headlines and lead stories for an angry public.  The problem?  The press did not put the testimony in any sort of context.  FUD, a wealthy man, will be sued.  He is being investigated by the Justice Department, the SEC, and state attorney generals and is in the cross-hairs of every securities class action attorneys in the country.  This, of course, means that he has been carefully advised on what he can and cannot say to minimize his litigation exposure.  When the press bemoans his failure to "take blame" and his willingness to "blame everyone else," it is laughable.  He would be foolish to admit anything in the face of these prosecutions.  If he "takes blame" it will be in exchange for some kind of deal, many years from now. With that perspective, it makes puts his answers to "Is it fair?" questions in context.

Finally--The Fed Will Buy Commercial Paper--A Way Out?

The Fed has finally decided to show up, even though very late, and buy commercial paper.  The market is up immediately on the announcement.  The Fed did not need the bailout bill to buy commercial paper; it had the power under New Deal legislation.  This blog has argued for some time that purchasing commercial paper to keep the operating companies open for business was the way to go.  Why did it take so long?  And why did we try less efficient solutions -- the $165 billion taxpayer rebate and the $700 billion asset purchase program -- first??

We are in a real estate asset bubble -- real estate must reprice and the markets must clear.  While this is happening we need to make sure operating businesses continue to get credit.  Delays in real estate repricing, which many folks argue for in a variety of guises (government asset purchases, government guarantees, mortgage resets, short selling bans), only hurt the markets, adding uncertainty to pricing and locking them up until buyers and sellers can price the risk. 

With the purchase of commercial paper, if the government lets the real estate prices clear, we can stabilize.

A Weekend of Foolishness in Haste:The Wachovia Deal

Our government -- the courts, Congress, and the Fed -- has totally lost it.  Exhibit A is the Wachovia Deal.  Here is the background.  Citigroup offered $2.2 B to buy parts of Wachovia with a stop loss guarantee from the Fed for $42 billion.  Wells Fargo steps up with a higher bid, $15 billion, with no Fed guarantee, to buy Wachovia.  And the silliness began.

1) Citigroup went Judge shopping, finding a New York state trial court judge in his home on Saturday willing to enter an order effectively blocking the Wells Fargo deal until a hearing on Friday.  Two errors:  1) The Judge, responding to manufactured panic, should have told them to go home and wait until Monday so he could hear it in court. 2) The Judge entered an order, in extreme haste, that no body could understand.  He X out something in lawyers paper's and hand wrote a sentence that made marginal sense.  Lawyers were on the phone making arguments, some could hear some could not.

2) Wells Fargo ran to a federal district court judge, John Koeltl, and convinced the judge, in extreme haste, to hold a hearing on Tuesday on the deal. A moment of sanity here. Wells Fargo argued that an obscure provision included in the $700 billion bailout bill passed by Congress on Friday, in extreme haste, had pre-empted the Citigroup deal. Congress has no idea what it passed. Both sides claimed victory. 

3)  Well Fargo also ran to a New York state appellate court judge, at his home Sunday, and secured an order, in extreme haste, overturning the trial court's order. A second moment of sanity.

4) The Treasury and the Fed. with Paulsen recusing himself because he is a buddy of the Wachovia CEO, is now in round the clock negotiations with Citigroup and Wells Fargo to settle the argument by slicing up Wachovia.  The government is trying to play, in panic, Solomon.  Back to the nuttiness.  The Fed should be delighted that taxpayer's may be off the hook and let Citigroup and Wells Fargo compete for the company without federal interference.

We have judges, Congress, and federal officials, having convinced themselves that only they can stop impeding doom, acting like panicked citizens listening to the "War of the Worlds."  Folks, gather yourselves.

Judge Ramos Blocks Wells Fargo Takover of Wachovia

A State Supreme Court Judge in New York (the Supreme Court is the trial court) has heard arguments at his home Saturday and, Citigroup claims, temporarily blocked a signed takeover deal between Well Fargo Bank and Wachovia.  Citigroup has argued that the deal interferes with its previously negotiated deal to buy the bank.  The Judge apparently will hear a motion for a temporary or preliminary injunction in court on Tuesday.  Citigroup's claim rests on a letter of intent.  The letter restricts further bid solicitations by Wachovia but states the parties have agreed to "proceed to negotiate a definitive agreement."  In other words, there is no deal but just an agreement to negotiate to a deal. Citigroup argues that the agreement is "exclusive" of other bidders.  Their position is weak, very weak. At best it is a claim that Wachovia breached a no shop/no cooperate clause or that Wachovia breach a "good faith" obligation to negotiate with Citigroup. 

Once again I am amazed at lawyers using these open ended letters with little or no specification as to what is a binding legal promise and what is not.  It would have been a very simple matter to make parts of the letter binding and parts not and specify the nature and character of the promises.  Why do lawyers, in multi-million dollar deals, use such open ended, poorly drafted language, leaving to latter claims of interpretation by both sides that are radically different???