Business Law Prof Blog

SEC Posts New Rules for Rating Companies

The Securities and Exchange Commission announced new rules for ratings companies.  Some of the rules are designed to limit conflicts of interest --firms cannot rate debt they helped structure, for example -- and some are designed to increase the disclosure of the rating process.  Rating firms must randomly disclose a sample of 10% of their credit ratings (with a delay of six months) on issuer-paid ratings and must disclose rating change percentages (upgrade, downgrade and defaults) in each asset class rated.  The changes are sensible so sensible that one wonders why they are 40 years overdue.   

Big Three Auto Companies' Pleas for a Bailout: A Hook??

The CEOs of our big three domestic automobile companies are back in Congress today, asking for emergency loan funds to stave off bankruptcy.  They drove, rather than flew in private jets, in energy efficient cars the 520 miles to Washington.  They submitted "viability plans" and they came with fresh union concessions (no more "job bank" payments and delay in payments to a new health care fund).  Congress will give them funds -- at issue is whether this Congress or the next one that takes over in early January will do it.  Republicans still have the votes to block the funding in this rump Congress. 

Several notable features of the "plans" spell trouble. 

First, the companies structural changes (selling brands and shutting dealerships) will take time and not produce immediate cash savings. 

Second, the new plans show the need for a $9 billion increase in funds over the amount that the Big Three asked for two weeks ago. 

Third, their emphasis on "green" cars comes when gas prices have fallen to historic lows and when the sales of green cars are falling substantially worldwide.  Moreover, green cars are often subsidized sales -- their price does not cover their costs. 

Fourth, labor costs of $75 an hour are not reduced and are too high compared to the labor costs of domestic plants of foreign auto companies ($45 an hour) and other manufacturing in the United States ($31 an hour).  Instead of reducing wages the companies, and this is classic, are firing workers and saving the high wages of senior workers who remain.

Fifth, what are they going to do with the cash?  My reading of their situation suggests that the most profitable move they could make would be to shut down most all their domestic manufacturing and import cars into the United States from their overseas plants in Brazil, for example.

And sixth, and most important perhaps, no one is doing a thorough due diligence on the companies and their plans.  When have their normal financials and 37 page plans but, as would happen in a normal acquisition or a normal workout, there is no due diligence being performed by anyone on the companies. 

All this adds up to trouble.  The amount requested looks to be a hook for more requests later.  Once the initial money is gone, one could conservatively estimate that another $75 billion of successful requests will follow.  Will the government take warrants or other equity with the loans?  The bailouts of the banks and AIG came with grants of equity.   

More Lawsuits

Icahn's investment partnership, an investor in the buyout of Realogy Corp. is suing to prevent the company from refinancing $1.1 billion in debt (a workout).  The $1.15 billion in old debt, below, Ichan's will be transformed into $500 million new debt, of which $237 is senior to Ichan's.  Not so fast, says Icahn, the move violates my debt covenants.  He, in essence, is unwilling to take a hit in the workout.  Realogy with threaten bankruptcy as an alternative and the parties with play a game of chicken in a tense negotiation.  Ichan will win. 

Novel Lawsuits Fly

A hedge fund, run by William Frey, has sued Countrywide and its parent, Bank of America, on their agreement with 15 state attorney generals to modify 400,000 mortgages originated and serviced by Countrywide.  In the lawsuit the hedge funds states that the settlement is fine but that Countrywide has offered to modify mortgages that it no longer owns - investment trusts own them.  The hedge fund, an investor in securities issued by the trusts and backed by the securities, says that Countrywide must repurchase the mortgages in the trusts at par in order to modify them.  The outcome of the case will turn on the contractual language in the pooling and servicing agreement between Countrywide and the investment trusts. If the hedge fund prevails, Countrywide will have to pay MBS security holders to modify the mortgages (with government bailout money??) A demand for redress, filed with HUD and awaiting HUD action, alleges that subprime mortgage originators discriminated against minority groups in pushing and selling subprime mortgages.  These will be just two of many, many lawsuits that will occupy lawyers for years as a result of the mortgage default crisis.

Sign of the Times: Insolvency Clauses Come the Fore in Stock PUrchase Agreements

For some time a buyer attempting to bust a signed leveraged buyout agreement would rely on the Material Adverse Change Clause, now buyers are relying on insolvency clauses.  In the Bell Canada buyout the buyers are claiming that a buyout would result in an insolvent company, triggering walk rights in the buyout agreement.  Insolvency clauses are a bit more poignant that MAC clauses, and we will see whether courts are more tolerant of the excuse than they are of MAC clauses.

Cerberus Reads Its Covenants

Cerberus has just read the covenants in its stock purchase agreement with Daimler Benz for 80 percent of the stock of Chrysler and has decided that Daimler "intentionally and materially" violated the value of its lease and loan portfolio.  This will end up in court on the contract language.  Proving again that contract language matters when deals do not work out and that lawyers "bothering" clients about contract language are doing their clients a real, valuable, often under appreciated ("don't kill the deal"!!) service.

Tax Losses and the Banking Crisis

Treasury, by two rule changes, has changed the tax loss carry forward rules for banks.  On September 30th, Treasury decided that a buyer of a troubled bank could use all the tax losses of the selling bank to offset the buyer's taxable gains.  It was a $100 billion change.  In October, Treasury decided that a bank receiving TARP money (bailout funds), could carry forward tax losses longer.  The second rule added value to the first, attracting buyers to banks with old tax losses.  Now foreign banks want the break, adding that it is unfair that only domestic banks get the benefit of the new rules.  Soon other buyers of failing non-banks (auto companies???) will want the benefit of the new rules.  This decidedly lack of principled approach to crisis should led to a reexamination of the principle of limiting tax loss carryovers for everyone -- a rule that was borne to limit tax shelter abuse and was applied too broadly.  The new rule should be tailored to limit abuse while still permitting liberal use of tax losses in acquisitions where there is no abuse. 

Tuesday's $800 Billion Credit Market Bailout: An Incentive to Sercuritize??

Monday was the Citigroup bailout and Tuesday was the $800 Billion credit market bailout.  The goal of the new bailout is to free up credit in consumer credit markets -- mortgages, car loans, student loans, and credit card loans.  The mechanism of choice is interesting -- $200 billion (in a Term Asset Backed Securities Loan Facility --TALF) and $500 billion to buy MBSs (mortgage backed securities) guaranteed by Fannie Mae and Freddie Mac.  The government is buying ABSs (asset backed securities) generated by the now notorious securitization process (structured finance).  Academics and journalists argue that the securitization process so dilutes accountability that no one is responsible for taking excessive risks (the borrower, the originator, the bundler, the rating company, the underwriter).  So to get people to loan we are going to stimulate the securitization process, reward the securitization process, by buying securities securities to encourage more borrowers, originators, bundler, and underwriters.  Great.

Geithner, The New Treasury Secretary: There is Nothing "New" About Him

The markets soared on Friday on the announcement of Tim Geithner as the "new" Secretary of the Treasury.  But just how "new" is he?  He was Paulson's "go to guy" as President of the largest Federal Reserve Bank in New York and put together the disastrous AIG bailout, which is still absorbing money.  He also was in on Bearn Stearns deal and the decision not to bailout Lehman (which, if we believe whispers, he opposed - very, very quietly perhaps, so quietly no-one heard him).  So we have a player in the jerky jerky bailout planning-- which is, as far as I can tell, is to throw loads of money at everything, something will work (the Harvard Law faculty hiring policy) out eventually and they can take credit.  Not a great choice; Obama is rewarding those who have made mistakes. 

The Citigroup Bailout: More Confusion

The markets hailed the fact of the Citigroup bailout, but we are just now digesting the details.  Last month Treasury bought $25 billion in preferred stock and warrants (at-the-market and equal to 10% of the value of the preferred).  Yesterday, the Treasury bought an addition $20 billion in preferred stock and warrants. The second batch of preferred stock pays an 8% dividend; the first batch pays 5% for five years and 10% thereafter.  The new batch restricts dividends on common to $.01 a share for 3 years without Treasury's consent; the old batch restricted an increase in dividends on common.  All the preferred is non-voting.  The big change is in control of executive compensation.  The new preferred requires that any compensation plans must be submitted to and approved by the "USG." The old preferred had open-ended compensation "standards" and a ban on oversized golden parachutes.  But wait.... there is something completely new... a government guarantee on a $306 billion pool of Citi's mortgage-backed securities (not 100% but with total exposure of $249 billion) in exchange for another $7 billion in preferred ($3 billion bought by the FDIC).  This new wrinkle fuels the ad hoc nature of bank bailouts and adds to market uncertainty over the bailout program.  The FDIC involvement hides a spirited debate between Paulson and Blair over the extent of FDIC exposure, an inter-agency debate that affected the final plan.  We also note with much interest that Robert Rubin, the new man behind the scenes in the Obama economic team was on the Citi board.  Who is in control here and who is making policy??? Now we wait for the new heavily negotiated, company specific bailout and wonder about transparency, standards and political power.  Wonderful way to calm the markets. 

The new bailout protects Citigroup debt and does not, yet anyway, dilute the common stock significantly.  The price of Citi common rose on the announcement.