Thursday, September 18, 2008

More on Debt-Equity, Transparency, Line-Drawing, and the Forest and the Trees

Posted by Jeff Lipshaw

I posted the gist of this as a comment over at Conglomerate, but I want to add a point about what seems to me to be a common over-reaction.  One theme seems to be that perhaps the Fed is playing fast and loose with interpretations of its own authority.  Perhaps.  It doesn't seem that way to me, but there's no precedent here.  It seems to me, however, an over-reaction to confuse close reading of text with attempts to finagle, fool, deceive.  There's a line to be drawn, and that's the point here.

To recap:  did the Fed have the authority to take "equity warrants" as a way of getting additional security for or return on its loan?  [I still don't know what the trigger is on the warrants, and don't know if they expire merely because the debt is repaid, as some commenters have suggested.  In my description of credit facilities in the prior post, the warrants would not expire merely because the debt was repaid.  If they do expire upon repayment, they are still not "collateral," but a device that serves as an economically equivalent substitute, because to post collateral you have to have rights in it (e.g. own it!), and AIG doesn't have rights in (i.e. own!) its own stock.]  Debt versus equity is a line that has existed in the law forever, as are well-accepted forms of financing, like sale-leasebacks, in which the economic substance is very, very similar to ownership plus loan. Reporting and transparency is another issue, but I don't think that's the critical one here. Another example is the law under Articles 9 and 2A of the UCC that attempt to distinguish a true lease from the mere granting of a security interest.

The inherent issue in any system that classifies by way of language is the (I apologize, but here it goes) linguistic "family resemblance" problem (see Wittgenstein). That is, debt and equity resemble each other in some ways, and one can, without any malevolence, work the edges. That's not to excuse attempts to make things opaque or stupidity, but it's what lawyers have always done. It's why good counselors tell their clients who are working the trees to make sure they step back and look at the forest.

One of the things I come back in many of my classes is the linguistic conundrum of definitions. Again, use the Howey test in securities law - is it really the definition we are applying ("a person invests his money....") or are we using a paradigm of stock versus not-stock and analogizing things in the middle? See John Searle's introduction to Speech Acts on this point - to criticize a definition or a distinction means that you have some a priori idea of what the difference is by which you can criticize the definition!

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Comments

Note, under Article 9 a debtor doesn't have to own or have rights in collateral. You merely have to have the ability to transfer rights in the collateral. So long as AIG has the ability to transfer rights in its shares via the issuance of warrants, there is no problem under Article 9 with treating those rights as collateral on a loan.

Posted by: Nate Oman | Sep 18, 2008 6:49:14 PM

Nate, you are right. If these are warrants, they are for unissued stock, and therefore AIG not only has the right to transfer, it may actual "own" its own unissued shares.

I still think the idea of enforcing the security interest on a warrant is kind of a square peg in a round hole. Why would you subject yourself (as lender) to the various restrictions of Article 9 on enforcement? You just want to be able to exercise the warrant! I'd be willing to be the documents don't call the warrants "collateral."

Posted by: Jeff Lipshaw | Sep 19, 2008 2:06:17 AM

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