Business Law Prof Blog

Tough Times Mean More Pressure for Government Preferences and Setasides

Two items of interest are in the news.  First women are upset that the Small Business Administration announced rules that require at least 5 percent of all federal government contracts to go to female "controlled" companies.  Controlled companies include those managed by women or owned 51% by women.  The women wanted more, 8% perhaps.  Small business owners are upset that the agency did not increase the present 23 % set aside for small business; they want 30%.  Second, state pension funds are participating in the bailouts of banks that employ people in their states.  New Jersey's pension fund is investing in both Citigroup and Merrill Lynch (along with governments of China, Korea, Singapore, Kuwait and others) to shore both up the banks' capital.  Many states put pressure on state investment funds to invest in "local businesses." 

This is all bad.  First, the subsidies pile up and hard to eliminate when the reasons for them wane.  Why not Latino set asides?  to geographic setasides (is the suffering Midwest getting its due in contracts?)?  Second, investment returns or quality of contracts is given a back seat to social engineering.  Give grants or loans to favored businesses -- they are more transparent and do not affect the healthy competition that maximizes the quality of the product sought (investment returns or product quality).  Third, China's investment fund has done this for years.  Is this the example we want to follow?   

Stoneridge v Scientific Atlanta Decided

The Supreme Court, very predictably to anyone who read the arguments, decided 5-3 in favor of the defendants in Stoneridge.  Justice Kennedy, the author of the earlier Central Bank of Denver opinion, wrote the majority opinion affirming the logical extension of the earlier opinion.  Pity.  The big winners are lawyers and investment bankers.  The largest of our financial frauds are now so complex that they must involve lawyers who write and file the paper and investment bankers who fund and underwrite the deals.  These professionals, if they participate with intent but do not attach their names to any of the fraudulent statements known to the public markets are free from liability in private suits.  The SEC can still sue them and seek substantial civil penalties but the SEC has traditionally focused on the CEOs and CFOs who are the primary violators.  There is an unimportant sense in which lawyers are losers however.  It is less likely that they will have a BarChris style opinion to hand out to young associates and clients as a defense to the pressures from clients to go along with clients' questionable activities.  The pressure to generate billable hours plus the strategy of documented plausible denial ("I only filed X based on assurances and did not know of the fraud") and the full plate of the SEC enforcement office may mean that lawyers will continue to be too willing to not ask questions when a lucrative fee is available. The claim that such an action would generate more "strike suits" has some merit but it is limited given the need to pled specifically and prove scienter, which would be signficantly harder in aiding and abetting cases than it is now in primary violator cases.

Lawyer CEOs?

The firing of Prince at Citigroup and Cherkasky  at Marsh & Mclennan has some wondering whether lawyers make good CEOs.  Too much attentiont to process and not enough attention to results was common in both firings.  Is this a bias that lawyers must overcome to be good CEOs?  Some think so.

Blaming the Fed

No-one on Wall Street seems to have anything good to say about the Fed.  The economy is slowing and some on Wall Street see cherished positions threatened by a higher than comfortable probability of recession.  I is hard to recommend (or sell or underwrite) stocks when the market is flat.  The Fed "knows nothing" according to a popular TV touter.  What Wall Street wants is for the Fed to roll over and drop fed funds interest rates a bundle -- make credit cheap again.  Such a move would, of course, hurt an already sagging dollar and could trigger inflation but so what -- with scads of cheap credit, assets will turn over again and the financial game, collecting fees on asset turnover, will again be afoot.  I wish it were so easy.  The Fed cannot change market fundamentals (other than the supply of money).  We know now that asset backed securities were mispriced and that large banks did not have internal controls sufficiently tuned to properly manage risk.  We also know that the improperly managed risk drove up real estate prices too unsustainable levels and we know that consumers overspent the phony equity.  The Fed can do nothing about all this.  We are simply too dependent on the need to blame someone as an idiot, read, the need to rely on someone as a savior, in times of financial difficulty.   It feeds our control fetish; someone, in the middle of a very complex, huge market driven economy, is in control and needs only to act sensibly.  I wish is were so easy. 

Smart People Seeking Dumb Money

There was a great headline in the NYT "Smart People Seeking Dumb Money" referring to the IPO's of private equity groups in the past year (all have lost money since their initial day price run-ups).  The headline is broader than the story.  This is an old, old Wall Street game.  It has some very familiar and repeatable themes; only the names of the securities sold change.  First, smart people sell something novel, new trendy -- with a promise of high returns-- and take fees [Goldman underwriting SIVs].  The fees go into solid investments (treasuries).  The recent new, new thing was CDOs and/or ABSs.  Second, some smart people get caught in the returns and themselves take equity, hoping to sell to greater fools (the greater fool theory) [Merrill Lynch; not Goldman].  If they get out fast enough they win; if they get in too late or hold too long they lose.  And third, the really smart people sell short the very thing they are pushing [Goldman].  The whole thing explodes and those who still hold the equity in the security lose big.  Government investigates, castigates and over-regulates.  It is a very old game. For our government, perched on a capitalist economy,  the issue has always been how much to protect the dumb money.  Too much protection and we get too little financial risk-taking and innovation.  Too little protection and we get too little investment capital.  The tendency of government is to overprotect -- with each crisis comes more federalism, more promises to protect, more efforts to appear concerned and empathetic.  Only the threat of new competitive economies elsewhere keeps government honest and even then we often get unhelpful subsidies and other forms of protection rather than structural reform than makes us more competitive.  What always amazes me is that we find enough common sense in this repetitive process to stay competitive at all.

Hard Lesson for Harvey Electronics

Harvey Electronics filed for Chapter 11.  The cause of its distress was a failed merger negotiation that led to "distractions" and increased professional fees.  As a result of the failed negotiation the credit markets lost confidence in the company and increased its borrowing costs, its stock dropped to below $1 and it lost its NASDAQ listing, and it triggered the default clause in its senior borrowing agreements.  The last event forced filing Chapter 11.  The lesson:  a failed merger negotiation, once publicly announced and far along, can have heavy, heavy costs for a company.

Genesco Ordered to Close Finish Line Acquisition

A chancellor in Tennessee has order Genesco to close its buyout agreement with Finish Line. A suit still pending in New York, brought by UBS, Genesco's financing bank, will now determine whether the deal will produce a viable or bankrupt company.  UBS is attempting to back out of financing the deal.  The Tennessee opinion is interesting in several respects.  The judge found a material adverse affect but also found that the MAC clause carved out Finish Line's financial decline (it was caused by general economic conditions).  Also of interest is the very quick assertion that legal damages were not an acceptable remedy.  Her finding depended on facts that one would find in any busted buyout -- the target was in limbo after a buyer refused to close-- and suggest that the "inadequate" part of the inadequate legal remedy is a very low bar.  The Chancellor also held, very carefully parsing the negotiation facts, that Finish Line did not mislead Genesco in the deal negotiations and did not otherwise have a duty to disclose negative information at the closing.  There may be an appeal.  This was a seller's agreement; the Chancellor figured it out and held the buyer liable on the pro-seller language.  Specific performance, however, would not seem to be the right remedy; legal damages would have been sufficient and also mooted the UBS suit (except for contribution perhaps).

Blankfein Pockets $69 Million for the Year

The CEO of Goldman Sachs made $69 million in salary for the year.  His base salary was $600,000 (plus a charitable gift of 200,000) and the rest was in bonuses tied to the performance of Goldman this year.  Cayne, the CEO of Bear Stearns, had a base of $250,000; the disastrous year for Bear Stearns meant he had few bonuses.   At least for investment banks, the incentive system put in by the tax code (limiting base salary deductions to $1m thereby encouraging salary in excess of the base to be incentive driven) seems to have worked.

URI v RAM

The Delaware Court of Chancery has decided the URI v RAM case.  Cerberus Capital Mgn. can walk away from its deal to buy URI on the payment of a $100 m reserve termination fee.  The Court decided, after a trial, that URI had given up its right to specific performance in the acquisition contract.   What makes the case noteworthy is the contractual ambiguity on a central point in the negotiated deal.  Why was the contract not much clearer on the contested issue?  Why was the specific performance clause in the contract not deleted altogether rather than made "subject to" the termination fee?  There never should have been a trial here on this rather simple drafting question.  The only trial, if at all, should have been on whether Cerberus could wake under the MAC clause and pay no reverse fee.  Cerberus by agreeing to pay the fee gave up its MAC clause rights. There should have been no trial.  Why do high paid lawyers draft such sloppy agreements?  I suspect that Cerberus lawyers read the language and said it got what it wanted and the URI lawyers read the language and were happy that some ambiguity gave them some imagined bargaining leverage if Cerberus triggered the fee provision.   

Potter v Bailey: The Wrong Debate

Several opinion writers, Floyd Norris is the latest, have noted the application of the movie "Its a Wonderful Life" to the sub-prime mess.  Bailey, the idealist, versus Potter, the cold hearted investor, in evaluating the plight of sub-prime borrowers who cannot face their mortgage payments in ARM resets.   Should we show compassion or be tough?  "We can't [foreclose]. These families have children." [Bailey]  "They're not my children" [Potter]  So Congress and the Fed are ready to pass laws that look silly on their face:  1) Banks cannot loan money to those who cannot pay it back.  2) Banks must verify income figures from those presented by borrowers (stopping "liars loans") 3) Banks must check the objectivity of appraisals on property that is collateral to loans.  They might as well pass a law that states 4) Banks should be profitable.  The laws restate bank's obvious business incentives and perversely given borrowers the incentive to try and hook wink banks so they can sue under the new statutes.  The most rational borrower under the new rules is now one that goes to a bank purposely ignorant, hoping a bank will make a mistake, so the borrower can get something for nothing.  The fallout, no more sub-prime loans to anyone anywhere anytime, will hurt people with poor credit ratings the most, the sub-prime borrower. 

The core of the problem in internal bank controls (whether as investor in SIVs or as originator/underwriter of SIVs) and banks are suffering huge losses because of it. We do not need legislation to correct this; banks will correct it themselves.  The market has its own penalties -- CEO are getting fired, financial stock is swooning, new owners (China and Abu Dhabi) are buying stakes in our banks, investors will not longer buy any securities backed by mortgage loans -- the correction is already in place.  We do not need new legislation.  Prosecutions should sue those it can find who lied to people and plaintiff attorneys should be class actions against banks that did not disclose problems with internal control fast enough.  The system is working the way it is.

This is another classic case of government overcorrection, fueled by bleeding-heart columnists.