Business Law Prof Blog

Liability of Government Director Nominees

Vice Chancellor Lamb of the Delaware Chancery Court noted recently in a pubic speech that government director nominees "should be treated like anyone else (other directors)" when fidicuiary duty standards are in issue.  This is the tip of the iceberg, of course.  The statement is a reaffirmation that the directors will be responsible to all shareholders, not just the government, in their board actions.  This will test government nominees ability to answer to both the government (which may have objectives other than a firm's profits in mind) and to equity investors (who are primarily interested in profits).  But liability will be another matter. Can the director nominees be personally liable?  They are subject to the court's injunctive powers, but are they subject to damages for official actions?  Their immunity as government actors will be tested.  Second, is the government as prinicipal liable for the nominees actions that may injure other shareholders?  The hazy area of liability of controlling shareholder for the actions of borad nominees, not yet fully developed in the case law, will be in issue as well the sovering immunity of the government itself?  Has the government waived its liability for the actions of the nominees?  (See, e.g., the Federal Tort Claims Act).  Plaintiff's lawyers will be busy, as the government is an obvious potential deep pocket in shareholder derivative actions.  I would suggest to all government director nominees that, before they accept the position, they get good advice on their personal exposure to private lawsuits. 

The New Finanical Products Consumer Protection Act

A piece of legislation sponsored by the new administration that makes sense, in theory, is the new finanical product consumer protection act.   Long championed by Professor Warren, a federal act is necessary to stop consumer fraud by national financial institutions.  State officials in states other than New York and a few other states have been reluctant to pursue cases of consumer fraud in the sale and marketing of complex financial products.  But theory is not fact and the new act may go too far, proscribing more the fraud.  It may limit the sale of selected complex financial products, however marketed and sold.  The impowered agency may be asked by Congress to act like a drug approval agency rather than an anti-fraud enforcement agency.  Banks have noticed the threat and are lobbying intensely against versions of the act in draft. 

Broker Liability

The new administration's financial regulatory proposal has big changes that dominate the headlines. It is hard not to focus on the proposal to give power of the Fed to declare large firms "too big to fail" and subject to heavy inspection and oversight.  The potential for politicial extortion under such a system is obvious. [Recall actor Fred Thompson's description of a "Japanese inspection" for imported lettuce.]  Wall Mart, get ready.

But in the proposal are small changes that are also huge in their spheres of influence.  Consider the change that would make all brokers "fiduciaries" to clients.  Lawyers will benefit as law suits against brokers will abound whenever a broker loses a large client's money.  Broker lawyers will test the limits of waiver, producing rafts of documents that clients must sign on any trade ("I have personally researched....")  And brokers will put clients in funds of funds, mutual funds and ETFs, passing the buck to other intermediaries that are not burdened by the heightened standard.  It will change the business entirely.

The New Financial Plan

Some of the details of the administration's new financial plan are out. Any newspaper has a summary.  A few observations:

1)  The big winner is not the Fed, as reported, but the Chairman of the Fed. They are different.  The Federal Reserve System is 12 banks, owned and capitalized by otherbanks.  The Presidents of these banks serve, along with the Chairman of the Fed, appointed by the President, on several very exclusive committees.  The Chairman of the Fed dominates the committee that engages in monetary policy, binding the banks, and otherwise works with Treasury on general economic planning.  The Chairman of the Fed will now, apparently, regulate risk taking by all major financial institutions in the United States.   The irony:  The Chairman of the Fed created the cheap money that fueled the housing bubble.  It is like SOX: the winners were the accountants, accumulating massive new fees under SOX, when they had misbehaved in the first place, failing to audit correcting telecom and technology companies.

2)  The elephant in the room not mentioned is the rating agencies.  The rating agencies were necessary to the housing bubble, overrating risky MBS securities so that banks could buy them and even use them for capital requirements.

3)  The Chairman of the Fed will have quasi- Chapter 11, receivership and conservatorship power over a large part of the financial system.  Chapter 11 comes with rules, this power is very open-ended and, as has been the very recent practice, is likely a vehicle for government intervention, not orderly winding up or reorganization.

4) The Chairman of the Fed will now have multiple and potentially conflicting assignments.  These "hybrid" government agencies do not work well. Fannie and Freddie had function creep and were part of the reason for the housing bubble.

5)  The proposal is too narrow.  The next bubble will be in some other commodity or asset class. The proposal focuses on asset securitization systems, yesterdays news and to which many in the market have wised up.  A bubble needs 1) Cheap money 2) A weak link, a sucker who takes risk she does not price correctly and 3) Those who shuffle risk.  Those who shuffle risk use the cheap money to pass risk, taking fees, on to the weak link until the true extent of the risk is discovered.  The cheap money for the recent housing bubble came from the Fed, the shufflers were those in the securitization process, and the weak link were those investors that relied on incompetentt rating agenices to qualify risk.  The proposal relies on the Fed and Treasury to accurately monitoror risk, something neither in the last crisis, which means we have added a new weak link ("Treasury thinks we are fine.") and have not repaired the old weak link, rating agenciess.  A broader solution? Competition among rating agenciess and auditors and other certifiers of risk; claw backs on salary among the risk shufflers; heightened anti-fraud prosecutions.

6)  It does not solve our central politcal problem. In the housing bubble we witnessed elected politicians putting pressure on government housing agencies to relax lending limits.  We will see this again. The government proposal gives mulitple government actors the power and direction largely to say "no" to private actors and again elected politicans will attempt inevitably to influence those decisions to aim local constituents.   Barney Franks successful efforts to secure TARP money for a badly run, tiny Boston  bank will seem to pale in comparison. 

7) This is not a "light touch." 

The New Evolution of Chapter 11

Ten years or so ago an article in the Yale Law Review criticized the Chapter 11 procedure as giving hold up power to lower echelons of creditors and claimants at the expense of the secured creditors.  Moreover the procedure was time consuming and expensive, lining the pockets of lawyers in particular.  Negotiations within the backstop of a simple Chapter 7 would be more efficient, it was argued.  The Chapter 11 bar closed ranks behind the procedure and the controversy subsided.  Now a new controversy.  Chapter 11, and perhaps new procedures that take the place of the Chapter 11 for financial institutions, are now the vehicle for government management.  Ironically, the government has chosen to injured secured creditors as well in favor of unsecured claims of labor and other favored constituencies.  This new development is more far-reaching and potentially harmful than the earlier charge of private hold-up power..

The Slow Motion Walk to a Managed Economy

It started with fear, that the failure of some companies would tank the economy.  The government then eschewed market self-correction and accepted the need for bailouts; only the government could fix the crisis.   The fear moved to an implied government guarantee.  Then the guarantee morphed into theory, the most dangerous move of all -- some companies are "too big to fail."  The theory is now moving to regulation -- the government must have a unified regulatory agency that regulates the risk practices of those companies that are too big to fail.  The result?  Companies have an incentive to grow to access the government guarantee and to enjoy the bailout money.  These incentives are only mildly related to business goals, low gross margins and the like.  Companies will be selected for success on their political power and size.  Not good.    

Why the Rush on Chrysler?

The Supreme Court, through the temporary act of one Justice, has delayed for a moment the rush to sell effective control of Chrysler to Fiat.  The government is dismayed.  We need to rush. Why?  The need to rush in a purely finanical deal usually means someone is getting a sweetheart deal (at the expense of someone else) and wants to close fast to lock in the benefits.  Only if market conditions are deteriorating very quickly, which is not the case here, is speed otherwise essential.  In this sale it appears Fiat and the UAW are getting the sweet deal and secured and unsecured creditors are taking it on the chin.  The argument to the Indiana pension fund in the paper is a riot -- "you are only losing $5 million, a pitance, on an investment of $17 m, take it for the good of the country" -- and is exactly why we should slow this down.  $5 m is a substantial sum for a state pension fund and they should seek to save it -- good for them.  The new administration is crying wolf on speed over and over and on many, many fronts.  "We need [fill in the blankk] now to stop a crisis from turning into a disaster."  Only much later do we see the results and wonder why the cry for urgency.  Slowing down these bankruptcies, if so important and with such huge consequences, seems very, very prudent.

Hedge Funds Back in the Black

The news this week is that the well run hedge funds are starting to make serious money, recouping losses and recording record gains.  Why?  Simple.  Hedge funds are lightly regulated and therefore free of political pressure to stay on the long side of the market -- they can use strategies that profit from both the ups and downs of the market.  They are free to use more investment strategies than mutual funds and other investment funds that are, through a variety of regulations either direct or indirect, told to make money long or stay out (hold fixed income,secure debt) of the market.  Of course they will show profits before the more heavily regulated funds can.   

363 Sales in Bankrutpcy

The Chrysler bankruptcy and now the GM bankruptcy feature 363 sales.  I have written briefly on this before,  This deserves the careful attention of more than a few blog entries.  Chapter 11 features, features, a well tested "plan approval" procedure.  First, managers, and it that fails, then groups of investors, propose a "plan" for the reorganization of the bankrupt company.  The plan compromises the claims of the lower tranches of debt (usually turning debt into equity and giving shareholders a token residual equity position for their shares) so that the company becomes solvent (the operating profit now can pay the remaining debt obligations on time).  The bankruptcy judge must be convinced the plan is viable (or he will send the company into Chapter 7, a liquidation) and divides the investors into classes. Those classes whose claims are "impaired" by the plain -- they are not receiving full payment on their obligations -- vote by class on the plan (the vote seeks two majorities, one by number of creditors voting and one by the amount of the claims being voted).  Some secured creditors, with high priority, may not vote because they are not impaired.  If enough classes vote in favor, the judge has the option of "cramming down" the plan on those classes that do not.  If the plan "passes," the company emerges from Chapter 11.  A 363 sale is an emergency sale of the company, proposed by management and approved by the judge, before any plan has been proposed, let alone passed.  A 363 sale can be an end run around the entire Chapter 11 procedure.  Once the company is sold, the Chapter 11 turns into an Chapter 7 -- the proceeds of the deal are the only thing left to do for the court.  Over twenty years ago, the Circuit Courts recognized that a 363 sale was a method of avoiding Chapter 11 procedures and thus they restricted the process with a threshold -- the assets must be time sensitive (like vegetables in a railroad car).  Here we see the government doing the same thing -- they are avoiding the Chapter 11 procedure, to avoid the claims of those pesky creditors that are not going along with the government's version of the a workout, by selling the companies first and quickly in 363 sales. The argument is that the companies must move quickly or lose all their customer. Yet last month was both companies best sales month in several months -- after the bankruptcies were either announced or known.  These 363 sales are, in essence, total cram downs without a vote.  The danger?  Managers sell the company cheap to reward themselves and their go along creditor buddies (read, the UAW and the government as debt holder here).  Bankruptcy judges, eager to avoid a year of hearings and decisions, and eager to "save" jobs of employees by keeping the company doors open, have a strong incentive to go alone.  In these cases, first Fiat and now a Chinese company (and the government itself in buying the "new GM") are getting too sweet a deal in these 363 sales.  In the government's case, the sweet deal is an avoidance of the difficult question of whether the "new GM" will survive - whether it should be thrown into a Chapter 7.  Taxpayers and unsecured, non-union creditors are taking the hit.  The bankruptcies should go through the full plan process.  Old time test procedures work -- new emergency reasons to avoid them are -- well, trouble in river city.  

GM Numbers: New Plan Does Not Make Economic Sense

GM has $90 B in assets and $170 B in debts.  The government plans to put in another $30 B, for loans.  the new company will be a shell of its former self, employing 40 to 50 thousand or so workers once all the plants are closed.  GM has 225,000 workers worldwide and, until today, 90,000 here.  Why spent so much on a shell of a company with a very questionable future?  Given even optimistic estimates for selling new cars, GM is likely not to show a profit for many, many years.  It is likely to go into bankruptcy again, soon.  This is a major government investment for 40 to 50 thousand jobs (less than half the seats in Ohio State Stadium). 

Morevoer, under the new plan, much of the overhanding debt is cancelled in exchange for equity in the new company.  Yet the amount of equity doled out to the various debt holders is very suspicious.  The standard is equality -- all unsecured debtholders with cancelled debt get an equal amounts of equity relative to the debt cancelled.  This equality standard has been, as many commentators have noted, trashed.  Workers unsecured claims get four times the value of the unsecured claims of all other creditors.  Taxpayers as current debtors get less, ceding much of the value ot their equity claims to the UAW.   In essence, taxpayer and bondholder money has been shuffled into the UAW.  

The new structure establishes severe conflicts of interest.  To whom does the CEO report?  The government?  Canada?  The UAW?  The government has a conflict -- it is both regulator and owner. As a regulator it reports to environmental constituencies, labor unions, and others.  Taxpayers lose in this. The UAW, on the other hand, supports American -only jobs (members pay dues).  The union does not care for GM cars imported from abroad (where some of its best small cars are manufactured);  it will willingly ssacrifice GM profit for job guarantees. In sum, this is a political payoff from a new Democratic government to one of its longest and most faithful supporters, the UAW.  The government is saving jobs that should not be saved to save a union.  The government will be protectionist (selling Opel on the condition that Opel not import into the United States, for example) and will subsidize the jobs to subsidize the union. 

A Chapter 11 reorganization, many months ago, without government interference and money, was the best route, but government interference cost GM the opportunity for a normal restructuring.  The past iinvolvement of the government, sacrificing the opportunity for a Chapter 11, now means the best decision going forward is a Chapter 7, liquidation.  Sell the $90 B in assets and divide the cash among the debtors.  

The history of government bailouts of auto companies worldwide is abysmal.  Why can we do better?  This goverment controlled Chapter 11 is either a very, very reckless path born of hubris or a calculated political payoff with long-term economic costs.  You pick.         

Setting Up a Scapegoat for GM

The NYTs today is gushing over a 31 year old who interrupted law school to "run" General Motors in the bankruptcy announced today. He has no formal economic training and no business training. His dad is a "green" engineer.  He is a scapegoat.  Obama's high ranking economic advisors haveset this kid up to take the fall of an inevitable failure of a government effort to run an automotive company.  They are not going to be front and center on this. They know that it is highly likely that GM will emerge from bankruptcy a mess.  It's future will pprobably be a second bankruptcy (similar to many of the struggling airline companies). 

Yesterday I took my son to a barber and we tested Buffett's advice: "Never ask a barber whether you need a haircut."  We asked the barber: "What to you tell people who ask you whether they need a haircut?"  He responded: "I always say yes, of course."  Obama has the same problem with his "experts."  When you ask and "expert" for advice th modern expert, educated at Harvard or Yale always will tell you they can fix the problem; they never say "I don't know" or  " We should stay out."  Obama and his experts think they can run a car company, reluctantly, of course, but they have "no choice, but to fix the problem."  Where is the humility? Not taught in school by experts; not held by experts.