Business Law Prof Blog

Yet Another Special Purpose Entity Scam??

Special Purpose Entities (or Vehicles, SPVs, for short) used for off-balance sheet financing were the focus of the Enron scandal and are back in the news again.  Enron "transferred" debt to SPVs and took the debt off its balance sheet.  The transfer is legit only if the SPVs are independently owned (not a sub of Enron).  Enron officials concealed the identity of Enron as a true majority owner of its SPVs, hence the scandal.  The new game is with "conduits" and SIVs (Structured Investment Vehicles).  These "independent" investment vehicles, created by investment banks (most notably Citigroup), hold assets and sell asset backed commercial paper (among other forms of debt).  Banks use the vehicles to issue commercial paper and use the proceeds to purchase long-term, often illiquid assets (receivables, auto loans, and home loans), all off the balance sheet and, therefore, not a problem with bank minimum capital requirements.  They learned from Enron -- ownership is independent -- but the new game is in the bank's guarantees of default.  Entitled "liquidity backstops" the banks in essence guarantee the vehicles against losses but technically skirt the definition of a legal "straight guarantee" (which would make them owners). These non-guarantee, guarantees have now put the true exposure of Citigroup to vehicle insolvencies on the table and investors are not sure they like what they do not know. 

Bush on Home Loan Defaults

Today President Bush proposed some very modest rule changes to help some home owners who are facing defaults on variable rate mortgages.  The primary proposal is to allow home owners in default to apply for fixed-interest FHA insured mortgages to refinance their debt. At present those in default are disqualified from the FHA insurance.  The proposal does not help those in the sub prime market and it does not increase the ceilings on mortgages (either in total amount or in individual amount) that can be held by Fannie Mae and Freddie Mac.  President Bush is attempting to walk a line between doing nothing (and therefore being accused of showing no sympathy) and offering a bailout to those who took a risk on housing prices and guessed wrong.  Predictably he is getting blasted by both sides.  The talk shows and conservative blogs are replete with those upset with the "bailout" and many Democrats (including, most notably, Dodd and Obama) are saying it is late and too little.  As is our tradition, there is going to be much finger pointing -- at the "flippers" (an estimated 30% of some hot markets) that bought homes, the originators that convinced people to use exotic loans, the poolers and rating agencies that packaged the loans and sold securities (CDOs backed by the loans) with glossy ratings, and the investors (hedge funds) that took the riskiest securities (the equity tranche) in the pools, and, finally, with the banks had loaned the hedge funds the money on the securities.  All the speculators (whose personal appeals for aid would be met with public derision) will use, as Jim Kramer has done, the "honest" home owner who was "duped" by "predatory" lenders (and there were some) as a front for aid that will help their positions as well.  It will be hard to carve out those that deserve aid from those who do not with any remedial proposals.

Judge Jacobs Shows Some Common Sense

Judge Jacobs, Chief Judge of the Second Circuit, started Court watchers when he dissented from a First Amendment decision of a panel of his own court by noting that he could not and would not make any legal arguments against those in the majority because he had "not read [the majority opinion]."   He thought the case silly, "years of litigation over $2," and he was busy.  At stake was a remark made in a college newspaper in 1997.  Judge Jacobs has long argued that many cases in the federal courts, especially those over federal jurisdiction or other constitutional minutiae, make only lawyers, judges, and law clerks happy at the expense of judicial time and sensible doctrine.  A voice in the wilderness. 

Compensation Disclosures

The Securities and Exchange Commission (SEC) has startled the CEOs of over 300 companies with letters asking for more detail in their compensation disclosures on the SEC's new rules.  The CEOs are startled because they did little to prepare the disclosures; their attorneys did.  We again have an example of corporate attorneys reading the SEC rules as closely and conservatively as is possible (or beyond what is possible) in order to disclose the barest minimum.  The SEC is apparently not happy with the practice and may have itself over-reacted in demanding more detailed information.  It will take some time for this ping-pong match to play itself out.  It is yet another illustation of the extreme sensitivity of the country's CEOs to executive compensation disclosure requirements.

Liquidating Hedge Funds

Now that some hedge funds are insolvent and forced to liquidate, investors are no longer gleeful over enjoying the tax benefits of a hedge fund organized abroad in tax havens such as the popular Cayman Islands.  How does one go through bankruptcy proceedings with a fund organized in the Caymans?   Our courts will have to apply the complexities of Chapter 15 of the federal bankruptcy law, which applies to oversees liquidations.  Again investors are reminded that the legal paper matters (what are the termination and redemption rights or the insolvency rights???) when the markets turn south. 

State Courts and Options Backdating

Early this year the Delaware Chancery  Court, in two opinions,, In re Tyson Foods and Ryan v Gifford, allowed shareholder derivative suits to proceed that were based on dating compensatory stock options.  In one suit the allegation was that spring loaded options (options given before the announcement of favorable news) could be deceptive if they were disclosed only as "at the market" grants.  In a second suit, backdated options could be a breach of fiduciary duty.  Both opinions were a clear declaration that options dating practices were potential violations of state law as well as federal law.  At issue is whether plaintiffs attorneys have taken full advantage of the opening.

Topps Delays Shareholder Meeting

The management of Topps Co. has delayed a shareholder vote because it fears it will lose.  The management is pushing a buyout with a favored bidder, Tornante Co., at $9.75 or so a share.  Topps management had previously rejected a bid, valued at $10.75 a share, from Upper Deck.  The Delaware Chancery Court has a long history of not supporting tampering with shareholder meeting dates and one wonders whether this move can past muster.

Auction IPOs Sag

The use of the auction IPO format, featured by W.R.Hambrecht & Co. for over eight years, continues to decline in frequency.  So far this year there have been only two.  In other world markets, in which their is also a choice between an auction and book building IPO, the auctions have all but been abandoned.  Is it a market based preference for book building or are the investment banks working together to kill a practice that reduces their fees?   

Securitization and the Rating Agencies

The bubble in the subprime residential mortgage market has caused many to take a hard look at securitization.  Securitization is the pooling of large asset pools, such as subprime mortgages, and the sale of securities backed by the pools.  The seller is often the securities division of a major investment or commercial bank.  The weak link seems to be the rating agencies that appraise and rate the securities. The rating agencies are hired and paid by the pooling agent, the seller.  Moreover, many of those working with the rating agencies are hoping to work eventually for the banks that hire them.  The conflicts are obvious and have led to the rating agencies being overly generous with their ratings.  The generous ratings led to a demand for assets, subprime mortgages, that could be securitized.  With the low interest rates adding another incentive, the makings of a financial bubble became inevitable. 

How Does One Get the Market Off Crack Cocaine??

The Fed has a tough job ahead.  The market is hooked on the crack cocaine of cheap credit.  The addiction has fueled crazy lending and crazier investing.  Cold turkey withholding of the cheap credit has led to severe withdrawal symptoms, tremors and shakes, and has the addict whining for another fix.  Yet facilitating a return to the full habit will reward the addicts and cause a resumption of the crazy lending.  The struggles required to get an addict off the habit of cheap credit should remind the us (and the FED) that it is easier and better to prevent the habit from forming in the first instance.