October 10, 2008
Financial Crisis, Governance, and Stock Performance
Posted by Jeff Lipshaw
I was working away this morning and trying not to look at the Dow when a thought struck me. Back when I was fighting the governance wars from the inside, arguing from the board's standpoint why having poison pills and classified boards made sense (at least in the right hands), there were several studies done linking good governance to share performance, the most famous being the Gompers/Metrick/Ishii study. I was not (and am not) statistician enough to know if the study was good; all I can say is that my intuition was and is that things like technology, cost productivity, barriers to entry, business savvy, and things like that would have a lot more to do with share price than whether there was a poison pill or the shareholders had the right to call a meeting. Moreover, I'm not sure how you would factor out those differences among companies other than to say it all evens out in a big enough sample. As I said, I'm not statistician enough to do the work myself.
What occurred to me was the question whether, if I had a portfolio of the "best governed" companies on October 9, 2007, at the very height of the stock market, and kept that portfolio unchanged for one year, how would it do? Given that I performed this little empirical study from the laptop in my den, don't have the individual governance scores on any survey (CGC from ISS, or whatever GovernanceMetrics puts out), and couldn't do the regressions and correlations even if I did (but I did leave a phone message for Bill Henderson), I simply went to the website of IR Global Rankings, and took the thirty companies it ranked best in corporate governance practices (listed below the fold), found their historical closing stock prices on Yahoo! Finance for each of October 9, 2007 and October 9, 2008, assumed a portfolio of one share of each, and looked at how the portfolio performed. (Other methodology disclosures also below the fold).
Here are the results:
Decline in "good governance" portfolio: 50%
Decline in S&P500 Index Fund 42%
Decline in NYSE Composite Index Fund 43%
Decline in Dow Jones Industrial Average 39%
Within the good governance portfolio, every stock declined. The best performers were Bayer AG (17% decline), Procter & Gamble (12% decline), and Global Payments (11% decline). The worst performers were ICA (93% decline), Wachovia (93% decline), Banco BPI (71% decline), and Life Time Fitness (70% decline). (I did not check to see if these numbers were adjusted for splits, but I assume so.)
But you'd still be better in index funds than picking stocks based on the IR Global Rankings of good governance practices.
The IR Global top ranked companies were Nexen, Royal Philips, Telekom Austria, Bayer, Infosys, Procter & Gamble, Deutsche Post, Satyam, Total, GE, Totvs, Norsk Hydro, ICICI Bank, Banco BPI, Wachovia, Bursa Malaysia, Global Payments, Kotak Mahindra Bank, JDS Uniphase, Perdigao, Deutsche Telekom, Life Time Fitness, Grasim, BASF, Indra, Pengrowth, Masisa, IC RUSS-INVEST, Hysan, ICA. I could not find quotes over the full time period for Masisa and IC RUSS-INVEST, so they are not included. Kotak and Grasim had Berkshire Hathaway-like stock prices, so I divided them by 10 and 100, respectively, so as not to weight the portfolio unduly. I used a NYSE common stock or ADR price if it was available; otherwise, I used the price on the main exchange on which the shares of the company were traded.
The portfolio was fairly well diversified geographically: North America - 8, Europe - 10, Asia-Pacific - 7, Latin America - 3. Of the 28 companies, 7 were financials. The remainder were split among industrials, telecom, technology, oil & gas, and consumer goods and services.
My data is here.
September 30, 2008
Posted by Jeff Lipshaw
If you want some sane commentary these days, try reading David Brooks in the New York Times. His column yesterday on the defeat of the bail-out bill was entitled "Revolt of the Nihilists." Here's a taste:
We’re living in an age when a vast excess of capital sloshes around the world fueling cycles of bubble and bust. When the capital floods into a sector or economy, it washes away sober business practices, and habits of discipline and self-denial. Then the money managers panic and it sloshes out, punishing the just and unjust alike.
What we need in this situation is authority. Not heavy-handed government regulation, but the steady and powerful hand of some public institutions that can guard against the corrupting influences of sloppy money and then prevent destructive contagions when the credit dries up.
Piercing The Corporate Veil In Ohio
The Ohio Supreme Court issued a decision today that modifies the court's position on piercing the corporate veil. The decision is summarized on the court's web page:
In a decision announced today, the Supreme Court of Ohio held that when a plaintiff pursuing a civil lawsuit against a corporation seeks to “pierce the corporate veil” (bypass the corporate structure and recover damages directly from a shareholder), the plaintiff must show that the shareholder used its control of the corporation “in such a manner as to commit fraud, an illegal act, or a similarly unlawful act.”
The 6-1 decision, written by Chief Justice Thomas J. Moyer, modified one part of a three-prong test for piercing the corporate veil this Court established in a 1993 decision, Belvedere Condominium Unit Owners’ Assn. v. R.E. Roark Cos. Inc. [See below for an explanation of the three-prong Belvedere test.] The effect of today’s ruling was to deny an attempt by Kimberly Dombroski, a policyholder whose claim for coverage was denied by Community Insurance Company (CIC), a wholly owned subsidiary of WellPoint Inc., to pursue recovery directly from WellPoint for her claimed physical and emotional injuries arising from alleged bad faith denial of coverage by CIC.
September 27, 2008
The AIG Deal
Posted by Jeff Lipshaw
This is what it feels like when you are on the inside of a deal. Can it really be that the AIG bail-out is old news, since trumped by the bigger bail-out bill, the WaMu seizure and sale, the McCain debate cancellation, the screaming session at the White House, the actual debate, and rumblings about Wachovia?
As Steve Davidoff pointed out eons ago, there was a problem with the original structure of the deal between the Fed and AIG in that it appeared to involve giving warrants to stock not yet authorized by a shareholder vote. AIG then pulled back with a press release and 8-K suggesting that it and the Fed had gone back to the drawing board. Also kudos to Steve. He predicted the final form: "I am curious to see how the parties get around this — perhaps by issuing out preferred with equivalent voting and dividend rights?"
The deal as struck now involves the Fed getting 100,000 shares of non-redeemable and perpetual convertible preferred stock. Until the shareholders vote to authorize enough shares of AIG to permit conversion of the preferred stock into 79.9% of the common equity, the Fed holds preferred equity with a liquidation value of $500,000 (that's right, five hundred thousand dollars), but with rights to vote and receive dividends that are as if the Fed owned 79.9% of the common equity. I haven't gone back to look at the AIG certificate of incorporation, but I'm assuming it had "blank check preferred" powers, meaning that the shareholders had granted to the board the right to issue preferred shares on whatever terms the board deemed appropriate without an amendment of the certificate of incorporation.
So.... I take back what I said about the Fed not actually owning AIG. It does. And it will, because there is no provision for the redemption of the preferred shares if the loan is paid back. Moreover, the only risk to the Fed is that AIG goes into bankruptcy before the shareholder vote, because at that point it only has a $500,000 liquidation preference. On the other hand, it still has security interests in all the valuable AIG subsidiaries in the event of a default on the primary loan. What I haven't found yet is what consequence, if any, would follow from the shareholders not approving the amendment to the certificate authorizing the additional stock.
By the way, for all you populists out there, or others interested in class warfare demagoguery, I was curious just who the bailed-out fatcats were. In short, who are the shareholders we are rescuing with our money? There's a lovely little website out there called www.j3sg.com that gives the institutional shareholder make-up of public companies, as well as the companies that institutions own. It turns out that the fatcats being rescued (at least as of June 30) are anybody who has an interest in these and other elitist institutions: Fidelity, Vanguard, TIAA-CREF, New York State Common Retirement Fund, CALPERS, the New York State Teachers Retirement System, the Teachers Retirement System of Texas, the Public Employees Retirement System of Ohio. I could go on and on. None of them were bitching when AIG was climbing up the mountain!
September 26, 2008
Credit Addicts and Their Enablers
Posted by Jeff Lipshaw
There's an old joke (I guess it's a joke) about a person searching for a lost wallet at night under a street light. "But you lost it over there," says a bystander, pointing down the street. "Yes, but there's no light there," responds the searcher.
I'm not sure I can improve on Christine Hurt's analysis of the situation: this crisis is not about evil, or class warfare, or fraud. It's about bubbles. Bubbles are about systemic misapprehension of risk. Bubbles are about the perception that something in the market always goes up, or at least, everybody else thinks it's going up, and if we are going to compete with them, we better do what they're doing. When the bubble burst, and it's really hard to understand how it all happened, and worse, when we still don't understand the impact of the bursting, it is certainly a lot easier to resort to tried and true bromides and political stereotypes (the bright spot under the street lamp) than to accept the more likely truth: we are all either addicts or enablers and co-dependents to the addicts.
Imagine a family. Dad, Mom, and the kids. Dad and Mom own a house. They believe the value of the house is the one true immutable in the world - it will always go up. Dad and Mom go out and borrow against the equity in their house to supplement the family's life style. And what a binge it is! Vacations to Hawaii. Private schools. Each kid gets a car. But the family now has a lot more fixed debt, and it has to be paid back sometime. The kids don't think about it, and Mom and Dad aren't worried; they know the value of the house will support it, and they seem to be alright making the payments.
But now there's a small glitch. Dad loses his job. Or the interest rate cranks up a notch. Now Dad and Mom are having a hard time making the payments. The drastic way out would be to sell the house, tap the equity and pay off the lifestyle loan, but it turns out the value of the house has gone down. Uh oh. Somehow the piper has to be paid. Who's going to pay it? Dad, Mom and the kids. Dad and Mom say to the kids: sorry but we have to move to a small apartment, sell the cars, take you out of private school, and put you in public school, because we just aren't worth what we used to be. The kids say: "how can that happen? Life was good. Mom and Dad, you were greedy scum (if not fraudulent creeps)." Mom says to Dad: "I told you something wasn't right!" Dad says to Mom: "you never should have bought those clothes." Mom said to Dad: "what made you think we could afford a golf club membership?" And the kids blame both of them, even though their lives in the short-term were probably better as a result of the binge.
Now take my story and write it large. We can see the analog of the kids' position in my following paraphrase of a bitter post over at the Wall Street Journal's website on the bail-out term sheet. An angry taxpayer notes that you contributed to the binge if, in the last eight years, (1) you worked in a position that allowed you to influence or alter the way people purchase real estate; (2) you purchased a house without a down payment or an understanding of your debt obligation; (3) you purchased a home with an interest only, Alt-A, sub prime, piggyback or other type of nonstandard mortgage to shoehorn your way into a house you could never afford without the benefit of financial magic; (4) you participated in cash out refinancing to pay for your kids education, improve your house, take a vacation or anything else that will not bring you a probable return for your spending borrowed money; (5) you worked within the real estate industry or any other business being financed by unduly cheap money.
This rant (not unwarranted, by the way) gets at the addicts but I'm not sure it identifies the enablers. In my analogy, the kids got to share, albeit indirectly, of the pleasures of the binge. Put another way, the creation of wealth in the financial markets is no longer "us" and "them." I don't have at my fingertips the amount of the NYSE and NASDAQ capitalization that is owned by institutions, but it's huge. When I say institutions, I mean mutual funds (Fidelity, T. Rowe Price, Vanguard), insurance companies, union pension funds, state employee pension funds (like CalPERS), university endowments, private foundations, 401(k) plans, 403(b)(7) plans. These institutions work for us, rich people and not so rich people, by making investment choices, which in turn are a matter of assessing risk. If CalPERS took no risk with the pension funds held for all the California public employees, and bought nothing but T-bills, it would have a flock of exceedingly upset retirees. The question is how much did CalPERS and the institutions like it (a) benefit from the bubble, and (b) enable the bubble by buying up the leveraged debt securities or the equity securities of the companies investing in the leveraged debt? Empiricists, do me a favor. Please track how much of the stock of AIG, Fannie Mae, Freddie Mac, and Sallie Mae was held over the last seven years by pension funds, and in particular, union pension funds.** (Note to file: CalPERS was one of the big investors in Enron. And full disclosure: as I recall my investment advisor bought Enron for me at about $80, but, as I recall, had the good sense to sell at $22.) This isn't to blame them: it's to say maybe we have met the enemy and they are us.
My point here is that a lot of people who are professionals in the quantification and monetization of risk got it wrong. They managed to get it wrong all at the same time because there is a "herd" aspect to this: if you don't show the short term returns others are getting, capital (for who owns the capital, see above, because it's all of us) will flee to other managers. I suspect the bell curve of venality is about what it is for any other group in society - most of them were probably about as evil as Mom and Dad. (This is the subject for another time: are corporate boards any more venal than synagogue boards, or non-profit boards, or law faculties, or the Congress? Put another way, what if your battles happen not to be for money, but instead the currency is power, or influence, or fame, or position, or re-election? But I digress.)
So now we're having a big family council, trying to decide who bears the brunt of this seven-year long family binge. Like the above-quoted ranter, the kids say "we benefited from this, but we didn't cause it, why should we have to pay for the excess? Dad should have to quit the golf club, and Mom should have to get rid of her car." One of the kids wants to cap Dad's allowance. One of them has asked the FBI to look into whether there was fraud. Mom and Dad say: "look, kids, we're really sorry we messed up, but we are still the best thing you've got to get this right."
And here we are.
** UPDATE: I did a little quick investigation of my own. If you look at AIG's proxy statement, Fidelity's funds owned 5.7% of the company as of Feb. 14, 2008, making it the second largest shareholder after C.V. Starr, which is Hank Greenberg's firm. Meaning that all of us who had 401(k) or 403(b)(7) or other retirement or investment accounts with Fidelity got the benefit, not so indirectly, of AIG's market value, spurred on in part by its participation in the credit markets. Similarly, as of June 30, 2008, the California Public Employees Retirement System (one of the largest pension funds in the country, holding $54 billion in assets as of that date) held securities in the following companies valued at the time as shown: JPMorganChase, $395 million; Bank of America, $355 million, AIG, $229 million; Goldman Sachs, $228 million; Morgan Stanley, $133 million; KB Homes, $6.7 million.
You can say that "we the taxpayers" are bearing the brunt of the diminution in asset value, but to some extent (and I think to a large extent), we are merely shifting the burden from a left pocket to a right pocket. That tells us two things: (a) it's still very unclear whether a bail-out helps or hurts in the end, but the markets seem to think it helps, and (b) It's a fair request that money not stick too much to those involved (transaction costs and agency costs), but, at the end of the day, all of us want competent people at the helm of all of those companies whose returns fund our retirements.
September 20, 2008
Complexity and Disclosure Regulation
Posted by Jeff Lipshaw
The only upside for me, I suppose, of the financial turmoil this week is that I'm teaching securities regulation so there is something exciting and topical to discuss. Reading Joe Nocera in the New York Times this morning and thinking about a timely piece of scholarship just posted on SSRN, it occurs to me there is some insight into the regulation issue here, even though I have no clue how to translate it into something that works as a practical matter.
The introductory portion of securities regulation (at least in the Choi and Pritchard casebook) deals with the appropriate form of regulation in markets where information is highly asymmetric, and the feedback loops are relatively long. (The counter-example is buying and selling salt water taffy that tastes like cod liver oil - you may not have known it would be disgusting when you bought it, but it doesn't take long to figure out that something is amiss.) What we discuss at the outset is the difference between merit regulation and disclosure regulation; in short, the 1933 Act, by and large, does not regulate the substance and merit of the securities offering, but rests on the assumption that markets will work more efficiently if material information about the issuer is disclosed.
I have long been skeptical of rational and cognitive solutions for what seem to me to be irrational and non-cognitive problems. This was my criticism of a lawyerly proposal in which venture capitalists would be required to disclose risks to entrepreneurs - since they don't even see risk in the same way, how is this going to work? Nor am I convinced that the strong or even the weak efficient capital market hypothesis holds (in terms of all or some information being efficiently worked into share prices). It also why I'm skeptical of Elizabeth Warren's proposal for a Financial Product Safety Commission on consumer credit (at least as one that has only disclosure powers, and not merit powers). But there's little doubt in my mind that at some level of widely understood kinds of information, the disclosure system works pretty well. That is, if you look at the way analysts cover companies in industrial or service industries, it doesn't take too much extraordinary brainpower to replicate the financial models and do a pretty good job of anticipating who is going to succeed and who is going to fail. That's not to say that the ordinary retail investor understands, but the institutional buyers do, and that's what drives the market.
On Wednesday, a student asked, "so what will the regulatory solution be?" (Or something like that.) I hadn't thought it through at the time, but I was pretty sure we didn't want merit regulation (e.g., the current ban on short-sales), but I wasn't sure how disclosure regulation was going to help. Of course, disclosure regulation morphs into merit regulation when it becomes apparent from the disclosure that nobody should be investing in this scam!
What if you have companies issuing securities not in pretty well understood industrial or service businesses, but in businesses that require the equivalent of understanding quantum string theory or decoding the human genome? Yes, that's great, there's disclosure, but either nobody understands it, or so few people do that truly robust and efficient markets in the securities never arises. Here, as quoted by Joe Nocera, is Henry Paulson, on the mortgage-backed securities that facilitated irresponsible borrowing and lending: "The inability to determine their worth has fostered uncertainty about mortgage assets and even about the financial condition of the institutions that own them." In short, even the experts have insufficient information.
Steven Schwarcz (Duke) has posted a number of timely and insightful pieces on this, including a Utah Law Review article on the failure of disclosure regulation in the subprime crisis. Most recently, however, he suggests in Complexity as a Catalyst of Market Failure: A Law and Engineering Inquiry that there is really a double-barreled effect here: the securities themselves are too complex to understand, and the system itself under which the securities are traded, or the contracts are signed is complex and fragile in an engineering sense.
I suggested to Steve that the thesis seems intuitively correct. Most deal lawyers know that the more complex the deal, the more difficult to get it to close. Moreover, I have experience in putting together several highly complex joint ventures between large and sophisticated multi-national companies. When you cannot reduce the structure of the business to something even the executives can understand, they will figure out something they do understand, and work to that goal, whether or not it was the one originally intended. For example, assume that for tax and public reporting purposes (i.e., what you consolidate and what you don't), you structure a joint venture reciprocally so that the European parent owns two-thirds of the equity of the joint venture entities in Europe and the U.S. parent owns two-thirds of the equity of the joint venture entities in North America. But the real opportunities are in Asia. Do the participants in the venture focus on the most efficient plan to exploit the Asian market for the overall benefit of the venture? Or do they look at the 33% spread between gaining the business in one JV entity over the other, and compete with themselves rather than for the ultimate success of the business? (I'm not making this up.)
My point is that even relatively simple business structures can promote unintended consequences because people either don't understand the dynamics, ignore them, or talk themselves into believing that they are manageable. Multiply this by an entire industry of credit instruments, and you have a market full of unintended consequences in which millions of people trade, presumably relying on efficient capital markets to protect them, when in fact there can't be an efficient capital market because too few people actually understand what's going on.
I have no idea how to draw the line I've just suggested. I have shelves full of closing books with relatively complex leveraged buyout financing or conduit municipal bond financing that most people don't understand, but which do not pose much of a threat to the financial system as we know it. The deal struck between AIG and the Fed doesn't seem all that complex to me, but that hasn't stopped much of the relatively sophisticated world from thinking that the Fed now owns 80% of AIG. I don't understand the complexities of wheeling electrical power, or how the telecommunication system allows me to be posting this note, or even how the guts of my computer do what they do. And I'm no worse off. It strikes me, however, that the problem is that those "masters of the universe" punching the computer keyboard of the financial system think they understand what's going on inside, and they don't.
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!
The AIG Deal and Debt Versus Equity
Posted by Jeff Lipshaw
My claim to fame is ego not hubris (there's a subtle difference), so I'm not going to sit here in the middle of the upheaval and claim to know that it is the end of free markets as we knew them or that the invisible hand will get everything settled just fine. It was, however, kind of neat to go off-topic in two business law classes yesterday and, as Usha Rodrigues observes, be cool (a rare event in my life!). I'm also not panicking. The one thing I told both classes was to look with some skepticism at anybody on Today, Good Morning America, The Situation Room, or Larry King Live who assesses the situation without a preface to the effect that this is all very, very complex and not really capable of being reduced to a sound bite. People are, as far as I can tell, getting it wrong. On the other hand, I tried to find the actual AIG-Fed deal documents yesterday, and could not, so I too am speculating.
I've been e-mailing back and forth with David Zaring, however, about his post analyzing the Fed's authority to do this deal in this form. The loose interpretation of the events is that the Fed "bought" AIG, or "took control" of AIG. If you frame the issue that way, it does indeed seem difficult to fit this within Section 13(3) of the Federal Reserve Act:
In unusual and exigent circumstances, the Board of Governors of the Federal Reserve System . . . may authorize any Federal reserve bank . . . to discount for any individual, partnership, or corporation, notes, drafts, and bills of exchange when such notes, drafts, and bills of exchange are indorsed or otherwise secured to the satisfaction of the Federal Reserve bank. . . . All such discounts for individuals, partnerships, or corporations shall be subject to such limitations, restrictions, and regulations as the Board of Governors of the Federal Reserve System may prescribe.
I moved from litigation to transactional work in the late '80s, and made my bones doing leveraged "vulture capital" deals. Our clients would swoop in and buy up troubled companies (mostly automotive suppliers). The financing consisted of "credit facilities" (the closing books are sitting on my shelves here) we used to negotiate with GE Capital and Westinghouse Capital in those halcyon days of being able to own companies with very little of your own skin in the game (i.e. lots of leverage!). The credit facility would consist of a term loan and preferred stock to buy the company, a revolving credit line for working capital, and warrants as the "equity kicker."
We need to zero in on these warrants, because as I read the press reports (not having seen the documents), the so-called "80% ownership" the Fed got was in the form of "equity participation warrants." This isn't collateral in the sense of an asset owned by AIG and capable of being foreclosed on if there is a default on the loan. (In contrast, what IS collateral is, for example, the shares in National Union Fire Insurance, which writes a huge chunk of the D&O coverage in the U.S. and I believe is nicely profitable.) Warrants are options to buy the stock - a contract right to own in the future, not present ownership.
The reason that lenders like GE Capital took warrants is that they didn't want to own equity (other than the preferred stock). What they wanted to do was exercise the warrants when the leveraged company got sold or went public (known in the parlance as "flipping" the company). The warrants served the purpose of making the potential return on the credit facility commensurate with the risk. What I'm suggesting, if in fact I'm correct about the structure, is that warrants as part of a loan package were ephemeral ownership at best.
Since nobody is going to "flip" AIG, it's less clear to me how the warrants produce value. Let's assume that AIG survives and even thrives. At some point, the government exercises the warrants and there is a humungous public offering of now extremely valuable AIG stock, and the Fed gets a return commensurate with having loaned $85 billion. Or the government sells the warrants and never owns any of AIG even for a fleeting moment.
The rest of the "control" of AIG occurs, I'm assuming, in the positive and negative covenants of the loan agreement. I had the good fortune of teaching the classic partnership case of Martin v. Peyton yesterday, in which the issue is whether the lenders are partners of the borrowers when part of the pay-back involves a profit-sharing plan, and the lenders have significant "control" rights (such as veto power on transactions, etc.) The holding of the case is that, notwithstanding all of the conditions, this is still fundamentally debt and not equity - that is, the lenders are not co-owners of the borrower. David thinks that the Fed's directive to change out the AIG CEO is evidence of "control;" it just doesn't strike me that way. It's the classic case of good lawyers being able to write affirmative covenants as negative covenants - we aren't telling you who to hire, we're just holding a veto over who you do hire, and we veto the incumbent.
So while the transaction may be unprecedented, the Fed doesn't own, and almost certainly never will own AIG. And, by the way, there is precedent for the government swooping in and owning a private enterprise. Way back when I was in law school at Stanford, Victor Palmieri offered a course (I didn't take it) called Crisis Management, the subject of which was the failure of the Penn Central railroad, and the creation of Conrail. Now it's true Congress authorized the creation of Conrail, and it was a private corporation all of whose stock was owned by the United States. But if the government really wants to own AIG (I seriously doubt it!), there's time. As I recall, when Citicorp agreed to acquire Travelers Insurance, which included Salomon Smith Barney, there was this little impediment called Glass-Steagall that had to get amended or repealed before the deal could close.
The bottom line: in complex financing, you reach a very fine line between debt and equity. Nobody can claim to have it absolutely right. But in my world, the equity kicker just sounds like part of the credit package, not "ownership." Accordingly, it didn't seem such a stretch to think it fell within "such limitations, restrictions, and regulations as the Board of Governors of the Federal Reserve System may prescribe."
September 17, 2008
Wisdom about Wisdom
Posted by Jeff Lipshaw
I was hoping a moderate conservative would say this, and David Brooks of the New York Times did. It's what was flashing through my mind as I imagined Secretary Paulson and Chairman Bernanke yesterday explaining a credit swap first to President Bush. I then flashed forward to the same conversation with President Palin. Here's an excerpt:
In the current Weekly Standard, Steven Hayward argues that the nation’s founders wanted uncertified citizens to hold the highest offices in the land. They did not believe in a separate class of professional executives. They wanted rough and rooted people like Palin.
I would have more sympathy for this view if I hadn’t just lived through the last eight years. For if the Bush administration was anything, it was the anti-establishment attitude put into executive practice.
And the problem with this attitude is that, especially in his first term, it made Bush inept at governance. It turns out that governance, the creation and execution of policy, is hard. It requires acquired skills. Most of all, it requires prudence.
What is prudence? It is the ability to grasp the unique pattern of a specific situation. It is the ability to absorb the vast flow of information and still discern the essential current of events — the things that go together and the things that will never go together. It is the ability to engage in complex deliberations and feel which arguments have the most weight.
How is prudence acquired? Through experience.
* * *
Sarah Palin has many virtues. If you wanted someone to destroy a corrupt establishment, she’d be your woman. But the constructive act of governance is another matter. She has not been engaged in national issues, does not have a repertoire of historic patterns and, like President Bush, she seems to compensate for her lack of experience with brashness and excessive decisiveness.
August 26, 2008
Rankings, Accounting, and Gaming
Posted by Jeff Lipshaw
Fresh off the front page Wall Street Journal article this morning, friends Larry Ribstein and Nancy Rapoport nail the analogy between law deans gaming the USNWR rankings and accountants massaging the numbers to meet the quarterly estimates, so permit me a moment of "I told you so" when I see this quote:
As for the charge of “gaming” the system, Phillip Closius, former Toledo dean, who successfully used the part-time strategy to improve the school’s ranking, says:
U.S. News is not a moral code, it's a set of seriously flawed rules of a magazine, and I follow the rules...without hiding anything.
My discussion of the resemblance between models like USNWR rankings, and games like football or chess is posted on SSRN and will be coming out in this volume of the Cleveland State Law Review. The piece is Models and Games: The Difference Between Explanation and Understanding for Lawyers and Ethicists. Here is the abstract. Enjoy.
There is value for lawyers in thinking about constructs of rules as games, on one hand, or models, on the other. Games are real in a way models are not. Games have thingness - an independent reality - and they can be played. Models have aboutness - they map onto something else that is real for the sake of simplification and explanation. But models and games are not as dichotomous as the preceding claim makes them out to be. Sometimes models look just like games, and sometimes games can serve as models. Because models look like games, we may come to believe they are real - that the models have thingness rather than aboutness. People are prone to think some of the models they deal in all the time are real, like games, and perhaps even more real than the reality the models are supposed to represent. When that happens unreflectively in business, ethical and legal problems can ensue.
There is also a relationship between games and models as a way of thinking, and the position of the thinker as modeler, game creator, or game player. To engage in any of those acts is to use the legally trained mind to make sense of what is going on, and to act on it. But there are different ways of making sense, either by explaining or understanding, and it is not common in legal education to undertake the exercise of thinking about thinking, or theorizing about theory. I explore the consequence of confusing games and models in two contexts, financial accounting and contract interpretation, and consider the possibility of co-optation from models into games and vice versa. I conclude that practicing lawyers (or law professors) need to think about thinking itself or face the possibility of being misled by precisely the same context facing their clients. In short, lawyers need to be pragmatic ontologists.
August 15, 2008
Joy, Inspiration, Leadership, and Free Agency
Posted by Jeff Lipshaw
Gordon Smith has jumped into the fray Bill Henderson created with his deft analysis of the "faculty free agency" issue, since added to by Jim Chen, Mike Madison and Paul Caron. Gordon's focus was on the need to create a sense of of intrinsic value or joy within an institution. (Aside: my own joy right now has a lot to do with the fact that Bill Henderson is a co-editor of this blog!) That was a conclusion I reached, perhaps not as articulately, in a response to Bill's comment on my deconstruction of incentives a couple days ago. But it is buried in the comments, so with the magic of technology and a bit of editing I'm going to repeat it here.
I love Bill's aspiration to create a mission beyond self-interest within a faculty. The wonderful thing about his is this: "an initiative that will add value for students and the institution--e.g., creating skills, building relationship, solving real world problems, etc." So the question is how translate great faculty accomplishments (like the one Bill describes Andy Morriss undertook in Cleveland). The task is to have those accomplishments be seen as capital, and then to do what we can to make them school-specific.
So the way to create school-specific capital is to have evaluators (students, alumni, other faculty) value it as such, and to keep people around long enough to get the programs institutionalized. My point is not to throw cold water on the aspiration, but to suggest: (a) doing that is really aspirational (read: difficult but not impossible); (b) the task is difficult (but not impossible) even where, unlike in law schools, there is a unifying metric (that's the only reason for distinguishing a complex business), and (c) in my experience, contracts are not motivators, they merely legalize a more, how shall we say, emotional commitment.
I truly believe that what inspires people to great performance is a sense of mission, purpose, creation, posterity, whatever, and contracts or other legal or rule-based commitments are the tail of that dog. Cool. Do five year contracts or commitments. But do it within an institution marked by inspired and inspiring leadership.
July 30, 2008
Sokol on Obama as Teacher
Posted by Jeff Lipshaw
Danny Sokol (Florida, left), over at Antitrust and Competition Policy Blog (A Member of the Law Professor Blogs Network), provides additional detail (he was also quoted in the New York Times story) on his experience with Barack Obama while Danny was a student at the University of Chicago Law School. His account confirms other stories I've heard about Obama's genuineness. When I was helping out (somewhat) back in the early primary season, some of the people who were working up in New Hampshire told me about the Senator coming out of a building and throwing snowballs at the volunteers, leaving them in something of a quandary - "do we throw snowballs back? are the Secret Service agents going to object if we do?"
It's also interesting to see peers and acquaintances go from being private figures to public figures in full view, particularly when, as Danny points out, part of your appeal and, indeed, charisma, is your individual attention to people. I've experienced the "looking beyond me to the next person" sense in talking to a number of politicians, and in fairness, the number of people who make demands on a mayor's or governor's or senator's or candidate's time simply forecloses the possibility of that now public person being everybody's friend.
July 23, 2008
Some Thoughts on the Bi-Modal Distribution from a Former Partner and Retainer of Partners
Posted by Jeff Lipshaw
Coming up for air after working on some other stuff, I finally had a chance to digest Bill Henderson's post on bi-modal distribution of starting associate pay. I have some visceral reactions to the data, as well as some "the sky is not falling" thoughts about how things will play out. This is all casual empiricism and seat of the pants theorizing, so take it for what it's worth.
1. Bill's post doesn't talk much about industry consolidation, but there's no doubt that has substantially impacted the law business since I started at a big Detroit firm in 1979. At that time, there was a big premium to working in a New York law firm - as I recall, as much as $10,000 a year. This will sound quaint and somehow Great Depression-ish, but my offer letter in the fall of 1978 from Dykema promised a starting salary of $22,000, and I am pretty sure an offer from Cravath at the time would have been in the low $30,000s. The gold standard of pay at the time was not as a lawyer, but as a consultant at The Bain Company, which was mainly a place for the JD-MBAs. (I remember this because the starting pay was $44,000, exactly double my offer, but the word was you worked three times as hard.) What Detroit (Dykema), Milwaukee (Foley & Lardner), Pittsburgh (Reed Smith), St. Louis (Bryan Cave), as exemplars, offered, even then, was a trade-off of life style for dollars: billable hour goals in the 1700-1900 range, versus 2200-2800, lower cost of living, accessible suburbs, greater assurance of partnership (ratios then were 1:1 in the smaller cities, with the 4:1 or 5:1 leverage even then in New York.)
What seems clear to me is that the midwestern model indeed did not work, and the continued admission of partners created what one of my late partners used to rail about at partner admission meetings: the creation of negative leverage by admitting so many people as equity partners. The solution was growth, but organic growth opportunities are cyclical with the business cycles, and consolidation growth is the alternative. And that's what we've seen. DLA Piper may be the best example, as a decent firm out of Baltimore turned itself into a global powerhouse over the course of a few years (my late friend Jeff Liss being a major player in that strategy). Dykema just swallowed up a medium-sized firm in Chicago.
My theory is there's less to distinguish the Am Law 200 now, and hence, less to distinguish in terms of non-monetary compensation, hence the trend to bi-modal distribution.
2. I want to suggest the banking consolidation model as a prediction of the way the law industry will go. Banks, like law firms, are natural consolidators. It's largely a service business, the services are fairly homogeneous, and consolidation offers huge cost synergy opportunities. But what happened with all the banks turning into Citis or Chases or Keys or National Citys is that market opportunities sprang up for local service oriented banks. The "private bank" phenomenon is a response to that. I used to listen to radio ads for a locally-owned bank in the Detroit area, Franklin Bank, that made this the focal point of its value proposition. (I'm hearing something similar this summer here in northern Michigan from local pharmacies, particularly those that do compounding, as a reaction to the CVS-Walgreen's-Rite Aid-Walmart consolidation.)
As smart and ambitious lawyers get tired of the bureaucracy of the mega-firms (and more importantly, like David Boies, having fruitful and remunerative new business killed by a conflict!), my prediction is we will see a cycle of boutique firms that return to something like the market distinction of the late 1970s. I can reveal here a not-very-hidden secret: GCs of big companies know that much of what they purchase in legal services is fungible, and they can get quality work in Albuquerque or Nashville or Birmingham, Alabama or Jackson, Mississippi.
My faith in the corrective power of markets is not quite as ardent as my friend and about-to-be co-author Larry Ribstein (Ribstein & Lipshaw, Unincorporated Business Associations, 4th ed., to be available for the 2009-10 school year, get it while it's hot!), but I think that's where we are going (see Larry's observations on this business acting more like other capitalist businesses). Like Larry, however, it's the debt that bothers me, and I second his historical observations on that score.
July 19, 2008
Notes from Michigan
Posted by Jeff Lipshaw
Some random observations this morning from up here in God's country. . . . (well, if David Broder could do it from Beaver Island thirty miles northwest in the middle of the lake, why can't I?)
- The front page of the Detroit Free Press has a story on the latest gaffe in the mayoral debacle, this time, the decision by Gov. Jennifer Granholm (D-Harvard Law School) apparently to try to broker a deal with the federal prosecutors to resolve the mayor's difficulties at the same time she may be called upon to remove him from office. Quoted in the article on the legal ethics angle is none other than our own Nancy Rapoport.
- They have begun to tear down vacant Tiger Stadium. See the New York Times.
- Reading the list of Starbucks closings to which Alan linked felt a little like going down a list of disaster victims. I knew the ones at 38th and Meridian and in The Precedent in Indianapolis. I used to stop at the first one on my way down to teach my entrepreneurship and the law seminar at IU-Indy, and the second one was the stop between the gym and my office at Great Lakes. Interesting that not a single store in Boston or Cambridge was closed. Here's a theory. Because of the significant competition in Boston from Dunkin' Donuts (I still don't get Dunkin' Donuts, particularly the abomination of having the servers put the cream in your coffee before they pour it, but Boston runs on Dunkin'), Starbucks never overbuilt.
- For those of you just dying to know the fate of yesterday's cherries, first they are pitted and sugared (see above left), and then they are consigned to a cherry crisp (right). We who merely climb the ladder to pick the cherries defer this latter highly technical activity to the experts.
- Humean dogs. My two dogs, Max and Annie, are constrained by an Invisible Fence. When somebody comes by walking a dog on the street in front of us, they run up and down barking furiously until the passersby are a couple feet beyond the lot line, and then they immediately stop. I have concluded they believe they are causing the passersby to go away.
July 16, 2008
The Definition of Chutzpah or I've-Seen-It-All-Now: Being On Both Sides of Appeal. Cal Court Calls It A Disregard of Duties "Without Precedent."
Posted by Alan Childress
If it were a Hollywood script, I would laugh at its utter incredibility: only Hollywood would unblinkingly make an attorney have a litigation interest in both sides of the appeal (and treat it as clever lawyering). But it happened, yes in California, and the court there called it a disregard of a client's fiduciary duties that is "without precedent." It certainly is, to my knowledge, and it as twistedly brilliant and stunningly nervy as it is stupid and in the "what were they thinking?" box. [Thanks to appellate attorney Greg May for letting us know and pointing us to his (detailed and excellent) post on The California Blog of Appeal.] My simplified but accurate version is this, re attorney Anthony Pagkas:
Civil defendant-client loses suit due to default judgment from Lawyer's alleged lack of diligence. Client then sues Lawyer for malpractice and also appeals the default. Lawyer then buys out the plaintiff's interest on appeal (gets an assignment of the interest from the prior plaintiff, for some "undisclosed consideration"). That's right: buys into the other side of the appeal and, now represented as a litigant by another attorney in his firm, owns the default judgment if it is upheld. On the other side from his barely-former client, in the appeal!
Brilliant: if Lawyer loses "his" appeal, then there are no malpractice damages and no causation. If he wins, he collects a $730,000 default judgment from the former client.
Stupid: this requires Lawyer to move the appeals court to substitute him as "respondent" in his former client's appeal.
Sort of predictable: ”Finding that the proposed substitution violates multiple rules of Professional Conduct as well as the Business and Professions Code, we will deny the motion.” Well, yeah. The court's stated astonishment to follow in explaining the denial and imposing sanctions is quoted by May, and its full opinion here as well, issued yesterday. Suffice it to say that "if the substitution were allowed, it is conceivable that Pagkas could prevail in both the malpractice action and in this appeal, leaving him with huge windfall at the expense of his former client. Pagkas’s disregard for his ongoing fiduciary duties to his former client in favor of his own personal gain is without precedent." (Footnote omitted.)
How did Lawyer ever think he would get away with this? The sanctions are merely $5260, but I am sure there is more to come. The case is Styles v. Mumbert, civil H029767 (6th Dist. July 15, 2008).
UPDATE: Not entirely without precedent, it has since occurred to me.
July 05, 2008
Jesse Helms, Racism, Manners, Law, and Cognitive Dissonance
Posted by Jeff Lipshaw
Jesse Helms, the former North Carolina senator, described by the New York Times as having a "courtly manner and mossy drawl," died. He was also an unrepentant and nasty racist and segregationist with a courtly manner. I don't have my copy of Barack Obama's The Audacity of Hope handy, but I recall there was a description of Helms' courtly manner upon Obama's arrival in the Senate. For those of you who remember this far back, Helms was the most recent incarnation of Allen Drury's character Senator Seab Cooley in Advise and Consent, played by Charles Laughton in the movie. (Before he became a Watergate hero, Sam Ervin had the honor.)
What do we make of the well-mannered racist? In the sequels to Advise and Consent, Drury got more and more conservative and hawkish, but I remember being troubled by his sympathetic treatment of Sen. Cooley, most of which had to do with courtesy and manners (like would it fair for the liberals to object to an aged senator leaning against his desk while filibustering against a civil rights act?) Our custom is to be charitable upon one's passing, but I don't think we have to go so far as to extol, which was what President Bush did: "Jesse Helms was a kind, decent, and humble man and a passionate defender of what he called 'the Miracle of America.' So it is fitting that this great patriot left us on the Fourth of July."
At the risk of taking on a political label, I'll confess I think a lot of manners and courtesy even if others think they merely promote the status quo, and even if it bars me from ever participating in a philosophy faculty workshop. I like Edmund Burke's famous quote about manners: "Manners are of more importance than laws... Manners are what vex or soothe, corrupt or purify, exalt or debase, barbarize or refine us, by a constant, steady, uniform, insensible operation, like that of the air we breathe in." Manners are about what we do rather than what we think, and perhaps it's the one place that law makes a difference, if there's something to the theory of cognitive dissonance, and particularly the variant that says we want to eliminate dissonance between what we believe and what we do. We can't, as a practical matter, outlaw racism, but we can pass laws affecting behavior that is the natural result of racism, and I think, slowly but surely, attitudes and beliefs start to change so as to harmonize what we believe with what we are doing. Putting aside the extremes of political correctness, when a Don Imus steps in it today, and there's a quick and relatively unanimous consequence, I think it's because what we do has required that we change how we think.
I'm reading Stephen L. Carter's New England White (more on that after I finish it), and it's helpful in seeing that even equal material status does not kill the instinct (I suspect the product of our evolution) that makes us fear the "other," and fear the "other" even more to the extent the "other" doesn't look like us. I'm still not sure that either President Bush or Sen. McCain were compelled, other than by political considerations, to mark Helms' passing, but even if compelled by friendship or courtesy in the Senate hallways, I would have preferred that it had gone something like this:
Jesse Helms will be remembered for his courtesy, his courtly manner, and his willingness to stand by his principles. These are all things we can and should admire. But he also stood for attitudes toward racial, ethnic, and other superficial differences whose day has long since passed. We should take solace in the death of very few, because we should mete out carefully our attributions of evil. But we will live in a better world if Jesse Helms' legacy is only his courteous behavior, and he is otherwise remembered as the last anachronistic embodiment of a condition we have overcome.
June 17, 2008
Breaking: Tx Ct Crim App Orders New Judge to Reinstate Death Warrant; UPDATE: Execution Ran Out of Time
Update at 10:03 pm -- The prior petition for writ of mandamus was denied, but a new one by Texas prosecutors aimed at the new (transferred-to) Judge just got granted. The Court of Criminal Appeals ordered mandamus to the new Judge below. Download cca20order2008202006.17.2008.pdf This means the death warrant is directed to be reinstated immediately.
Update at 10:27 -- The Austin American-Statesman reports:
The Court of Criminal Appeals has ordered a North Texas judge to reinstate the death warrant for Charles Dean Hood. The warrant had been recalled earlier in the day. Prosecutors in Collin County successfully asked the state’s highest court to order the region’s presiding judge to reinstate the case. Hood could be executed this evening if the order is reinstated by midnight, when the warrant expires.
Later, from the Statesman:
UPDATE, 11:10 p.m.: A North Texas judge has reinstated the death warrant ordering the execution of Charles Dean Hood, said his lawyers. Hood remains in a cell adjacent to the Texas death chamber in Huntsville as prison officials await word on his final appeals.
Update 11:18 -- from Hood's lawyers: The presiding judge signed the warrant, the governor denied reprieve, and "just denied in SCOTUS."
Final update 12:02 am -- Hood's lawyers report that the execution was stopped. They wrote at 11:56: "We just learned from a reporter who is at the prison that the execution has been stopped because prison officials said they ran out of time."
Even if you're a death penalty supporter you can't think it's a good thing for Texas' highest criminal court to rubber stamp executions with such obvious problems in the case, especially when there's a conflict of interest that might implicate them personally. You just don't use a legal technicality to avoid examining possible wrongdoing by your friend, not when somebody's life is literally hanging in the balance.
All of the recent SCOTUS-created restrictions on the death penalty - for juveniles, for the mentally retarded, in cases where black jurors were eliminated because of race - were established because of routine abuses, both real and perceived, allowed in Texas courts by the CCA. In each instance, SCOTUS found Texas' judicial practices so egregious it eliminated the death penalty or ordered new trials for large classes of defendants. I've often thought that if SCOTUS ever does wind up abolishing the death penalty entirely down the line, it might well be because Texas does the most executions and our courts aren't giving these cases enough scrutiny.
Update: Tx Ct Crim App Denies Prosecutors' Mandamus Request to Reinstate Death Warrant
Further Update (8:44 pm Texas time): The latest in the Texas case of Charles Dean Hood, noted earlier below, is that very recently the state's highest criminal court issued an opinion essentially denying mandamus, thus the death warrant is not reinstated. The opinion is here: Download cca20order2007202006.17.2008.pdf
There is a twist: the Court finds that the Judge should not have dealt with the merits since it itself had not given leave to do so after deciding the matter earlier this week. But since the Judge had also recused himself and transferred the case, mandamus could not lie against the Judge because he no longer had authority to act in the case. Interesting opinion to read. [Alan Childress]
Breaking News: Texas Judge Removes Date of Execution in Case Involving Allegations that Trial Judge and DA Were Involved; State Appeals
Posted by Alan Childress
Updating Nancy Rapoport's post on LPB here (and more at her personal blog), and the vital efforts of Monroe Freedman at LEF here, I just received an email from one of Charles Dean Hood's attorneys (Andrea Keilen) saying:
Just a few minutes ago, the Collin County District Court judge presiding over this case withdrew Charles Hood's execution date and recused himself (without explanation) from any further proceedings. The prosecutors have not decided whether they will appeal this ruling.
I will update more soon. (The execution would have been six minutes from now.)
Update: To see the Judge's order and recusal, Download order20collin20county206172008.pdf
Further update: A Notice that was made requesting discovery on the relationship under Brady and the like, filed today before the Judge entered the removal of execution date above (and apparently is still pending), was emailed by another attorney for Hood, Laura Burstein. To read it, Download notice_of_brady_evidence.rtf Both documents were posted here with permission from the relevant attorney.
Update #3: Prosecutors right now are appealing the Order, above, of removal of the execution date, reports Ms. Burstein (6:22 pm cst). The mandamus request has been filed in the Texas Court of Criminal Appeals (that's the state's "supreme court" for all criminal matters). They are seeking for the Order to be vacated and the execution to proceed tonight.
Update #4: The Dallas Morning News is on top of the story and notes that the Judge who withdrew the execution had worked as an ADA in the office that tried Hood. It also notes that legal ethicists have protested the potential execution in light of the possible conflict.
Further LPB updates are in new and separate posts above this post, such as this new one.
June 14, 2008
Next Time Ask For Damages In the Amount of $138,542,796
Best line in the story, reported as Sudoku Addicts Halt Drugs Trial, is: "The judge was alerted after some of the jurors were observed writing their notes vertically, rather than horizontally."
Not quite as inspirational as is Nancy's post on the Nevada attorney who made good on his boss's wrong. But inevitable. Look for the University of Chicago Law School to ban sudoku from its classrooms. [Alan Childress]