posted by Dave Hoffman
As Larry Ribstein, Gordon Smith, Jeff Lipshaw (below) and others have pointed out, the rise of Bear Stearns’ stock price after the announcement of its deal with J.P. Morgan creates some really complex corporate law problems. Today’s close, $5.33, is around 2.5 times the offer price (2.30 a share). Whether the Delaware Chancery Court will enforce “Bear’s Put” (as Steven Davidoff coined it) seems to me to be underdetermined by caselaw and instead likely will depend on the state of the financial markets. In a less edgy environment, normal rules – like Quickturn – should apply and DE Courts inclined to strike down the clause, even over the Fed’s objection. Indeed, the case would be a good platform to reassert Delaware’s dominance! But if current market volatility remains unabated when these issues are decided, I imagine that the no-shop, multiple-vote, clause will be upheld. Thus, J.P. Morgan would be wise to push hard to close the deal sooner, while the market remains turbulent and a potential jurist pliant. (I’m rooting for assignment to V.C. Strine, if we want a wide-ranging opinion to teach in a few years). Useless speculation? Sure!
A distinct part of this evolving story is the buyers of Bear’s stock. Some are probably bondholders. Another group, according to today’s W$J, are Bear’s employees, free (now) to trade and encourage others to buy up the firm. They are reported to believe that several hedge funds, having shorted Bear several weeks and months ago, then broke the bank by withdrawing business from its prime brokerage in the last week or so. Those withdrawals in turn resulted in downgrading Bear’s investment rating and putting its ability to trade in jeopardy. (It’s the Enron story, but without a Fastow or JEDI, that we know of.) Maybe they think that the SEC will bring some kind of market manipulation case against the shorting funds, which seems like a long-shot. Another possibility could be civil suits seeking disgorgement from the funds, on the theory that they have some kind of fiduciary duty not to provoke a bank run. On what theory such a lawsuit would proceed, I can’t imagine, but I wouldn’t underestimate the creative power of a hungry mob of lawyers. Finally, we’ll almost certainly see a lawsuit against Bear’s directors. I, like Lipshaw, have “some sympathy” for these folks, especially those on the outside, who can’t possibly have foreseen the magnitude of the events that overwhelmed the institution.
Third, as many have noted, Bear’s executives aren’t going to walk away with much cash. Their options are under-water, and their guaranteed compensation has been intentionally set at a low level to promote firm performance. Now, some, including Jack Dolmat-Connell, an executive compensation expert, are criticizing this equity-heavy pay schedule for encouraging Bear “to take on too much business risk.” (Again, from today’s W$J). I don’t buy this. Is the idea that if their pay were fixed, they’d have been more risk averse because their upside would have been limited? This seems (to me) to be an unrealistic account how investment bank executives are likely to behave. More than most, such executives are the product of the tournament model, likely to be extremely overconfident and risk-seeking no matter what their compensation structure. (The easy cite here, of course, is Liar’s Poker.)
Finally, you’ve got to wonder what lessons to draw from the last two weeks. In 1966, Henry Manne argued that legalizing insider trading would have several pro-social consequences, among them that it would lead to more accurate prices and thus substitute for public disclosure in circumstances where it might not otherwise occur. There is (admittedly) limited empirical evidence that insider purchases have strong price effects, but insider sales are generally stronger signals. Last Monday, investors valued Bear at between $60 and $70 a share, but there was obviously non-public information that made the price unsustainable. Maybe had insiders been permitted to trade on their knowledge of Bear’s financial condition, its decline would have been less precipitous, giving the bank more time to approach the Fed for help before its fire sale became necessary. [Update: Paul Krugman's analogy is a good one. In describing the run on Bear and other like institutions, he says "In other cases, the bank is fundamentally unsound — but the bank run magnifies its losses. It’s as if someone calls “Fire!” in a crowded theater, and there really is a fire — but the stampede kills people who would have survived an orderly evacuation." Exactly - would insider trading have made the run more orderly?] Just a thought, as folks start to think about ways to avert tomorrow’s crisis.