Business Law Prof Blog

FDIC and Private Equity

When will this new bunch learn.  Ms. Blair, the head of the FDIC, is running out of money to bailout the depositors of failed banks and will attempt to push failed bank purchases by healthy banks.  The problem?  She needs buyers.  She has attacked and imposed heavy capital requirements on one of the best group of buyers, private equity funds.  Now, she must eat crow and reduce the requirements and beg, beg the private equity funds back into the bank purchasing game.  The private equity folks did not cause the current crisis, traditional financial institutions, regulated by the likes of the FDIC, did.  Pick the right target folks.

SEC's Woes

The SEC has admitted that it lacks the expertise or the technology to monitor securities trading and that, therefore, it leaves such matters to the SROs, Finra and NYSE Regulation.  Yet the SEC is close to proposing rules to "regulate" trading practices, flash trading and dark pools among others.  What is wrong with this picture?  The SEC, without data and expertise, is ready to impose trading rules on the markets.  This follows a long history of the SEC micro-meddling in the market procedures and struggling with enforcement.  It should reverse course:  simplify trading rules and upgrade enforcements of the rules that are left (those against fraud).  The effect would be to let markets innovate and to deter fraud in trading.  Now we stop innovation and poorly prosecute fraud.   

SEC Once Again After Shorts

The new SEC proposal aims at slowing down short selling, again.  The proposal would force short sellers to limit sales to prices higher than the current best price offered by buyers (best bid price) of the stock.  Since stock is traded in multiple markets, to meet the rule short sellers must wait until the best bid price in mutliple markets is exhausted by sellers before they can find a buyer.  This may take time, and in the markets unknown time delay is a serious additional risk to the trade. The SEC is considering the rule as universal or as contingent on "circuit breakers," a percentage drop in the value of a stock.  This stuff is bad.  By building in a bias in favor of long positions, which is already too strong in the market anyway, the SEC encourages a boom and bust market -- the bias attaches (and people know trade on the bias as well as the fundamentals of a stock) until it reaches unsustainable heights and fails, very quickly when confidentence in the bias falls. 

Fed Extends TALF to Repair Damage

On Monday the Federal Reserve extended its program to loan cheap money to those purchasing asset backed securities (TALF).  Once again, after publicly trashing an entire industry, the securitization industry, the administration has quietly admitted that the industry's health is crucial to the country's health.  The extension of TALF is an attempt to get the securitization process back into gear after public condemnation froze all investors from buying ABSs and MBSs.  Moreover, new regulations threaten further the process (issuers must keep 5% of any deals sold through securization).  The industry would be much, much better off had the administration (I am not using Obama's name any more) and its economic advisors not jumped on the condemnation bandwagon so quickly and trashed the reputation of an industry necessary to the finanical health of the country.  Unfortunately, the TALF has had only very limited success in jump starting the new securitization pools and the dampening effect of the new regulations will not be over come by cheap loan money.  Once again, the administration is trying to play it both ways -- doesn't work.

Supreme Court to Weigh in On Executive Pay

The Supreme Court has agreed to take a case on executive pay, Jones v Harris Associates.  In case is on manager's fees in the mutual fund industry but the holding will have profound effects on corporate governance in all industries.  The question is whether a mutual fund board of directors or mutual fund investors have adequate incentives to police executive fees, in this case the fees of the mutual fund managers.  Judge Easterbrook, writing for the majority, said yes; Judge Posner, writing alone in dissent said no.  On the facts, the mutual fund paid higher fees for managers managing its large public funds that it did for the same manager managing its private funds controlled by large institutional investors.  The Court could go with the new "behavorial economic" theorists that say small investors make predictable mistakes in both voting (incumbants always win) and in investing (holding losers too long and chasing winners) and that the boards of directors selected by small investors are not accountable in fact to them.  Or the Court could go with traditional economists that argue that investors power to sell their investments is power enough to control boards and executives that invest their funds and that other paternalistic overview systems (government oversight) would be worse, stifying innovation and competition.  This case will reaffirm or change existing practice and either result will have ripples across the governance of companies countrywide.   

Hope for Change: Yes We Can Fire Bernanke

Ben Bernanke, the Chairman of the Fed, is up for reappointment.  The economists all want him reappointed.  I want him fired.  Not because his replacement will be better, she will not, but because he will get what he deserves -- credit for a mess.  I recognize that firing Bernanke would mean the Administration would admit economic mistakes so it cannot happen, but I hope for change.  Bernanke is claiming credit for "stopping the meltdown" of the finanical markets.  To analize the claim one must speculate on what would have happened had he acted differently -- he claims he averted disaster.  Did he?  I am a doubter.  I believe he made things worse.  The history will show that the panic of Bernanke, Paulson and Geithner set in on the collapse of Lehman when the commerical paper markets were under threat.  This was the date of the potential meltdown.  Reconsider:  First, why the threatened collapse of the commerical paper market?  Paulson (and his buddies) had bailed out Bearn Stearns and led Fund to believe they would bail out Lehman.  As a result Fund did not take two serious offers to buy his company and did not take steps to seek new capital.  To this day, Fund is still stunned that the trio did not act to bail him out.  A consistant public policy at the time of the Bearn Stearns collapse could have averted the Lehman debacle.  [I would not have bailed out Bearn Stearns either, forcing Lehman to sell to the Korea Development Bank.]   Second, once the commerical paper market stumbled, what should the trio have done?  One commerical paper fund had "broken the buck" on its Lehman investments.  A targeted response, would prop up the commerical paper market.  The Fed buys commercial paper (which it did and which worked).  Instead the trio went blunderbuss.  They pushed anything and everything -- a pork laced stimulus package (which has not and will not work), bailouts of insurance, automobile and financial institutions (which are bottomless pits and compromise private markets), mortgage forgiveness (which has not worked), the purchase of mortgage backed securities (which has not helped the securitization market), attacks on executive salary, attacks on private equity, empty reform of finanical regulators and of the derivative markets, and the list continues.  It is the blunderbuss approach that is painful to watch.  Bernanke is taken credit for killing a fly on the wall with an 8 gauage loaded with buckshot.  He should be fired. 

Cash for Clunkers: Free Morphine for Pain

Total up the costs and the benefits of the cash for clunkers program -- it is nuts.  The government is borrowing $3 billion at 3.5% to buy old cars, will the government get a return of over this (4% on the 3 billion)??  No.  Tax revenue is highly unlikely to increase that much just due to the program.  The benefits:  An illusory temporary stimulus of the car industry and an insignificant affect on CO2 emissions and on the use of gasoline.  The stimulus of the car industry is illusory because -- pick one -- it is temporary (once the program goes away so do the "new jobs" at dealorships, if any), people will not buy other goods, people are buying foreign cars over American cars, people are buying cars they will not buy in the future, people are buying cars they do not prefer because inventories of wanted cars (Toyota Fit) are stretched.  Economists have long noted that temporary stimulus cash grants are pointless; people take the cash and resume their pre-stimulus behavior.  Scientists have calculated the CO2 reduction and gasoline reduction as peanuts because of its small size and the fact that people will use the new cars more than the old ones (due to cheaper cost per mile).  The costs are understated.  Not only is the government borrowing money for the program that it does not have and will not have for decades, it is destroying valuble assets (the old cars, running and usable are destroyed), it is driving up the price of older cars for low enevel users, it is driving up the price of parts for the repair of older cars, and it is encouraging a bailout out mentality among the general population.  To make the point, suppose the government decided to buy and destroy all homes on which the owners had defaulted (to stop blight).  The destruction of valuable assets adds to the cost of the program.  The government is just giving free morphine to people in pain; it masks the symptoms for a while and when the gifts are over the pain returns, more severe perhaps. 

SEC Enforcement

The Wall Street Journal has an article on C1 on the "urgency" of SEC enforcement.  Listing three new settlements, BofA, GE and Greenberg, the author applauds the SEC chairman's efforts.  The headline has it backwards.  The settlements are too small, too late and come with no admission of guilt--they are pathetic.  The SEC has long spent way too much time and energy on fine tuning market mechanisms and passing new rules of behavior and far too little time enforcing the rules it has.  At time I have wondered whether we need two agencies, one for pure enforcement and a second for securities rule making.  The efforts of the first would not be compromised by the second and the good work of the first would not give a free ride to the silly efforts of the second.   

Judge Rakoff Questions SEC Settlement with BofA

A federal district court judge, charged with approving the SEC settlement with Bank of America on the Merrill Lynch deal has delayed ruling, a very unusual move, after 90 minutes of negative questioning of the presenting lawyers.  The questions were painfully obvious.  A $30 million settlement over $3.6 billion in bonuses that were not properly disclosed in a $50 billion merger???   The government paid in $45 billion.  Why were no executives sued???   Someone made decisions for BofA.  And the government and or shareholders will pay part of the fine.  Why no admission of guilt???  At some point an admission ought to be required to set up the private litigation.  The private litigation, of course, is the elephant in the room. There is much to be said for and against this confluence of public/private enforcement actions.  But for the moment let me say that the SEC ought not let the private actions have an effect on what it does -- as it seems to have here. 

Landry's Failed Buyout

Vice Chancellor Lamb, in his last written opinion before retiring, refused a motion to dismiss in the Landry's litigation over a busted buyout.  The facts are a bit odd.  The CEO had proposed a going private transaction in a cash-out merger between the company and an entity he controlled.  The price, in the low 20s, was a 41% premium over market.  Hurrican Ike hit Texas and damaged a number of Landry's holdings.  The lenders threatened to walk.  The CEO bought stock, increasing his holdings from 36% to 57%, at an average of round $13.50  a share before the lenders' threat was revealed publicly.  The special committe negotiating the deal on behalf of Landry's complained but did not stop the purchases. Then the CEO and special committe renegotiated the buyout price at $13.50 (the CEO would have broke even on his share purchases, after all he was selling shares to himself here) and negotiated a "fall back" loan to the company if the deal failed (so as to stave off bankruptcy due to a cash shortage).  The lenders again balked, for other reasons, and the company agreed to cancel the deal and enjoy the benefit of the "fall back" loan. No termination or reverse termination fees were paid.  The minority shareholders who wanted the cash for their shares in the deal sued. Lamb held that the complaint stated a cause of action against the board for breach of a duty of loyalty and waste (for the loss of the reserve termination fee).   The complaint also state a cause of action against the CEO for dominating the board and mixing buyer and CEO roles in negotiating the refinancing buyout commitment letter with the alternative "fall back" loan.   It is hard to see how the minority shareholders were injured here.         

Speculators and Regulation

The SEC is considering regulating "flash orders" and "dark pools" to discourage "high-frequency" traders and the CFTC is considering position limits on commodity futures.  The NYSE, which has been losing trading volume, will benefit if any of the changes are implemented.

Cuban Insider Trading Case

A federal court dismissed the SEC insider trading case against Mark Cuban, demonstrating once again troubles with the outlines of the doctrine.  SEC v Cuban (N.D. Tex. July 17, 2009).   The CEO of a public company in which Cuban was the largest shareholder called Cuban to discuss the merits of a potential PIPE offering.  At the outset of the discussion the CEO told Cuban the information was confidential and that Cuban should keep the information confidential.   Cuban traded on the information.  The CEO was not a tipper, he was not breaching any fiduciary duty to the firm in disclosing the information, and Cuban was thus not a tippee.  Was Cuban a quasi-insider?  The court held no because he did not agree explicitly not to trade.  The holding does not make sense.  If Cuban has passed on the info and the recipient had traded both would be liable under Dirks.  Can Cuban trade himself and not be liable?  The confidentiality agreement implicitly included a promise not to use the information, a promise which included a promise not to trade.  

Paulson Abandoned

The Bush Treasury Secretary Henry Paulson, testified in Congress yesterday in defense of his bailout policies.  He was ripped by Democratic Congresspersons, which was to be expected, but also abandoned by Republican Congresspersons, which was also expected.  As a Treasury Secretary, he was heavy-handed, self-rightous, and -- often wrong.     

Cit Group Not "Too Big to Fail"

Cit Group, a lender to small and medium businesses, a major factor, asked for and was refused TARP funds this week.  It was not "too big to fail"; it was "too little to bailout."  The company was only 1,900th in size.  Small business is furious, claiming that Treasury will only bailout the big players on Wall Street with lobbying clout and the big manufacturers with labor clout.  Conspiracy theorists are having a field day with last week's announcement of Goldman Sachs' profits; Goldman receivedd TARP money.  I do not know who is correct but whenever the government decides to call the winners and loser in the financial markets, hard feelings and conspiracy theory are inevitable. 

Sotomayor Testimony on Business Cases

Judge Sotomayor, discussing business cases, noted that business "needs certanty" in the law.  This is correct as noted here as far as it goes. Uncertainty has to be negatively priced in deals on both sides and is a net social loss.   The certainty of a bad rule may be worse than the uncertainty around a potentially good rule if the bad rule cannot be mitigated by planning however.  Moreover,  the saying means on thing for intermediate courts (do not attempt to open up or reshape the law) and another for the Supreme Court (that, by virtue of being the final court) can bring certainty and reshape the law at the same time.  The testimony is close to meaningless. What judge would come out in favor of "uncertainty in business law"? 

Private Equity Under Attack, Again

The FDIC has announced that private equity buyers will be penalized if they purchase failed banks in distress sales by the FDIC.  Private equity will have to put up more capital and make more guarantees.  The FDIC does not want private equity to make money on failed bank turn-arounds.  The favored buyers are other operating banks.  This will of course discourage private equity buyers from putting new capital into failed banks, concentrate the banking industry, encourage private equity to buy healthy operating banks to participate in the market for failed banks, and, finally, encourage domestic private equity to seek overseas investmets.  Each of these developments is not healthy for a recovery of the American economy.  Worries about private equity capitalization should be addresses through traditional attribution and "look through" rules (the definition of affiliate) for buying syndicates, not this.  

When Governments Sell Companies: The Opel Deal

Anyone with any doubt over whether governments will inject political considerations in deals affecting government owned operating companies should take a close look at the Opel sale.  GM, with its majority owned the United States government, is attempting to sell its Opel division, a major manufacturer in Germany and other European countries.  The German government is willing to help finance the sale.  There are at least three potential buyers:  1) A Chinese company that probably will pay the most and require the least subsidy; 2) A private equity company with a major United States investor that will pay royalties for intellectual property after the deal; and 3) A Canadian-Austrian automotive supplier (operating company) that probably will pay the least.  Who is the front runner for the deal?  3, the operating company.  Why?  The German government, going into an election, is anxious to keep German plants open (the Canadian-Austrain company is the most likely to do so) and German officials up for re-election has been basing private equity companies and Chinese buyers.  The United States government does not want to "upset" a close ally when seeking more help in Afghanistan.  If GM wants to maximze the returns for its taxpayers/owners it would sell to China.  No chance.  GM will take the hit.  When government owns businesses, investor welfare is easily and quickly sacrificed for political goals.

The BofA Story

The heavy-handed approach of government regulators to the Bank of America, both over the Merrill Lynch acquisition, and over the current operation of the bank is good theatre.  Did Paulson or Bernanke threaten to fire the CEO, Lewis, if he did not complete the Merrill deal? What is stunning, however, is the lack of public disclosure by a publicly traded company of what was happening behind the scenes due to government pressure.  The government has one agency, the SEC, demanding the disclosure of all material information to the trading markets, and another agency, the Treasury (and perhaps the Fed) demanding confidentiality of what are obviously material events.  The Bank is, as I write, operating under a secret Memorandum of Understanding with the Treasury on board composition and operating targets.  Investors are guessing at its content and effect.  Does Treasury have the power to waive the disclosure obligations of a publicly traded company? 

The Government is Played for a Sucker by Bank of America

The Bank of America and the Treasury had agreed to a "term sheet" that had BofA paying a sizable fee for a "back-stop" guarantee on the value of Merril Lynch toxic assets so that BofA would purchase the failing brokerage company,  The back-stop guarantee kept the price of BofA stock up a bit after the deal was announced.  Now BofA refused to pay the fee, arguing that it had not signed the term sheet.  Term sheets are not formal written contracts; they never have been.  Term sheets are the critical deal terms that will be included in the formal contract to follow that is signed by both parties.  What are terms sheets then?  Moral contracts? Agreements in principle? Agreements to agree?  Or enforceable contracts on the included terms?  Usually the term sheet itself, written by careful lawyers, will specify it's legal status.  The Treasury term sheet did not.  So BofA has schooled the government lawyers on the effect of an incomplete term sheet -- a threat of noncompliance reopens negotiation on the fee.  The government has the option of a lawsuit -- arguing that 1) it was a contract (or a ratified contract) and 2), if not, that BofA's acceptance of the benefits of the term sheet supports a restitution claim.  The government has the upper hand in pressuring parties to do what is wants ex ante, but ex post, after the dust settles, the government must rely on the paper and the quality of its attorneys or the private section sharpies will eat its lunch.

Data on Private Equity Management Skills

I noted some time ago that private equity firms, once they buy a public company, set up a management structure that is very different from the one advocated by corporate governance "experts."  Data is coming in on how private equity does.  It is mixed.  Josh Lerner at Harvard says the PE firms fail more than public companies but are more innovative.  Nick Wilson at the University of Leeds says in the UK there is no difference once one neutralizes the effect of leverage.  Nicholas Bloom of Stanford finds that PE companies are less well managed than public companies but better managed than family run privately held companies.  All the studies suffer from two flaws.  First, at issue is how the PE purchased companies do in relationship to those same companies had they not been purchased.  PE firms tend to buy companies that show substantial room for improvement and attempt to profit from making those improvements.  Thus the comparison is between those companie unpurchased and those companies as purchases, not between all public companies and all PE purhcased companies. Second, the data shows that things revert to the mean. Of interest is the finding that some PE firms consistently outperform others, that the best indication of future performance is past performance.  What management proctices do these successful firms use in comparsion to public companies (and other PE buyouts)?  The data is enlightening and helpful but not conclusive.