Business Law Prof Blog

Real Estate Flipping

I am still perplexed at how easily real estate flippers got away with false appraisals on overvalued land.  The banks loaned too much based on the true value of the underlying collateral and the seller's walked with the excess cash (often repeating the process as buyer then seller in the next cycle).  In the simple case the lending bank has a strong interest in checking the accuracy of the appraisal (or hiring its own reliable appraiser) before loaning money on a land purchase and taking back a mortgage.  Some argue that structured finance dilutes everyones incentive to check for fraud. The argument notes that the bank sells the paper to a special purpose vehicle (SPV) and the SPV sell securities to investors.  The risk of fraud is borne by the investors who do not or cannot check on the validity of any appraisals.  The investors rely on rating agencies to rate the default risk and the rating agencies are operating under conflicts because they are paid by the SPV and get consulting fees from the SPV.   The bank (and the originating broker) and the SPV no longer care because they take fees and pass on the risk.  The investors end up holding the bag.  The argument seems overly simplistic.  Most SPVs sell tranches and the lowest tranche, the so-called equity tranche, is not rated and very risky.  Those who buy the equity, usually hedge funds, have an increased risk of loan defaults and should therefore have an increased incentive to monitor the quality of the loans.  Indeed, one could argue that the equity buyers and a stronger incentive than a bank that does not sell the paper to check on the default risk in the loans because the hedge funds took more risk with each default. There were long time rumors in the market of real estate flipping. Why did the hedge funds not check out the rumors, or at least price the equity to account for the rumors?  Moreover, many of the same banks that passed on the risk to the SPV then bought SPV securities in their own hedge funds (and those funds are now in distress).  Why did the banks not have the proper incentive, when purchasing back the paper, to make sure the paper that went to the SPVs they invested in was sound?  In short, I continue to be baffled by stories of easy money (made even by gangs of thugs) on real estate flipping that overvalued land in the appraisals. 

Sallie Mae Deal Heads to Court

The private equity group that has signed a buyout deal with Sallie Mae has offered a lower price and Sallie Mae has refused.  Sallie Mae wants the original price.  The buyer will allege that new legislation limiting government subsidies for student loans is a "material adverse change." Sallie Mae will counter that the buyer is using the new act as a pretext to bail because the buyer's financing has become more expensive since the deal was inked.  I have come to believe that the negotiators of buyouts and other major market events such as IPOs spend most of their time on the upside potential of the deals and little time on legal provisions limiting downside risk.  The downside stuff is left to "form agreement" debates among lawyers and resolved by "street" standards.  Only when the market goes sour do the documents matter.  Those who understand the documents, the M&A hedge fund arbs, can make a buck betting on court outcomes.   

Hedge Fund Investors: How Wealth Should They Be?

The Securities and Exchange Commission is proposing to increase the net asset requirement for individuals seeking to invest in hedge funds to $2.5 million from $1 million.  The increase represents more than just a number that attempts to correlate wealth to the ability to bear losses.  It is a shift in regulatory philosophy.  The $1 million number comes from the accredited investor exception in the private offering rules (investors who are worth over $1million are not counted towards the minimum 35 in Reg. D Rule 505 and Rule 506 private offerings.  The increase will be tucked in another exemption in another act, the Investment Company Act.  Hedge funds then will not be able to do private offerings that other types of operating companies will still be able to do.  There is little justification for the division as investors can loss money in high risk operating companies as easily as they can in hedge funds.  Indeed, hedge funds are diversified and individual privately held operating companies are not -- the risk might be greater in the privately held individual companies.  Whenever the SEC focuses on individual industry rule-making it often just shuffles investors and their risk choices off to somewhere else.

Derivatives and Banks

There is a worldwide explosion in the use of off-exchange (OTC) derivatives by asset managers (such as university endowment offices) and pension funds.  This means, of course, that there is a similar explosion in the writing of such derivatives by counter parties, investment banks.  As numbers and variety of the complex instruments proliferate there are two problems -- a short term back office processing problem and  longer term valuation problems.  Both problems increase the risk of mistakes and any major trading mistake, given the inherent leverage of these instruments, can have huge consequences.  It is likely that we will see, with some increasing frequency, some spectacular losses as investment managers or bank agents miscalculate risk and valuation on some of these exotic instruments.  The quality of internal controls over investment decisions make by fund traders will be sorely tested and some will be shown to have been wanting.    

Tax and Hedge Funds

Congress has figured out why over 80% of our nation's hedge funds are located offshore -- tax avoidance.  The funds use financial derivatives (swaps) to minimize dividend taxes and use other systems to minimize compensation taxes and unrelated business taxes.  Congress has scheduled hearings and will not doubt pass legislation to close today's shelter systems.  Behind the shelter is, of course, our basic double tax system (tax corporate earnings and then tax dividends) that should be eliminated, eliminating most of the tax planning devices in place today.  With no tax on dividends (and no capital gains tax on the sale of stock), funds would a minimal incentive to locate offshore.  Revenue lost could be gained back through the adjustment of remaining personal rates. 

The Fed, The Market and The Consumer

Several years ago I wrote on this blog that I thought we were heading into a market correction of 10% or so.  That market correction has yet to come and I have taken some friendly and not so friendly advice to stay with legal analysis and stay away from future market predictions.  My projection ast the time was based on data that Americans, for the second year consecutive year, were spending more than they earned (in other words, that they were spending their savings or the equivalent, the equity in their house, for example).  They last time Americans had done this was some time in the 30s.  I thought the following -- the American consumer is holding up not only our stock market but the world's stock markets and he/she is running out of money.  Well, I underestimated the American consumer; he/she continues to spend more that he/she earns and has not run out of money nor has he/she decided to economize.  I can come up this three possible explanations:  First, the earnings numbers are low (the gray (or black) market or exchange economy is much larger than the numbers reflect); Second, Americans have more savings to burn than I anticipated; Or three, Americans will spend until someone says they cannot (they fall off the cliff).  In any event, do not follow any market advice I may offer, now or in the future. 

Shareholder Activism and the SEC

There has been a lively debate in the editorial pages of our financial newspapers on whether the shareholder activism practiced by modern private equity funds, hedge funds, and public pension plans is healthy for American business.  On one side are the traditional republicans (with a small "r") that believe shareholders should delegate management details to their boards of directors and then let them do their work.  Shareholders who are displeased should replace the poorly performing managers or sell their shares.  On the other side are investors that believe the board should listen to their specific strategies to increase stock value. Many of the strategies include leverage (stock buy-backs or extraordinary dividends) or unbundling the business (spin-offs or bust-up buyouts).  The debate is complicated by a side-bar debate (the activism debate does not inherently depend on the side-bar debate) on the shareholder primacy principle.  Those who are not comfortable with shareholder value as the primary concern of a board of directors are new-found republicans; a board with maximum discretion can favor non-shareholder constituencies. 

The SEC in a very unusual move, promulgated two mutually contradictory rules on shareholder voting (one re-affirming the traditional view and one giving major shareholders access to the firm's board nomination procedure), to see what public comment it would generate.  I doubt either side is correct or, if one side is correct, that it will be correct for very long.  Firms should be able to choose their internal structure (a division of power between shareholders and firms included), publicize it to the markets, and suffer or enjoy the consequences of their choices.  Those firms that choose well will lower their costs of capital and have a competitive advantage.  In other words, the danger is for the SEC to attempt to try and pick a winner in the debate.  The best position for the SEC is an enabling position:  the proxy machinery regulated by the SEC should act in furtherance of whatever state law allows.  Far-sighted states (and/or exchanges) should enable firms to opt into various internal control systems, no one system is mandatory.  Let the investment market, not the political (or academic) market, decide on optimal firm governance procedure.   

Busted Buyouts

The refusal of a private equity group to proceed with its buyout of Sallie Mae and the refusal of Finish Line to close its merger deal with Genesco both pose the same question.  Can a buyer walk away from a buyout agreement when the buyer's financing dries up (or becomes much more expensive)?  The buyer will assert multiple breaches of the acquisition agreement by the seller but most claims come down to two:  First, a failure of the seller to disclosure accurately something about the seller's business; And second, a material adverse change that triggers a MAC clause out.  Courts, in deciding both issues, will know that the buyer wants out because it financing has become more expensive and it looking for justifications.  Since financing problems are traditionally considered to be the buyer's and not the seller's problem, courts start with a presumption against the buyer's claims.  Buyers can convince a court however that the seller's breaches or the adverse changes are real and justify a refusal to close.  Tie the disclosure breach or the material change to the reason for the financing to increase in cost and the buyer has a chance.  General market downturns are not enough here however; the buyer must show that the the disclosure breach was calculated and material or the material adverse change was unexpected and material.  In the Sallie Mae case, the collapse of the CDO market (collateral debt obligation financing) on which Sallie Mae depends for is operating revenue would seem to qualify as unexpected and material.  In the Genesco deal, the deepening losses posted by both firms on the eve of the closing may not, without more, justify walking away from the deal.  In both deals, however, I am surprised at the parties reliance on overly general terms.  It would be easy to trigger a walk condition on specific market conditions in the credit markets or in operating revenues.  Why do more acquisition agreements not do this?    

CEO's Personality Cult Promotions Bite Back

CEO's, in justification of their very generous salary and severance packages, have trumpeted their unique importance to the success of any company -- "We make or break companies."  Personality cult promotion by companies of their CEOs is now a common marketing tool.  It may have backfired.  Researchers are running correlations on CEOs' personal life to their performance.  We have studies on CEOs buying large houses and CEOs frequency on the front page of business magazines (there are negative correlations to performance on both).  The latest is a study on family deaths.  CEOs that have suffered the death of a child (or spouse) belong to companies that underperform the market (the death of an in-law correlates to market overperformance).  Trading on CEO family loses is profitable but unsavory.  CEOs do not welcome this kind of introspection (as none of us would) but it may be inevitable due to the larger than life role of the CEO in the profitability of a company -- something the CEOs have themselves told us to true. 

Lawsuit Against Deal Lawyers

The private equity firm that bought Refco, the company that collapsed with cooked books, is suing Refco's attorneys in the deal, Mayer, Brown, Rowe & Maw, for complicity in the fraud.  This suit bears close watching.  The PE firm alleges that Mayer Brown "knowingly" allowed its client to lie..."  Deal lawyers have become experts at taking fees from questionable clients and careful limiting their exposure to criticism when a client tanks ("CYA" in the the trade).  We shall see how a judge handles it.