Ideoblog

The dark side of nationalizing the banks

It’s true that the banks didn’t do so well lately in private hands. Will they do much better if they fall into public hands? Consider this (HT MR):

The worry is that if the government cannot or will not extricate itself from Fannie and Freddie, it will face similar problems should it eventually nationalize some large banks. The lesson, many fear, is that a takeover so hobbles a company’s finances and decision making that independence may be nearly impossible. * * *

On Monday, Freddie Mac’s chief executive, David M. Moffett, unexpectedly resigned less than six months after he was recruited by regulators, having chafed at low pay and the burdens of second-guessing by government officials * * *.

Fannie Mae has also experienced a wave of defections as people leave for better-paying and less scrutinized jobs. * * *

[T]he takeover has provided legislators with a long-sought ability to influence the mortgage marketplace directly and pursue social goals like low-income housing.* * * “When you use mortgage companies for political purposes, such as helping low-income borrowers or expanding homeownership, you make bad economic decisions,” said Mr. [Scott] Garrett, the Republican congressman. “And bad economic decisions are why we’re in this trouble right now.” * * *

Lawmakers say they are unlikely to begin serious discussion about the companies’ futures until this fall.

So, should we solve the problem of the banks being profligate with shareholders' money by having the banks be profligate with taxpayers' money? 

AIG, Pee Wee Herman, and the brave new world of finance

Like some horror film franchise, AIG is back. After getting $85 billion credit last September, increased to $123 billion in October, then to $150 billion in November, AIG earns $30 billion in TARP money by its record-breaking $62 billion loss. The US Treasury now will have huge equity stakes in AIG and two life insurance subsidiaries. Moreover, per the WSJ, the government may have to finance buyers of AIG's aircraft leasing business. 

So, taxpayers, what do you think about the government ponying up a quarter trillion for an insurance company, with a little aircraft leasing on the side?  As I said about last September's AIG bailout:

Was this an emergency? * * * One might say that it’s more like Pee Wee Herman: a bunch of grownup companies living in a child's world in which real estate prices always go up. When they go down, should we prop up the stage set anyway?

The rationale, of course, is that this is about protecting from future systemic risk. So rather than thinking about what can't he helped, we should focus on whether this is the best plan going forward.  And that's what has me really worried.

As I suggested last September, the real danger here is that AIG’s new owner, the government, may be no better, or even worse, than AIG’s old owners and managers.  Consider that we got to this point in part because of the government -- specifically, because the government was asleep at the regulatory switch.

AIG was supposedly insuring risky paper for both banks and money funds.  AIG got fees, the banks and the money funds got to look better. The problem is that AIG's plan for covering the risk was to assume, along with everybody else (as I discussed last September) that real estate prices would only go up. In other words, everybody was living in a Pee Wee Herman-like fantasy world. 

Joe Nocera described this as a huge “scam” that existed with regulators' consent:  

Here’s the crux: It’s not as if this was some Enron-esque secret, either. Everybody knew the capital requirements were being gamed, including the regulators. Indeed, A.I.G. openly labeled that part of the business as “regulatory capital.” That is how they, and their customers, thought of it.

* * * A.I.G. helped create the illusion of regulatory capital with its swaps, and now the government has to actually back up those contracts with taxpayer money to keep the banks from collapsing. It would be funny if it weren’t so awful.

In fact, its even worse. The government is bailing out AIG because AIG undermined a system that the government was supposed to be, but wasn't, protecting. And now who's in charge?  The government, of course.

And that's not all. How are we going to pay for all this? In (very small) part by taxing an important solution to the corporate agency costs that got us into this mess – venture capitalists who we hope will fund new jobs, and the private equity fund managers that we hope will help clean up the existing companies' mess. The Obama plan is to have them help pay down the deficit by raising the tax on their carried interest from 15 to 39%.

As discussed here, venture capitalists are properly incensed:

The capital gains rate essentially gave firms a buffer to weather failures while waiting for something like Google or Genentech to hit the bigtime. According to VentureBeat, this has been the general consensus among investors, who say the industry will probably place its bets on safer, less innovative concepts if the Obama plan is implemented — and the results will run counter to the administration’s other major goals, namely energy efficiency and cost-effective health care.

Many are also concerned that V.C.s will be less inclined to invest as much time working alongside portfolio companies to help refine their business models and foster growth, the publication says.

[Mark Heesen, president of the National Venture Capital Association] told VentureBeat, “We are involved in long-term job creation, and if that’s not worthy of capital gains taxes, I don’t know what is.”

And how much will we get from the tax raise?  According to the administration, $2.7 billion in 2011 and $4.3 billion in 2012. Compare that to $250 billion for AIG alone.  And that assumes that the venture capitalists and private equity managers actually will pay the tax, instead of shifting their structures and incentives to avoid it. 

In short, the AIG bailout is in part the price we're paying for government failure.  The plan will "solve" that by putting government in charge.  At the same time, we're going to pay for a pitifully small part of this by diluting the incentives of the market actors who could get us out of this fix.

As Nocera says, it would be funny if weren't so awful.

The Oracle talks about mortgages and the financial crisis

From Warren Buffett's Letter to Shareholders (HT CR):

I will write here at some length about the mortgage operation of Clayton Homes and skip any financial commentary, which is summarized in the table at the end of this section. I do this because Clayton’s recent experience may be useful in the public-policy debate about housing and mortgages.* * *

The present housing debacle should teach home buyers, lenders, brokers and government some simple lessons that will ensure stability in the future. Home purchases should involve an honest-to-God down payment of at least 10% and monthly payments that can be comfortably handled by the borrower’s income. That income should be carefully verified. Putting people into homes, though a desirable goal, shouldn’t be our country’s primary objective. Keeping them in their homes should be the ambition. * * *

Clayton’s lending operation, though not damaged by the performance of its borrowers, is nevertheless threatened by an element of the credit crisis. Funders that have access to any sort of government guarantee – banks with FDIC-insured deposits, large entities with commercial paper now backed by the Federal Reserve, and others who are using imaginative methods (or lobbying skills) to come under the government’s umbrella – have money costs that are minimal. Conversely, highly-rated companies, such as Berkshire, are experiencing borrowing costs that, in relation to Treasury rates, are at record levels. Moreover, funds are abundant for the government-guaranteed borrower but often scarce for others, no matter how creditworthy they may be.

This unprecedented “spread” in the cost of money makes it unprofitable for any lender who doesn’t enjoy government-guaranteed funds to go up against those with a favored status. Government is determining the “haves” and “have-nots.” That is why companies are rushing to convert to bank holding companies, not a course feasible for Berkshire. Though Berkshire’s credit is pristine – we are one of only seven AAA corporations in the country – our cost of borrowing is now far higher than competitors with shaky balance sheets but government backing. At the moment, it is much better to be a financial cripple with a government guarantee than a Gibraltar without one.

Today’s extreme conditions may soon end. At worst, we believe we will find at least a partial solution that will allow us to continue much of Clayton’s lending. Clayton’s earnings, however, will surely suffer if we are forced to compete for long against government-favored lenders.

So, to summarize: 

1. Making loans to borrowers that they couldn't and didn't want to repay was bad business.
2. The poorly managed lenders that did that are now being rewarded with government guarantees.
3. The well-managed lenders that did not do that are being punished because they can't compete with the guarantees.

Buffett is often referred to as a genius.  But maybe the secret of success, and good public policy, is just not being stupid.

Citigroup, AIG and the uncorporation

The Delaware chancery court has decided two very important cases arising out notorious cases of managerial malfeasance or neglect – In re Citigroup Inc Shareholder Derivative Litigation, decided last Tuesday, and American International Group, Inc. Consolidated Derivative Litigation, decided February 10. '

The bottom line is that Chancellor Chandler dismissed a Caremark bad faith monitoring claim in Citigroup, but VC Strine let the Caremark claim proceed in AIG. Chancellor Chandler let a waste claim proceed in Citigroup based on approval of excessive compensation for Prince. Note that both cases came up on demand excuse/refusal issues, so there may be a lot more litigation to come.

I don’t need to exhaustively analyze the cases here, because they’ve been well discussed elsewhere, notably including Francis Pileggi’s discussions of Citigroup (with links to other discussions) and AIG. But I will emphasize a couple of points relating to this blog’s themes.

First, critics of Delaware indeterminacy will have a field day. Yes, one can distinguish the two Caremark claims on the ground that AIG involved claims of criminality and insider trading. But one can also ask lots of questions about how much redder the flags have to be without those elements. Also, as to the Prince compensation claim in Citigroup, there wasn’t much discussion of the Supreme Court’s Disney decision dismissing a claim for excessive compensation.

Anyway, I’ve argued that indeterminacy is more the corporation’s fault than the court’s, which brings in my next couple of points.

Second, let’s think about the Caremark claims rejected in Citigroup. Plaintiff alleged that the board (a majority of whom had also been on the Enron board) ignored problems “brewing in the real estate and credit markets” starting in 2005.

And, indeed, that’s probably true. Recall that the financial community as a whole basically bet their companies on the dubious proposition that real estate prices would keep going up, and kept the bet going amid signs that the vast Ponzi scheme that was the real estate market was starting to unravel.

However, the court rightly held that this is not the sort of deliberate failure – like a complete absence of any oversight system – that will establish Caremark liability. Basically, as long as you’re going through the motions and not ignoring distinct whiffs of smoke and bright flashes of fire you’re ok.

And as Chancellor Chandler pointed out, it has to be that way. The court simply cannot get into the habit of second-guessing business decisions, particularly when this second-guessing leads to personal liability and the extreme risk-aversion that breeds.

So the case is not wrongly decided, but it shows clearly why at least one prong of the corporate monitoring system – fiduciary duties – provides very little assurance that corporate managers are actually doing their jobs. The other prongs – shareholder voting, director oversight – similarly provide little comfort. That’s why, as I’ve discussed (most recently here, with other links) we need uncorporations, particularly in the financial sector.

Third, and perhaps most intriguingly for me, there’s the question of how these cases relate to a notable recent Delaware Supreme Court case dealing with a publicly held LLC, Wood v. Baum. As I’ve discussed, Wood indicates that the court will apply a lighter contractual standard of care in uncorporate cases, rather than adhering to the rigid corporate standard regardless of business form.

Interestingly, while VC Strine did not discuss Wood in AIG,Chancellor Chandler discussed and cited Wood several times in Citigroup. So what is going on here? Is Wood spilling over into the corporate realm or not?

Chancellor Chandler arguably was merely citing Wood for the proposition that the court will apply whatever the applicable standard is in determining excuse. Yet the Chancellor never indicated any difference in standards. That’s despite the fact that the operating agreement in Wood arguably did apply a looser standard of care -- “bad faith violation of the implied contractual covenant of good faith and fair dealing” -- than the one applicable in corporate cases under 102(b)(7). This standard suggests that to be liable you not only have to violate the contract, but you have to do so in bad faith. By contrast, the corporation statute does not allow waiver of the duty of loyalty, which can include some version of Caremark duties.

In short, Citigroup says that whether demand is excused in both corporate and uncorporate cases depends on the applicable fiduciary standard, whatever that might be. This doesn’t preclude the possibility of applying a lower contractual standard in an uncorporate than in an uncorporate case. There is no problem with all that. But I'm concerned that convergence of corporate and uncorporate standards could have the perverse effect of transmitting the corporate virus to uncorporations -- inflexible rules and costly indeterminacy. 

What I wish the President hadn't said

Yesterday I suggested that hope for our economy lies in the "incredible creativity that has been unleashed on the world by our vibrant economic system."

In that vein I wish the President last night had told Congress something like this:

The weight of this crisis will not determine the destiny of this nation. The answers to our problems don’t lie beyond our reach. They exist in our laboratories and universities; in our fields and our factories; in the imaginations of our entrepreneurs and the pride of the hardest-working people on Earth. Those qualities that have made America the greatest force of progress and prosperity in human history we still possess in ample measure. What is required now is for this country to pull together, confront boldly the challenges we face, and take responsibility for our future once more.

Oh, wait. He did say that.

The problem, as discussed by Holman Jenkins, is that he went on (and on) to talk about a lot of other stuff that no longer makes sense, if it ever did, particularly including (in Jenkins' words) “rais[ing] taxes on small business, on investment, and on the incomes of the most productive job creators.” In other words, not harnessing our creative efforts but dissipating them in stuff that no longer makes sense, if it ever did.

The President is going to have to decide soon enough which part of his speech he really believes.

More on the uncorporation and investment banking

James Glassman and William Nolan get on the Michael Lewis bandwagon in today's WSJ by arguing that that the root of Wall Street's excessively risky ways was abandoning the partnership model:

[I]n a $14 trillion economy, you can't hire enough overseers to pore over everyone's books. There is, however, a better solution: expose players in the financial game to greater personal loss if their risk-taking fails. When you worry that a mistake will cause you to lose your second home, your stocks and bonds and your club memberships, then you're less likely to take the kinds of risks that expose the rest of society to your failures. A simple mechanism exists to achieve this purpose: the private partnership. Partners face liability that extends to their personal assets. They aren't protected by the corporate shield that limits losses to what the corporation itself owns (as well as the value of the stocks and bonds the corporation has issued). * * *

[I]nvestors -- and governments -- should recognize the extra safety inherent in doing business with partnerships. In the end, the partnership -- not more regulatory intrusion -- is an efficient, even elegant, answer to the thorny risk-mitigation problem. Partnerships are less likely to make big mistakes, but, even if they do, their smaller size means they pose less of a threat to the financial system as a whole, and to the taxpayers who have to pay for the clean-up.

I have for months been making a similar argument about the role of the corporation's role in Wall Street collapse.  See, e.g., here, here, here, here, and here.  My longer paper, which itself caps years of research and publications and antedates the meltdown, is here. A shorter version will be published soon in the University of Chicago Law Review, and this is part of my longer book-length project on the Rise of the Uncorporation.

My specific remedy is not, however, the same as Glassman, Nolan and Lewis.  I don't think we should necessarily go back to the general partnership, with partner liability. Over the last generation, better governance technologies have evolved through private equity, venture capital and hedge funds.  This should be the model for the reorganization of Wall Street, and much of the rest of what used to be called "corporate" America.

A corrective rant

Well, since every story you read now is about how bad things are, I thought I would offer a corrective: “We live in an amazing, amazing world, and it's wasted on the crappiest generation of spoiled idiots."

Now let's apply this to our current economic situation.  Inventions like airplanes, the internet, and internet in airplances result from the incredible creativity that has been unleashed on the world by our vibrant economic system. Bill Gates made a lot more money for the rest of the world than he did for himself.  There's potentially a lot more where that came from. How can we predict what's next?

And yet mostly what we hear is about the greed of business people and how our infinitely wise government leaders will get us out of our current situation by nationalizing and regulating everything, including incentives.  Our leaders are so wise that they can predict the deficit out to 2019, as the President did a couple of days ago. Who predicted the current world in 1999?

While I have no data to support this, I suggest that one of the things the market is suffering from right now is what I would call the "hopelessness of audacity."  I would prefer from our leaders less audacity and more hope.

Handouts and incentives

The NYT’s Thomas Friedman said yesterday:

You want to spend $20 billion of taxpayer money creating jobs? Fine. Call up the top 20 venture capital firms in America, which are short of cash today because their partners — university endowments and pension funds — are tapped out, and make them this offer: The U.S. Treasury will give you each up to $1 billion to fund the best venture capital ideas that have come your way. If they go bust, we all lose. If any of them turns out to be the next Microsoft or Intel, taxpayers will give you 20 percent of the investors’ upside and keep 80 percent for themselves.

That’s a lot better than some ideas I’ve heard. But it misses some of the point. Friedman reasonably guesses VC funds will do a better job with the money than other possible recipients because they’ve done a good job in the past helping grow the economy. But it is important to understand that they did so not because they were called “venture capital” or because of some accident of nature but because, unlike now-moribund banks and investment companies, they got the incentives right. This was a product of their “uncorporate” governance structure, as I’ve stressed repeatedly (e.g.).

The incentives include managerial compensation. Friedman recognizes they need to keep some of the gain.  They also should be subject to discipline, such as giving investors access to the cash through distributions and limited life. And the same goes for hedge and private equity funds, which bring similar incentives to bear on more mature firms.

This raises some important questions.  How much of that 20% compensation that Friedman is allotting to the fund managers will they get to keep after the taxes on fund manager compensation Congress is promising?  Also, to the extent that managers are disciplined by investors' demand for the cash, how does that work when the investor is the US government?  If we're going to continue to rely on non-government investment, what will their incentives look like under the new tax regime the President and Congress are threatening?

On the latter point, note that it was the reduction of individual rates in the 1980s that fueled the rise of partnership-type entities in which there is no tax penalty on distributions. Raising those rates could well return us to the higher corporate agency costs of the pre-Reagan era.

The basic point is that even more important than throwing money around is getting the recipients’ incentives right.  I don't see any sign the government is moving in the right direction on that front.

California's anti-employment bill

One would think that with labor (and other) markets in the tank, our lawmakers would be working on ways to bolster them rather than tear them down. And that states would be trying to compete for business rather than driving it away.

Choice of law and choice of forum provisions are powerfully pro-market, as discussed at length in my and Erin O’Hara’s new book, The Law Market (first chapter and summary here). Among other things, the market for law backed by these contract provisions provides predictability, deters wasteful forum-shopping, coordinates law in a world where all contracts cross geographic borders, and disciplines interest group attempts to pass laws that impose costs on society.

To be sure, it is also the case that choice of law and forum can undermine efficient state regulation. But state lawmakers need to take a nuanced approach to invalidating these clauses. And that's not just because enforcing the contracts can serve public policy. Contracting parties always have the option of avoiding the state completely, hurting its residents. Moreover, the firms whose contracts are thwarted can turn to Congress for protection and add to the increasing marginalization of state law.

Unmindful of all that, a stupid bill in the California legislature would invalidate all choice of law and forum selection clauses in contracts for employment in California. Here’s the bill via California Civil Justice Blog and PoL.

“Nuance” is something this bill avoids assiduously. Many states void some choice of law and forum clauses that would undercut some kinds of mandatory provisions. This bill applies to any employment contract. Even to the ceo of a Fortune 500 company? It protects not only mandatory state laws but also default rules.  This prevents interstate firms from getting standardized interpretation of their contracts even where this would not interfere with state policy.

Not only that, the bill includes an escape clause that is sure to provide ample grist for litigation:

(d) Nothing in this section affects the right of an employee to voluntarily agree to a choice of law or forum selection provision that is not required as a condition of employment and that is the subject of independent consideration.

Does this mean that the job can have two pay scales – minimum wage without the clause and 100,000 a year with? Or what?

O’Hara and I do recommend in our book that if states are going to outlaw these clauses, they do so by explicit statute rather than by court decision. That gives competing interest groups a chance to fight it out in advance (this bill has already gone down once), and affected parties an opportunity to avoid states that impose these restrictions on contracting. 

Is that what the legislator who introduced this monstrosity, Felipe Fuentes, has in mind – less employment in California to go with an already tailspinning economy and 42 billion dollar deficit?

The Obama market

Evidence is here (HT TOTM). 

As suggested by one of the comments to the post linked above, somebody should study market reaction to Obama-favorable events through the election campaign. I suspect even before November the market had the sign (though not the magnitude!) of the Obama effect. 

Iseman suit settles

I wrote in December about Vicki Iseman's suit against the NYT for falsely insinuating she had an affair with McCain. I thought the suit posed a risk to the Times' fraying reptuation. 

Now the suit's been settled.  Here's the story from Politico, via Overlawyered.  The Times is publishing what an assistant managing editor called a "sui generis" "Note to Readers":

The article did not state, and The Times did not intend to conclude, that Ms. Iseman had engaged in a romantic affair with Senator McCain or an unethical relationship on behalf of her clients in breach of the public trust

You decide if it's a retraction. At any rate, it would have been more in keeping with Times' traditions if the story had been written so that it did not require this clarification.

Cell phones in public: the revenge plan

About four years ago, totally fed up with loud rude cellphone users, I wrote this:

A self-help plan occurred to me a couple of weeks ago as I waited for a plane in the Indianapolis airport. Just across from me a guy filled the terminal with news of the accounting problems the university he worked for was having regarding a major gift, and how he was planning to deal with them. He was talking so loudly I could barely make out the details of the LLC operating agreement the guy down the row was drafting over the phone.

Here's my plan: do what you can to piece together the details of the conversation. Then ask the speaker some questions to fill in the blanks. If the speaker is annoyed, flustered and suddenly reticent, point out that you're curious enough to turn to Google for help with the rest. It would be nice if you could figure out your seatmate's name, from the conversation, briefcase, laptop screen, or whatever. * * * [D]oing this on a large scale might cut the rude, self-important creeps down to sizes

Now consider this, from ATL:

Last night, we received this information, from a law student traveling from D.C. to New York: This afternoon I boarded a train from Washington bound for Penn Station.... I, along with all of the other passengers, were sitting quietly when the man directly behind me decided to make a phone call using his bluetooth. He was talking so loudly that I think most people in the car were able to hear him. His conversation, though he stressed how necessary it was to be kept secret (ah, the irony), detailed the current plans of Pillsbury to lay off somewhere in the range of 15-20 attorneys from four offices by the end of March, including a few senior associates with low billable hours and two or three first-year associates.

The caller identified himself and named names over the phone. All of this, plus the names and partial verification, is laid out for ATL's thousands of readers.

My reaction:  AHHH!

The SEC: from fraud accessory to quack corporate governance

The SEC has been a miserable fraud watchdog – perhaps even Madoff's unwitting accessory. So what is it doing now?  Seeing how much it can mess up corporate governance. Per Dealbook, SEC Commissioner Elisse Walter has joined Chair Mary Schapiro in backing say on pay and shareholder access to board nomination.

I've described say on pay as "quack corporate governance." As I've said:

Efficient compensation must be crafted on an individual-by-individual and firm-specific basis to provide the right incentives and attract the best people. It's like designing a product. Can anybody seriously believe that shareholders en masse can make a meaningful, intelligent, up-or-down decision on executive compensation?

Here I note:

Unions already have secured an extensive executive compensation disclosure rule to whip up populist resentment about executive pay. The next step is to create a mechanism to bring that resentment to bear in corporate elections. * * * They are not seeking to represent the interests of investors generally. Their ideal is the sclerotic European firm, with its labor representatives on the board.

I added that say on pay also provides a basis for litigating board elections, increases benchmarking of compensation, increases firms' incentives to manipulate compensation, and spurs the drain of talent from publicly held firms.

Perhaps more importantly, as I discussed here and here (the latter summarizing my testimony before the SEC), these nuances of corporate governance -- executive compensation and director elections -- are best covered by state law.

These observations are more important than ever. We’re trying to get firms moving again, not hobble them. Politicizing corporate governance, distorting incentives, giving unions more leverage, etc, do not seem like ways to do this.

The SEC has not even been able to do its main job of policing obvious frauds. We should not expect it to do a better job mucking around in the sensitive arena of internal corporate governance.

Bebchuk vs. blindingly stupid pay rules

Harvard’s Lucian Bebchuk, perhaps the leading academic critic of executive pay, has found a regulation of executive pay he didn’t like – the stimulus bill. Here’s what he says in today’s WSJ:

Mandating that at least two-thirds of an executive's total pay be decoupled from performance, as the stimulus bill does, is a step in the wrong direction. * * *

[T]he value of some banks' common shares might largely represent an "out-of-the-money option," expected to deliver value only if things considerably improve. In such circumstances, restricted stock may provide incentives for executives to take excessive risks with the bank's survival. * * *

The bill provides executives with counterproductive and unnecessary private incentives to terminate or avoid TARP funding, even when doing so would not be in the bank's best interest.* * *

Public officials should be wary of introducing new distortions and perverse incentives. With so much hanging in the balance, ensuring that those running the country's banks have the right incentives is as important as ever.

Sounds familiar. As I noted (discussing a column by Jason Zweig) with respect to the intially proposed paycaps:

paycaps let covered executives get preferred stock that they can cash in the minute taxpayers get their money back. This encourages the managers to bet the bank – heads I win (and get paid), tails you lose (bank goes bust). Sounds like the sort of perverse, short-term incentives that got us into this mess. 

See also my other criticism of the paycaps here and here.

Academics often do not seem to understand when they propose regulatory fixes that they do not control the lawmaking process. I and many others have pointed out that whatever problems there are with executive pay are best fixed by the market than by turning regulators loose amid populist angst over high-paid executives. Professor Bebchuk, at least, is now learning about the dark side of regulating governance. I fear he may have his eyes opened further over the next few years.

Does NY have a law on LLCs?

Courtesy of Peter Mahler we learn of the NY courts' latest foray into what is now the impenetrable murk of NY LLC law. The NY Appellate Division has held in Gottlieb v. Northriver Trading Co., LLC, 2009 NY Slip Op 00432 (1st Dept Jan. 27, 2009) that an LLC member has a right to an equitable accounting, though none is provided for in the LLC statute. 

Readers will recall that the Court of Appeals held a year ago in Tzolis v. Wolff that LLC members had a right to bring a derivative action though, again, none was provided for in the statute. Now the court is adding the accounting actiong to this mishmash. 

This is no minor detail.  As Mahler says,

the accounting involves more than simply turning over existing financial records. In New York practice, if the court grants an accounting, it may order the fiduciary to prepare a "long accounting" with detailed schedules of income and expenses over a defined period, followed by the filing of objections to the accounting, followed by proceedings before a court-appointed referee to hear and determine the accounting.

For a discussion of the partnership accounting, see Bromberg & Ribstein on Partnership, Section 6.08.

Mahler notes that the trial court in Gottlieb had dismissed the complaint because defendant provided all of the documents that it is required to provide" under LLC Law Section 1102. It further held that the "plaintiff is not entitled to an accounting merely by virtue of her status as a member of the limited liability company" and that "there is nothing in the LLC Law to suggest otherwise."

But the Appellate Division reversed, holding:

Contrary to the court's ruling, members of a limited liability company may seek an equitable accounting under common law. The assertion that such members are limited to statutory remedies with regard to potential fraud is inconsistent with the reasoning in Tzolis v Wolff (10 NY3d 100 [2008]). Furthermore, while plaintiff's sole claim was for an accounting, the ad damnum of her complaint did seek monetary damages based on misallocation of the company's assets, and the case should thus be permitted to go forward.

This is the only LLC case I know of analyzing a member’s right to an accounting in an LLC. The other cases holding in favor of accounting that I know of are all in NY, and none has significant analysis: East Quogue Jet, LLC v. East Quogue Members, LLC, 2008 WL 1903793 (N.Y. App. Div., April 29, 2008); Lio v. Zhong, 2006 WL 37044 (N.Y. Sup. 2006) (noting that accounting is an equitable proceeding); Zulawski v. Taylor, 2005 WL 3823584 (N.Y. Sup. 2005). Thorpe v. Levenfeld, 2005 WL 2420373 (N.D. Ill. 2005) (Ill. law) denied an equitable accounting in the absence of an allegation that plaintiff had no adequate remedy at law).

As discussed in Ribstein & Keatinge 10:4, LLC statutes do not generally provide for an accounting. There I note that modern pleading and joinder rules and the accounting’s basis in the “outmoded aggregate theory of partnership in which litigation generally accompanies dissolution of the firm” support accounting being “neither an exclusive, nor even a predominant, remedy in LLCs.”

Mahler asserts:

Whether one agrees or disagrees with Tzolis, it's hard to quarrel with the First Department's implied prediction that the Court of Appeals likely would apply similar reasoning to uphold an LLC member's common law right to an accounting. Gottlieb can be viewed as another step toward New York's judicial homogenization of the closely held business entity, in which court-imposed fiduciary obligations and common law remedies are imported and spread evenly across partnerships, business corporations and now limited liability companies. For better or worse, this is in sharp contrast to the emerging Delaware model in which LLCs are "creatures of contract" and the courts are loathe to impose duties or create remedies outside the four corners of the members' operating agreement.

I disagree with much of this. To be sure, Gottlieb is part of the misbegotten legacy of Tzolis, which by judicial fiat inserted the derivative remedy in the LLC statute despite strong evidence of contrary legislative intent. Here’s my criticism of that “highly questionable” case. But beyond that, nothing is "likely." Part of the problem with Tzolis is the unpredictability it invites. If the court’s going to add stuff to the statute, where does this end?  Even NY courts have recognized that the statute isn't infinitely flexible.

In particular, I disagree with Mahler that the Gottlieb result follows clearly from Tzolis. To begin with, as noted above, the accounting remedy arguably does not belong in LLCs. Moreover, the accounting is actually inconsistent with Tzolis. As I discussed in connection with Tzolis:

the court wrongly observed that without derivative suits there would be "no remedy when corporate fiduciaries use corporate asssets to enrich themselves. . . . they are the one that has been recognized for most of two centuries. In other words, Tzolis got to its result by accepting the corporate analogy and suggesting that only derivative suits are appropriate and therefore that plaintiff would be without a remedy if the court didn’t add the derivative suit to the statute.

Thus, recognition of the accounting remedy is inconsistent with both the Tzolis court’s reasoning on legislative intent and its application of the corporate analogy.

In short, Tzolis has thrown NY LLC law totally off the rails. It is now wholly unclear not only what the LLC statute does and does not provide for, but even how the court should fill the resulting gaps. The courts have now said that since the LLC is like a corporation it has only the derivative remedy, and that since it is like a partnership it should have the accounting remedy.

It is worth adding that the NY courts are wrong on both accounts. The LLC is not like a corporation and it is not like a partnership. It is an LLC. As discussed here, that is why the derivative remedy is not appropriate for LLCs either.

And whether or not I'm right on that score, surely NY firms are entitled to know what the law is so they can plan accordingly. The courts and legislature have failed them there. Contrary to Mahler's assertion above, this is not about sticking to the contract. This is about sticking to the law.  Moreover, if Mahler is right that NY courts also won't stick to the contract, then what refuge would NY firms have?

NY firms wanting to be LLCs would be well advised to look to other statutes, including Delaware’s, until their lawmakers get the law straight and vow to stop deciding LLC cases on an ad hoc basis.

Madoff and the class action bar

I’ve described the SEC as an “unwitting accessory” to Madoff’s fraud. Now there’s a suggestion that another cog in the government’s anti-fraud machinery might also have been involved.

Walter Olson reports on correspondence from securities lawyer and Milberg Weiss critic Howard Sirota that Madoff’s investor list includes not only Mel Weiss as previously reported, but also his wife, son Stephen A. Weiss, partners David Bershad and Pat Hynes, plaintiff Howard Vogel, accountants Buchbinder Tunick, and class action firms Wolf Popper and Wolf Haldenstein.

Olson adds:

Sirota believes that other persons and entities on the Madoff victims list have also served as lead plaintiffs in securities litigation or as plaintiffs in other litigation handled by class-action firms. All of which could be mere coincidence, or could suggest that either Madoff himself or others in his circle might have played some role in funneling lead plaintiffs to the class-action bar. (Particularly in the “race to the courthouse” era that preceded the Private Securities Litigation Reform Act, having a stable of cooperative repeat plaintiffs was vital to the success of many plaintiff’s firms.)

One way to check this thesis, Sirota suggests, would be to check the names on the Madoff victims list against those on the list of plaintiffs maintained by the Stanford Law School securities class action clearinghouse to see whether there are any other noteworthy matches and if so whether they follow any particular pattern.

It would be richly ironic if lead plaintiffs were “paid” with Madoff investments. Or perhaps this was just a way for Madoff to "conflict" out lawyers that might one day want to sue him.  In any event this looks like a story worth following.

Even more blindingly stupid paycaps

When the initial Treasury paycaps were announced I said "[t]his is so blindingly stupid that it would barely deserve comment but for the fact that it threatens to help further impede a desperately needed recovery." I added that "this could be a model for the future."  Here's more. 

Alas, the "future" is now.  From the WSJ:

The giant stimulus package includes a last-minute, little-noticed addition that restricts bonuses for top earners at firms receiving federal cash -- including those that already received it -- more severely than the Obama administration's previous pay limits. The most stringent pay restriction would bar any company receiving funds from paying top earners bonuses equal to more than one-third of their total annual compensation.

That bit is courtesy of Chris Dodd.  "Top earners" goes way beyond "top executives." Even worse, the banks can repay the government without raising new money -- which of course they now have a big compensation incentive to do.

"I'll bet you will see in the next month or so, banks paying back the government," said Alan M. Levine, an executive-pay attorney at Morrison Cohen LLP in New York.

As for my "model for the future" point, the WSJ notes: "The limits build on executive-pay rules announced earlier this month by the Obama administration."

There's more.  Treasury must "examine Wall Street and bank bonuses paid last year and early in 2009 to determine if they were in the public interest. The government could then try to claw back any bonuses deemed excessive."

It will be signed, and it's probably legal:  "Language in the contracts banks signed when banks took money from the Troubled Asset Relief Program allowed the government to change terms retroactively."

Some "stimulus." 

I don't want to, but I am beginning to believe that we may be in the hands of morons.

Thoughts on Black Thursday

So big law firms laid off about a thousand lawyers in a single day. That may not seem to compute with the hundreds of thousands of other jobs lost, but remember, these are lawyers. For news and analysis see Bruce MacEwen, WSJ Law Blog and minute-by-minute coverage on Above the Law.

Here's what I think is happening:

• Law firms have to keep their most mobile partners from walking. Yet they are thinly capitalized, and have this huge nut in lawyer pay and debt. 
• In order to keep the money flowing, law firms have to have lots of associates. The big partners bring the clients in, and associate time billed at high standard hourly rates keeps the partners paid. The clients pay because that’s the price of hiring the firms.
• Then markets collapse, and the clients no longer power the gravy train. The law firms are stuck with large numbers of associates who are no longer paying their keep. Firms' ppp is plummeting and big partners might walk.
• When the thin margin of capital evaporates things can happen fast. Think bank run, a la Bear Stearns and Enron. 
• In normal times the firms would lose big on reputation and recruiting if they cut associates, so they have to wait for their competitors to do likewise. At some point there’s a tipping point and they all follow.

Now here's what I think is going to happen:

• Cutting associates is obviously a short-term solution – a tourniquet, not a cure. The firms that are losing associates may improve ppp in the short run, but not to the point of keeping their biggest partners.
• In the next phase, the big partners walk, and dissolution, merger or bankruptcy will swiftly follow.
• In the longer run, we now see very clearly that running law firms as thinly capitalized worker cooperatives is not an equilibrium solution in this market.

Here are my broader thoughts on that, and some links.

News summary

Congress launches a desperate hope that we can make the present better by borrowing it from the future. Treasury dithers over how to buy bank assets without facing the reality of how much they're worth. Maxine Waters criticizes Ken Lewis, whose bank is losing billions and headed down the tubes, for raising credit card rates. Meanwhile the market, gazing dourly at all this, reacts appropriately.

More on Say on SOX

Last November I suggested letting shareholders opt out of SOX – a proposal that was also in my book on SOX with Henry Butler.

Last December, Henry Butler and I had an article in Forbes on this, discussed here, connecting it with “say on pay.”

Now Butler and I have a Washington Legal Foundation Legal Backgrounder developing the “say on SOX” idea.

I understand that this proposal bucks the groundswell for more regulation. But the WLF article shows not only why this idea is good policy, but also why it may not be as politically improbable as it might sound on the surface.