April 24, 2010
Goldman and the Issue of Objective Materiality Versus Subjective Reliance
I think I've changed my mind about materiality being the key issue in the Goldman case. While strong arguments have been made equating the reasonable investor with the sophisticated investor in the context of materiality determinations, that issue is far from settled. I believe the better view is that the use of "reasonable investor" in the materiality definition means we are to use an objective standard (i.e., ignoring idiosyncratic values) while taking the perspective of a subset of persons consisting of all investors, not just those that are sophisticated.
If that is correct, then the much-debated facts about ACA's and IKB's sophistication and trading plans really go to the question of reliance rather than materiality. As the court in Abell v. Potomac Ins. Co., 858 F.2d 1104, 1117 (5th Cir. 1988), put it:The element of reliance is the subjective counterpart to the objective element of materiality. Whereas materiality requires the plaintiff to demonstrate how a "reasonable" investor would have viewed the defendants' statements and omissions, reliance requires a plaintiff to prove that it actually based its decisions upon the defendants' misstatements or omissions.
Of course, the problem for Goldman then becomes that the SEC, as opposed to a private plaintiff, does not need to prove reliance. Settlement, anyone?
April 23, 2010
Reynolds on the Future of Law Firms
Glenn Harlan Reynolds has posted Small is the New Biglaw: Some Thoughts on Technology, Economics, and the Practice of Law on SSRN with the following abstract:This paper looks at technological and economic changes affecting lawyers, and their effect on the competitiveness of large law firms. It explores methods of unbundling big law firm features, and providing similar services on a more ad hoc basis. In addition, it considers whether current legal education is properly preparing students for a world in which large law firms will be much less dominant. Based on a talk given at Hofstra Law School in March of 2009.
Energy Plays: The Next Great Short?
As we’ve seen, in light of the SEC complaint against Goldman Sachs, picking against the market when it is about to go bad can be just as lucrative (more?) than getting into the market before it booms. Any time a market gets hot, there will be those who think it’s too hot and will bet against it. In fact, it’s essentially required; there need to be two sides to any transaction.
Now comes news that energy deals (mergers and acquisitions) are trading “above market,” much like the mid-2000s real estate market, with acquirers often bidding over the asking price to reduce due diligence, keep other bidders out, and shorten the time to closing the deal, which avoids the chance that volatile oil and gas prices will slip during the auction process.
Energy sources like oil and gas are especially volatile in the market almost all the time, in part because the discovery, extraction, and delivery of the commodity are all complex and interrelated processes. And none of those parts of the process are especially transparent. As such, whether we are discussing the commodity itself or the resources that provide (or hope to provide) the commodity, we are talking about a market that will fluctuate, often wildly. (Side note: this is yet another compelling argument for non-fossil fuel energy sources.)
It may be that, in the long run, these energy investments are strong enough to make the purchase prices proper, but in the relative near term, you can also be sure that some people will make a ton of money betting against those who made these investments. You can be sure some people (including some stockholders) will call foul if the market tanks, and the short sellers make a subsequent killing. Then, like 2008, we will probably have another round of complaints about energy speculators ruining or inflating the market.
I’ve said it before, and I will say it again: There is a difference between speculation and market manipulation. Speculators are trying to make money based on their read of market trends; market manipulators are trying to guarantee they make money by ensuring the market does what benefits them. If and when energy prices soar, then crash again, we need to look for the latter, and not the former. Otherwise, we are investigating the market itself.
April 22, 2010
I Heart William Black
And I don't care who knows it. After I watched him at this past AALS meeting dismiss every apology for the crisis and punctuate it with: "This is fraud!"--well, he had me at "fraud". Wanna feel some of the love? Go here.
Valuation and Materiality
Last week, Larry Ribstein (who’s been all over this story) put up an excellent post explaining why the issue of materiality is at the center of the Goldman case. I agree with Larry that the critical materiality question is whether the influence of Paulson on the structure of ABACUS would have been material to sophisticated investors like ACA/IKB.
On the one hand, Leslie Rahl, president of Capital Markets Risk Advisors, a derivatives and structured finance consultancy in New York, is quoted in the Wall Street Journal as saying: "If ACA performed an independent analysis and concluded that the [Abacus] portfolio met ACA's criteria, I'm not sure what the issue is." (HT: Ribstein.)
On the other hand, John Coffee is quoted by Charlie Gasparino over at The Daily Beast as follows:
“Even if ACA knew Paulson was short, Goldman
couldn’t have sold the investment to IKB without the notion that a neutral
third party evaluated the investment,” Coffee told The Daily Beast, adding that
“enough of the portfolio was influenced by Paulson & Co.,” that its
omission from the sales documents and pitches by Goldman “could be
material”—meaning a court could rule on the side of Goldman.
I tend to agree with Coffee here. As I understand it, even the best valuation experts can come to widely diverging conclusions about the same set of assets—it is arguably as much art as science. So it is hard for me to believe that even sophisticated investors with great confidence in their valuation models would consider immaterial the fact that the assets in which they were about to go long were cherry-picked by a bear just looking for someone to let him go short (assuming that is what happened). This is particularly true because for a fact to be material does not mean it would necessarily cause me to act differently. I may still ultimately buy the assets. All that is required is for there to be a substantial likelihood that a reasonable investor would consider the fact important in deciding whether to buy or sell.
April 21, 2010
Hovenkamp on Antitrust Law
Herbert J. Hovenkamp has posted Harvard, Chicago and Transaction Cost Economics in Antitrust Analysis on SSRN with the following abstract:
Since Oliver Williamson published Markets and Hierarchies in 1975 transaction cost economics (TCE) has claimed an important place in antitrust, avoiding the extreme positions of the two once reigning schools of antitrust policy. At one extreme was the “structuralist” school, which saw market structure as the principal determinant of poor economic performance. At the other extreme was the Chicago School, which also saw the economic landscape in terms of competition and monopoly, but found monopoly only infrequently and denied that a monopolist could “leverage” its power into related markets. Since the 1970s both the structuralist and Chicago positions have moved toward the center, partly as a result of TCE. For example, already in 1978 Areeda and Turner produced the first volumes of the Antitrust Law treatise, which completely repudiated the leverage theory and abandoned the structuralist and leveraging positions on vertical integration.
A distinctive feature of TCE is that transactions occur with a limited range of partners depending on limits of knowledge and previous technological commitment. The question of who trades is at least as important as the terms of trading. TCE analysis of contractual restraints recognizes that an important threat to competition is double marginalization, which can occur when market power is held by separate firms with complementary outputs. Antitrust is relevant in two ways. First, private arrangements can minimize double marginalization, justifying practices such as tying in markets characterized by single firm dominance or product differentiation. Both tying and bundled discounts operate as a kind of “reverse leveraging,” benefiting consumers. Second, transaction costs sometimes explain why private contracting is inadequate for addressing double marginalization problems and thus justify antitrust intervention.
TCE has also reinvigorated the link between conduct and exclusion, as illustrated by the Williamson/Areeda-Turner dispute over predatory pricing, and the rise of the antitrust literature on raising rivals costs. The RRC literature has attempted to restore a meaningful conception of anticompetitive exclusion without a return to the excesses of the structuralist school.
Nevertheless, one comparative advantage of both structuralism and the Chicago School was their simplicity. For the structuralists concentration explained everything and inferences were drawn in favor of condemnation. Within Chicago School analysis the impossibility of leveraging and the mobility of resources explained everything and inferences were drawn in favor of exculpation. TCE analysis is more specific to the situation, however, demanding close scrutiny when significant market power is either present or realistically threatened.
Tough Mortgages, even in a Boomtown
The housing boom and bust did not hit my state of North Dakota, in large part because the whole sub-prime loan concept was driven by the expectation that housing prices would continue to increase year on year. Thus, equity would be built relatively quickly though appreciation of the home’s value (assuming, of course, the homes continued to appreciate). That was never an issue in North Dakota. Housing prices tend to stay stable with modest increases year to year, so there were no lenders offering sub-prime options. In fact, North Dakota trails only Vermont in the number of foreclosures.
The New York Times reports that the housing crisis is having an impact in western North Dakota, and not really in the way you might expect. In Williston, ND, where the oil business is continuing its strong growth, the city may have grown by as many as 3,000 residents in the last couple years (from 12,000 to possibly 15,000). This has made housing a premium and leaving many sleeping in campers, basements, and even cars.
Williston is the one place that has had a relative real estate boom. Prices there increased by about 24% in both 2006 and 2007. In contrast, Fargo, the state’s largest city, saw home values increase 2.5% and 3.8%, for the same respective years, and statewide home prices increased 3.7% (2006) and 6.8% (2007).
Despite full hotels and apartments, there are a few houses on the market in Williston. However, as the area’s population explodes, many of the newcomers are leaving behind lost jobs, and, often, homes in foreclosure, meaning that home loans are out of the question.
This all provides a great example of basic economics. The market is, in one sense, working perfectly here. Housing prices are increasing in places where there is low supply and high demand, and falling in places where there is a surplus of homes and low demand. But great numbers of people are still struggling
When we talk about efficient markets, it is often easy to overlook the extraneous costs, including human costs, related to the process. I believe very much in the value of the market, but I also think we need to do a better job of regulating some markets to help ensure good information filters to all in the marketplace. For example, when banks were providing 100% loans for homes that had doubled in value in the three prior years, they were sending buyers a signal: this housing market will continue. And buyers listened, even though it was wrong. Buyers need to take responsibility for what they purchased, but the lenders need to own their role in this, too. And if they won’t do it on their own, we all have an interest in making sure it happens anyway.
April 20, 2010
Time to address mortgages?
Reuters reported in late March that, according to Treasury Department statistics on 34 million mortgages, deliquencies are up 14%. CBS news reported yesterday that 2010 has already produced 900 thousand foreclosure notices. Moreover, the White House's modification program has produced less than stellar results, with nearly 3,000 of the subject loans subsequently failing. See Defaults Rise in Loan Modification Program, New York Times, April 14, 2010.
Which raises the question, has Congress lost the forest for the trees? While politicians banter about the potential utility of another regulatory agency, the mortgages that are blamed for the lingering economic downturn continue to tumble. Why not spend some of the astronomical bailout amounts allocated to the financiers on the homeowners themselves? Plans already have been uttered which would convert a significant number of adjustable rate mortgages into fixed, conventional loans. Working from the Treasury Department stats (which encompass $6 trillion in principal balances), $8.4 billion would seemingly be needed to bring the 14% of non-performers up to speed. Even $6 billion would go a long way.
What's the import of $6 billion, you might ask? That's the TARP money committed to each of 16 entities, each, presumably, too big to fail. See http://bailout.propublica.org/main/list/index.
April 19, 2010
A "New" Revlon Duty for Plaintiffs' Counsel: A Duty of Candor to the Court
In a 46-page opinion, Vice Chancellor Laster substituted new lead counsel in a representative action against Revlon related to the merger process that made MacAndrews & Forbes Revlon's controlling stockholder. The case criticizes the process used by many of the "regulars" in Delaware stockholder actions and provides an overview of what the Vice Chancellor views as typical of certain representative actions following a merger.
My favorite part of the opinion is right on the first page:
Having reviewed the record in the case to date, I conclude that the original plaintiffs' counsel failed to litigate the case adequately. Indeed, their advocacy has been non-existent. The memorandum of understanding to which they agreed raises serious questions about whether they focused foremost on the interests of the class, or instead settled on terms that would be easy gives for the defendants while still arguably sufficient to support a release and a fee. Factual representations in the memorandum of understanding appear inaccurate. When the defendants later wanted to amend a non-waivable majority-of-the-minority condition to effect a de facto waiver, original plaintiffs' counsel readily signed off. Then, when forced to defend their conduct and leadership role, original plaintiffs' counsel approached the concept of candor to the tribunal as if attempting to sell me a used car.
It is rarely easy to admit when we make a mistake (or a series of mistakes), but it is usually the right thing to do even though it can be costly. Just ask golfer Brian Davis, who this weekend called the penalty on himself that ensured a second-place finish. Even if it means losing in the short term, when we come clean and own our mistakes, we at least keep our own self-respect and have the chance to earn the respect of others. And that's even more important as a lawyer, than it is as a golfer. At least, it should be.
Return of the Jedi
Two SEC actions since April 7th answer the long-asked question of whether the Commission will be succumbing to "the Perfect Storm" version of events between 2008 and 2010. In a pair of cases centering on mortgage-related products, the SEC made clear that cries of complexity and unforeseeable risk shall not further cloud the assignment of blame for questionable sales practices in recent years.
In the Morgan Keegan case, the firm is alleged to have "masked from investors the true impact of the subprime mortgage meltdown" on five affiliated funds by preventing market quotes from lowering the daily net asset values. Among other things, the case counters remarks by regulators made early in the Crisis seemingly acquiescing to the industry's proffered difficulty in pricing exotic investments.
Separately, in the well noted charging of Goldman Sachs last week, the Commission alleged that the firm and one of its employees made misstatements in offering a synthetic CDO whose reference portfolio was influenced by a hedge fund "with economic interests directly adverse to investors." The ensuing downturn is said to have cost institutional investors over $1 billion while generating a profit of approximately the same for the hedge fund. See the civil complaint at http://www.sec.gov/litigation/complaints/2010/comp21489.pdf.
The Goldman Sachs case at once demonstrates the conflicting interplay of credit default swaps and CDOs and the dangers of blandly accepting the notion that downturns (and market victors) are inevitable. It also serves as an eery reminder of the "tainted research" case brought by New York years ago where it relies on internal e-mails colorfully disclosing a lack of faith in marketed products (e.g., "the cdo biz is dead, we don't have a lot of time left"; February 2007).
Collectively, the cases will, of course, test new legal theory and may encounter difficulties in the form of 1) procuring expert testimony, which is more accustomed to supporting Wall Street's valuations, and 2) re-evaluating the role of hedges, which, by definition evidence contrary actions by brokerage firms. But both actions make good on the SEC's longstanding promise to undertake "sweeping enforcement measures" against frauds contributing to the subprime crisis. See http://www.sec.gov/news/press/sec-actions.htm (January 2009). We can only hope that Congress evidences such loyalty to its Crisis-related reforms, which have languished in committees for the past 18 months; in that regard, it bears noting that federal remedies speaking to consolidating regulators, limiting net capital, regulating credit derivatives and adding consumer protection from predatory loans have still largely been neutralized by lobbyists/political forces.
April 18, 2010
Hayden and Bodie on Corporate Governance
Grant M. Hayden and Matthew T. Bodie have posted Shareholder Democracy and the Curious Turn Toward Board Primacy on SSRN with the following abstract:Corporate law is consumed with a debate over shareholder democracy. The conventional wisdom counsels that shareholders should have more voice in corporate governance, in order to reduce agency costs and provide democratic legitimacy. A second set of theorists, described as “board primacists,” advocates against greater shareholder democracy and in favor of increased board discretion. These theorists argue that shareholders need to delegate their authority in order to provide the board with the proper authority to manage the enterprise and avoid short-term decision making.
In the last few years, the classical economic underpinnings of corporate law have been destabilized by a growing recognition that shareholders are not a homogeneous group of wealth maximizers. This recognition has, among other things, undercut the arguments
made in support of the typical corporate structure where shareholders alone possess the right to vote in corporate elections. Board primacy seems well-positioned to retheorize corporate law to adapt to this new reality. In their analyses of the issue, however, board primacy theorists have conflated two very different aspects of group decision processes: the responsiveness of the governance system and the composition of the electorate. This confusion ends up putting many board primacy theorists in the curious position of moving away from the public choice emphasis on preference aggregation toward a more civic republican model of less responsive, more deliberative
By restricting the franchise, board primacists have detached their governance structures from the underlying desires of their constituents without substituting anything in their place. We argue, however, that the breakdown of this particular distinction between shareholders and other constituents could mean that we should investigate treating other constituents more like shareholders, rather than the other way around.
Wagner on International Trade Law
Markus Wagner has posted Taking Interdependence Seriously: The Need for a Reassessment of the Precautionary Principle in International Trade Law on SSRN with the following abstract:To date, WTO panels and the AB have relied heavily on positive definitive evidence when a WTO member attempted justifying a measure affecting international trade. Only in rare circumstances has the dispute settlement process allowed for the precautionary principle to become operational in trade disputes. This is especially troublesome in a time when issues such as global climate change, increases in endocrine disrupting compounds and the rapid decrease of fish stock threaten the very livelihood of millions of people. Combined with a persistent and growing disparity between scientific information and the international legal system to respond to it, problems of international economic and environmental governance will continue to persist. It is before this background that it is necessary to reassess the role of the precautionary principle in international trade law. Environmental groups have tried to lay claims regarding the precautionary principle that may be going too far, a majority of WTO members – for a variety of reasons, including the forthcoming of the organization and the largely trade-driven agenda of the WTO – to diminish its importance.
The project aims at operationalizing the precautionary principle in a meaningful and effective manner in international trade law. Not all environmental or health disputes will necessarily have to be analyzed through this lens. However, disputes that involve practices that threaten the livelihood or indeed survival of a large number of individuals should not be held to standards that may be sensible in other instances. The project therefore will propose a layered approach to evidentiary requirements in international trade law. This approach is based on a careful reading of existing case law within international trade law and would reassess existing rulings further in an effort to adequately address issues the true impact of which could not be fully considered at the creation of the WTO in 1995, much less so at the creation of the GATT in 1947. Moreover, it also shines a light on the problems involved in transposing the language and syntax of natural science into a legal system that has so far been static, formalistic and reluctant to concern itself with matters that are perceived to be outside of its core jurisdiction.
Jarvis on Law School Histories
Robert M. Jarvis has posted Law School Histories: A Panel Discussion on SSRN with the following abstract:Many law professors are interested in publishing a history of their law school, but few know how to do so. This paper identifies and discusses the various steps, including: 1) securing the necessary institutional support; 2) locating the underlying source material; 3) deciding on the manuscript's direction and tone; 4) working with co-authors; 5) finding a publisher; and 6) developing and executing a marketing plan.