We had a job candidate come through at some point this Fall who generally is interested in the field of commercial law.  That person mentioned in passing that although they were more than willing to teach the traditional secured transactions course, in their opinion it wasn’t well structured.  Why? Not, as the navel-gazer might imagine, because the field of commercial law is supposedly intellectually dead.  Rather because the traditional secured transaction course is too narrowly conceived — it usually is limited in coverage to personal property security interests under Article 9.  But many security interests that matter to lawyers aren’t held on movable property.  Since secured [...]]]> I’ve never taught Secured Transactions, so I’ll start by saying that the following is purely speculative and subject to correction.

We had a job candidate come through at some point this Fall who generally is interested in the field of commercial law.  That person mentioned in passing that although they were more than willing to teach the traditional secured transactions course, in their opinion it wasn’t well structured.  Why? Not, as the navel-gazer might imagine, because the field of commercial law is supposedly intellectually dead.  Rather because the traditional secured transaction course is too narrowly conceived — it usually is limited in coverage to personal property security interests under Article 9.  But many security interests that matter to lawyers aren’t held on movable property.  Since secured is ordinarily the foundational course for the commercial curriculum, students are left starting on too narrow a footing in understanding bankruptcy and bank regulation.  It’s even worse than having a corporations course that excludes LLCs.  Because of its technicality, ST is traditionally so difficult to teach that many students are turned off to the idea of commercial law practice at all.

Again, I don’t know much about this area of law.  I never took ST in law school, I haven’t taught it, and (worse) I haven’t even read a ST syllabus at my current institution.  But it struck me as an interesting thought, at least worth airing.  It’s related to concerns I have about the general corporate curriculum — is “corporations” really a subject that ought to be taught in a single course, or is it really a merger of too many (or too few) legal principles that have glommed together over time.  It’s also related to concerns that one might have about continuing to use the increasingly outdated, purportedly uniform, UCC to teach when States’ adopted versions are moving ever-further-away from that ideal.

1) food poisoning 2) systemic risk in the financial system 3) data breaches 4) violations of civil liberties 5) tax evasion 6) insider trading

In each case, we could do a lot more to stop the problem if we better tracked the actions that lead to it. An “audit trail” can enable that tracking. Decades ago, such tracking would be inordinately costly. Nowadays, it is increasingly embedded into any quality logistical system. The technologies of RFID chips, cheap imaging and data storage, and rapid search are ubiquitous. Corporations use them to track customers and products. Now public authorities need to use them to track corporations.

Consider, for instance, this recent story on food safety:

More than 75 percent of seafood and [...]]]> What do the following problems have in common?

1) food poisoning
2) systemic risk in the financial system
3) data breaches
4) violations of civil liberties
5) tax evasion
6) insider trading

In each case, we could do a lot more to stop the problem if we better tracked the actions that lead to it. An “audit trail” can enable that tracking. Decades ago, such tracking would be inordinately costly. Nowadays, it is increasingly embedded into any quality logistical system. The technologies of RFID chips, cheap imaging and data storage, and rapid search are ubiquitous. Corporations use them to track customers and products. Now public authorities need to use them to track corporations.

Consider, for instance, this recent story on food safety:

More than 75 percent of seafood and half of the fruit Americans consume is imported. The FDA has registered 254,088 foreign farms and processing facilities that feed into the U.S. food supply. Something as commonplace as a frozen pizza can have upwards of 50 ingredients from 10 or more countries. That includes spices sourced from around the world—most spices are imported—as well as an array of preservatives and additives. . . . “The consumer has absolutely no idea,” says William Kanitz, president of ScoringAg.com, which sells traceback software to food companies.

The Food Safety Modernization Act, which went into effect this year, gives regulators new powers to order food recalls, access company records, and close food plants. . . . Yet Congress put off perhaps the most useful tool for quickly heading off outbreaks: A rule requiring food companies to keep records about where their ingredients come from was left out of the final bill. . . . So far, the powerful food lobby has been successful at fighting the government’s efforts. The House version of the food bill required manufacturers to keep records that would enable the government to trace food all the way back to the grower within two business days. By the time it was ratified by the Senate, that requirement had been watered down to a pilot program.

So an unscrupulous middleman can engage in “food laundering,” just as banks or drug dealers might engage in complex accounting to hide the origins of certain funds. The article quotes the director of food programs at the Pew Health Group on the reasons why the system suits the shady: “It’s less likely you’ll be held liable if folks can’t prove that you’re the source of the contamination.” And so long as processors and distributors have no obligation to record all their sourcing, they, too, might opt for a “hear no evil, see no evil” policy of willful blindness. The FDA appears to be even more helpless in the wake of a “tidal wave” of adulterated supplements.

Black Box Finance

So what does this problem have to do with systemic risk in the financial system? Having turned the continent of Europe into a subprime CDO, bankers are now worried that they may be the odd men out in a high stakes game of musical chairs. As John Lanchester explains,

‘Credit events’ . . . are chaotic and unpredictable, and all the more so because the fundamentals of the economic order, as constituted in 2008, are still intact. Who owns [] Greek debt? [M]ainly French and German banks. Yes, but banks insure their debt via the use of complex financial instruments. Insure it with whom? Don’t know: some of it is insured with British banks as counter-parties to the risk, but that risk will be insured in its turn, so that the identity of the person holding the parcel when its last layer of wrapping comes off is a mystery. That mysteriousness was the thing that made Lehman’s collapse turn instantly into a systemic crisis. [link added]

Global banking is a house of cards, not by necessity, but by design. Both Lehman and the EuroCrisis recapitulate a pattern of willful opacity by banks enabled by the willful blindness of regulators. The Financial Crisis Inquiry Commission reported that a former OTS director had “no clue—no idea—what [AIG’s] CDS liability was” as of September, 2008—when the insurer’s sudden near-collapse threatened to trigger a financial meltdown. Opacity is at the core of capital market dysfunctionality. As John Gapper has argued:

The behaviour revealed in the JPMorgan and Goldman cases is a product of the conflicts of interest embedded in how integrated Wall Street banks work. As they say in Silicon Valley, it’s not a bug – it’s a feature. That feature is inherent in most of what banks do, but the opacity and complexity of credit derivatives – especially mortgage-related securities such as collateralised debt obligations – let deception, overpricing and ultimately fraud flourish. From this black box came the bulk of revenues and bonuses. [emphasis/link added]

Moreover, the same types of tactics pioneered by tax evaders can be domesticated into not-quite-legal or perfectly legal forms of obscuring an entity’s earnings or tax obligations. And as anyone who’s followed the “cloak and dagger” of the SEC’s notable insider trading cases knows, “white collar wiretaps” have been a game changer, uncovering a “sprawling network” of favors and corruption.

From Food to Finance to Privacy, and Beyond

Hidden harms are also a hallmark of the privacy field, where Kafkaesque databases can mark individuals out for bad treatment in ways they never discover. As I noted earlier, “fourth bureau” entities that blackball consumers actually brag about how impenetrable their data and processes of evaluation are. The three credit bureaus are also frequently opaque, discrediting individuals in ways that are difficult to challenge or understand. The intelligence agencies and contractors that constitute “Top Secret America” are even more secretive, and their work can have dramatic consequences for targeted individuals and groups.

In all of these areas, we face a twofold challenge: a) improving recordation systems in order to better understand what is going on, and b) recording the activities of those who access the systems, to deter abuses of the power such knowledge gives.

Many privacy advocates have tried to limit troubling monitoring. This is often thought of as the whole of a reformist position on government surveillance. But data law needs a larger vision, and an intensification of new kinds of surveillance, including sousveillance.

As corporations gain the same free speech rights as individuals, they also need to be subject to the same level of scrutiny. Purposeful avoidance of tracking may well indicate a corporate plan to destroy evidence of wrongdoing. Justices Kennedy and Scalia have called corporations “the voices that best represent the most significant segments of the economy,” but they also manage to do a great deal of damage. Reallocating surveillance toward corporate actions can repurpose a leviathan state that seems obsessed with spectacular attacks or frightening stereotypes, but perplexed by corporate practices we desperately need to understand. Both the SEC and HHS realize the power of audit trails, and I hope to see them adopted as a tool by more agencies in the future.

Image Credit: Bill Bouton.

But as Nick notes, equally important is a debtor’s will to pay.  The differences appear in the contrast between the United States and Greece.When  Standard & Poor’s recently lowered its credit rating of the U.S. Treasury by one notch, it registered doubt not so much about the country’s ability to pay its debt, but the will [...]]]> In this week’s New Yorker, Nick Paumgarten, in the Talk of the Town, kindly draws on my work  about the cultural contingency of financial reporting; he quotes me on the need to update the idea of insolvency.  Usually defined as the ability to pay debts as they come due, or assets exceeding liabilities, there has always been a strong objective thrust to the notion.  The emphasis is on measured financial activity reduced to a verifiable expression of ability. 

But as Nick notes, equally important is a debtor’s will to pay.  The differences appear in the contrast between the United States and Greece.When  Standard & Poor’s recently lowered its credit rating of the U.S. Treasury by one notch, it registered doubt not so much about the country’s ability to pay its debt, but the will of its incumbant political class to do so. In contrast, Greece’s political elite seem committed to finding ways to meet that country’s debts; alas, its resources compared to its obligations raise real doubt about their ability to do so. 

Another example of the difference between the ability and the will to pay debts arose in the September 2008 tussle over what to do about American International Group. It was then the world’s largest insurance company and shortly before the crisis  boasted a market capitalization of $180 billion. Much of its trillion-dollar balance sheet was securely housed in walled-off insurance subsidiaries. 

The roiling financial crisis infected two dozen banks with which AIG had financial contracts.  The U.S. Treasury, reeling from a series of bank failures and criticism of its responses to them, feared that those banks could disintegrate one-by-one. It had run out of good ideas to boost their solvency. 

So Henry Paulson, then Treasury Secretary, and his successor Tim Geithner, then head of the New York consortium of private banks misleadingly called the New York Fed, opted to wrest control of AIG in order to rescue those banks.  The government loaned the company $85 billion and the government siezed 80% of its equity.  The government then used that money, along with additional loans about twice that, to pay the two dozen banks off, dollar for dollar, under the financial contracts.

AIG may have been facing a liquidity squeeze while at the center of the financial crisis. But it had ample capital. And it was engaged in heavy negotiations with its counterparties about settling payments under the financial contracts–whose value was highly uncertain given the frozen capital markets.   AIG, in short, had the ability to pay its debts.

AIG’s shareholders, of course, including Hank Greenberg, who built the company from the 1960s to 2005 when he retired as CEO, objected vigorously to the Paulson-Geithner move.  Not only did AIG command ample capital internally, at its super-solvent insurance companies, many investors around the world were lining up to invest more. 

What divided the government and the shareholders was less the question of whether AIG had the ability to pay its debts, but whose will mattered.  The government’s will won out.  It was an ironic result, considering that U.S. culture is generally against governmental nationalization of private business, and that AIG had stood for the principle in fighting nationalization of its property and that of its customers around the world for decades.

Simkovic argues that 80 years of erosion of classic commercial law doctrine ensured that “complex [...]]]> Secretive practices and institutions are common in contemporary finance. For those who’ve ceased the search for long-term value creation, temporary information advantage is key. Even commonplace practices can be reinterpreted as havens of hiddenness. My colleague Michael Simkovic’s article “Secret Liens and the Financial Crisis of 2008” exposes the role of derivatives and securitization as secretive borrowing strategies, designed to keep the naive or trusting from discovering the fragility of the institutions they loan funds to. His work has been presented to the World Bank Task Force on the Bankruptcy Treatment of Financial Contracts, and is relevant to both private and sovereign debt risks.

Simkovic argues that 80 years of erosion of classic commercial law doctrine ensured that “complex and opaque financial products received the highest priority in bankruptcy.” Products like swaps and over-the-counter derivatives were not adequately disclosed (either by banks in their consolidated financial statements or by their counterparties in publicly accessible transaction registries). By concealing those debts, these already overleveraged financial institutions were able to attract ever more credit and investment, at better rates than those who reported their overall financial health more accurately. (All other things being equal, it’s safer to lend to an entity that owes 10 billion rather than 100 billion dollars.) The genius of Simkovic’s article is to show how “fundamental causes of the financial crisis are relatively old and simple,” even as an alphabet soup of instrument acronyms (CDO, CDS, MBS, ad nauseam) and government programs (TARP, TALF, PPIP, et al.) makes our time seem unique.

As Simkovic explains:

Losses act as a spark; widespread leverage is the powder keg. Leverage can be “regulated” privately by creditors or regulated by government, but only if the extent of leverage is known [emphasis added]. Hidden leverage is a perennial problem because debtors rationally wish to borrow at the lowest price possible. Debtors can borrow at more attractive rates by hiding their existing debts and creating an exaggerated appearance of creditworthiness. [emphasis added]

Debtors who wish to hide their debts can exploit competition between potential creditors to gain active cooperation from some creditors. These cooperative creditors will work with debtors to hide loans either through simple non-disclosure or through complex structures. Debtors may compensate these cooperative creditors for their assistance with higher fees, a deeper business relationship with the creditors, or liens on the debtors’ property. The result of this subterfuge is lower financing costs for the debtor and lower profits—or steeper losses—for unsophisticated unsecured creditors.

Note that Simkovic’s work is more incrementalist than that of Stephen Lubben (another colleague of mine) or Mark Roe, who question the wisdom of safe harbors for derivatives in bankruptcy. Whatever you feel about that position—and however you feel about the relative advantages of regulation or market forces in deterring systemic risk—Simkovic’s work points to a fundamental problem that all sides in these debates must grapple with. Neither market forces nor regulators can deter systemic risk if there’s not fair warning that an interaction between secrecy and priority in bankruptcy can suddenly create disastrous runs on financial institutions. It’s one thing to create priorities (or supersecured creditors) that everyone knows about. It’s quite another to allow sophisticated debtors to promise the moon and stars to entities that have no idea what rival claimants are going to demand.

Pushing for Priority

For “financial innovators” in the years leading up to 2008, the game was straightforward: sophisticated lenders wanted to obtain first priority in bankruptcy (and/or the right to make collateral calls quickly), while borrowers wanted to hide how much they’d borrowed (and how encumbered their assets were). Like the fraudulent subprime broker who added a few zero’s to the end of his client’s W-2 form, leading bankers exaggerated the well-being of the desks and divisions they fronted for by obscuring certain obligations on their books.

How did they do it? Simkovic explains how the bankruptcy code now favors “securitized” over “secured” debt. The code forces secured creditors to try to keep their bankrupt debtor afloat during reorganization. For example, an “automatic stay[] prevents a secured creditor from seizing and liquidating the underlying collateral to recoup its investment.” A securitization can stave off such obligations by “distancing” certain obligations from bankruptcy. Simkovic explains these steps:

In an asset securitization, the debtor (or “Originator,” the term typically used in documentation) transfers financial assets such as credit card receivables or mortgage receivables to a special purpose entity, or SPE, typically a wholly-owned subsidiary of the debtor. The SPE (or another transferee) issues debt to investors. Investors pay the SPE which then pays the debtor.

For the securitization to isolate the underlying assets from the debtor’s bankruptcy, the transfer of assets from the debtor to the SPE must qualify as a “true sale.” Most securitizations do not economically resemble “true sales” because the debtor retains the risk of default or non-performance of the underlying assets. The debtor retains risk because the debtor owns the equity (or “first loss tranche”) in the SPE, and because the debtor may be required to repurchase assets from the SPE if losses reach a level exceeding . . . [a] pre-set trigger.

However, just as clever legislators let AIGFP characterize its disastrous CDS business as “protection-selling” (rather than insurance), Delaware’s Asset-Backed Securities Facilitation Act let securitizers safely call the SPE fancy footwork a “true sale” to avoid the responsibilities associated with secured debt. The debtor’s obligation to its SPE’s is kept “off balance sheet,” hidden from many creditors. Limited disclosure of asset securitizations (and their terms) means that “even professionals can underestimate the extent of debtors’ exposure to losses from securitized assets.”

Rating agencies have given very high ratings to securitized debt, reasoning that the originating “‘companies retain the subordinated interest in the transaction known as the equity tranche or ‘first-loss’ piece.’” But they ignored the underlying economic motivations behind the transaction: those who brokered the deals would walk away with huge fees regardless of how well it did overall. Aside from sacrificial wolf Fabrice Tourre, virtually everyone involved in the securitization machine has done fine financially. And as the WSJ noted in 2008, the SEC failed to require rating agencies to “disclose to the public all underlying information about any debt they are rating.”

Financial Innovation as Epiphenomen of Legislation: The Case of Credit Default Swaps and BAPCPA

Simkovic also highlights how another aspect of the CDO doomsday machine thrived on secrecy. Just as a firm could both stand behind a securitization (to assure buyers of the securitized assets) and not stand behind it (for accounting purposes, so it looked like it had less exposure than it actually did), so too could the buyers of securitized assets have their cake and eat it too. The securitized asset promised a steady income stream, and a transaction called a “credit default swap” allowed its beneficiary to offload the risk that the income would not materialize onto another entity, in exchange for steady payments of its own. So even when outside observers might bridle at the amount of leverage an entity took on to buy securitized assets (often from another entity that was heavily leveraged to create and support the same assets), the buyer could outwardly appear to be placing one bet with its publicly disclosed balance sheet, while secretly hedging its bets by buying a credit default swap from a well-capitalized firm that promised to pay in case the SPE and originator could not. Its purchase of the assets, a “vote of confidence” in public, might even be swamped by skepticism about the viability of the assets, if the CDS paid off far more than the expected value of the CDO it insured.

By September, 2008, AIG had sold $440 billion of CDS protection. It had no way of paying out anywhere near that amount, and had not reinsured itself, or offloaded some of the risk onto someone with deeper pockets. Where were the regulators? Stupefyingly uninformed, as the FCIC Report shows:

The Office of Thrift Supervision has acknowledged failures in its oversight of AIG. . . . [S]upervisors failed to recognize the extent of liquidity risk of the Financial Products subsidiary’s credit default swap portfolio. John Reich, a former OTS director, told the FCIC that as late as September 2008, he had “no clue—no idea—what [AIG’s] CDS liability was.” [emphasis added].

According to Mike Finn, the director for the OTS’s northeast region, the OTS’s authority to regulate holding companies was intended to ensure the safety and soundness of the FDIC-insured subsidiary of AIG and not to focus on the potential impact on AIG of an uninsured subsidiary like AIG Financial Products. Finn ignored the OTS’s responsibilities under the European Union’s Financial Conglomerates Directive (FCD)—responsibilities the OTS had actively sought. (350) [emphasis added]

Throughout late 2007 and 2008, the company’s accountant tried repeatedly to discover the true amount of risk involved in its transactions. As Simkovic shows, this was exceedingly difficult to do:

Credit default swaps, like most OTC derivatives, are an ideal vehicle for hidden leverage and secret liens because of their inherent complexity, limited disclosure, and superior treatment in bankruptcy. . . .Unlike exchange traded derivatives, which are standardized, simplified, and priced by the market through frequent trading, OTC derivatives are custom, bilaterally negotiated, relatively illiquid contracts and therefore difficult to price. The value of the derivative depends on three things: (i) the value of the underlying asset; (ii) the contractually negotiated formula that determines the counterparties’ obligations to each other based on that value; and (iii) the creditworthiness of the counterparty to the derivative, which determines the likelihood that the obligation will actually be paid. . . .

In the case of credit default swaps written on CDO tranches held by financial institutions: (i) the value of the underlying assets is difficult to determine because of the mathematically complex structuring that governs loss allocation among tranches and because of limited information about the credit quality of the underlying loans; (ii) the extent of counterparties’ obligations to each other is difficult to determine because of the subjective nature of determining when a “credit event” has occurred and the risk that disagreement will result in litigation; and (iii) the creditworthiness of counterparties is difficult to determine because they too have extensive and hard-to-measure exposures to derivatives such as credit default swaps.

Simkovic discusses how it may be impossible, even in principle, for large players to figure out the true extent of their exposure. CDS counterparties thought they were safe once they bought protection from AIG, and didn’t realize that AIG might go under. The banks didn’t accurately gauge the risk posed by AIG.

Willful Blindness

Simkovic’s position has been amply confirmed by other critics’ work. Consider, for instance, the cutting analysis from Eric Banks’s prescient The Failure of Wall Street (2004), which describes “financial controllers and auditors who don’t understand the nature of the business they are meant to be ‘independently monitoring,’” and trading desks which have little sense of “what kind of credit risks they are exposed to.” Combine these internal weaknesses with the regulatory arbitrage that allowed institutions to seek the most pliant “watchdogs,” and disaster was inevitable.

Of course, there were some forward-thinking participants in the financial markets who saw the risks, and ran away from them. As one report noted about Warren Buffett:

When Berkshire bought General Re in 1998, the reinsurance company had 23,000 derivative contracts. “I could have hired 15 of the smartest people, you know, math majors, Ph.D.’s. I could have given them carte blanche to devise any reporting system that would enable me to get my mind around what exposure that I had, and it wouldn’t have worked,” [Buffett] said to [a] government panel. “Can you imagine 23,000 contracts with 900 institutions all over the world with probably 200 of them names I can’t pronounce?” Berkshire decided to unwind the derivative deals, incurring some $400 million in losses.”

As one commentator observed, this type of complexity leads to a number of other problems:

Derivatives, because they are so hard to value, make it easier for traders and chief executives to inflate earnings. They exacerbate problems if a company, for unrelated reasons, suffers a credit downgrade that requires it to post collateral with counterparties – “a spiral that can lead to a corporate meltdown,” [Buffett] wrote. They create a “daisy chain” of risk as the troubles of one company infect another.

That “daisy chain” of risk echoes the diagnoses of Yale economist John Geanakoplos (whose work has indicated the instability caused by high leverage and “tight chains of financial interdependence”), Rick Bookstaber (who chronicles the instability inherent in “tightly coupled” systems), and Lawrence Baxter (who brings attention to recent network science on the “cascading failure” that is “common to many complex systems”). An interdependent system as complex as the OTC derivatives market can crumble at any moment. If key participants are too highly leveraged and one or more of them experience a shock, disaster is inevitable. The problem is not a “black swan;” it’s the black box dealmaking that make it impossible for markets or regulators to grasp how leveraged and fragile institutions really are.

Secrecy vs. Resilience

So how resilient should these systems be? That is a matter due much more political and regulatory attention than it is currently getting. Regardless of one’s views on leverage, one thing is clear: the types of opacity described in Simkovic’s article prevent us from getting any handle on the scope and severity of the problem. As he notes,

[E]ven basic information about OTC derivatives transactions can be extremely hard to come by. Market participants themselves are often unaware of the extent of their net exposures or the identity of counterparties to their transactions. Mandatory disclosures to third parties are even more limited, and the industry group, the International Swaps and Derivatives Association, has resisted voluntary disclosure.

Why the lack of clarity? There’s a fundamental contradiction in finance. Financial managers need to compete by keeping what they know secret so they can place big bets at “wrong” prices and make money when the prices eventually correct. At the same time, the policy justification for financial markets is that markets get the pricing right. As Simkovic has argued, “Allowing greater secrecy is essentially a decision to allow financiers greater private profits and to reduce the public benefit from quick ‘price discovery’ by markets.”

Accounting rules compound the difficulties, allowing certain deals to be quarantined from the rest of the bank’s financial status. For example, since a “simple fixed/ floating interest-rate swap contract . . . has zero value at the start,” it “is considered neither an asset nor a liability, but is an ‘off-balance-sheet’ item.” Lehman Brothers had $738bn in derivative contracts labeled as “off balance sheet arrangements” in its 2007 accounts, it’s now hard to accept uncritically its estimate of their ultimate “netted” value at the time. Carol Loomis did a post-mortem on the situation:

Lehman had a derivatives book of only $730 billion as it neared bankruptcy. Even so, when Lehman’s U.S. entities filed for Chapter 11 in September, this not-so-big figure translated into about 900,000 derivatives contracts. The great bulk of them have been “terminated” by derivatives counterparties which under industry protocols had the right to immediately “net” their accounts with Lehman in the event it declared bankruptcy. A handful – the last reported number was 18,000 – are still open.

Each of these contracts has a “fair value” – an amount that one side owes the other. Lehman, in fact, has a lot of open contracts that have been going its way. In a droll sign of how derivatives have come to be viewed as indispensable, Lehman has received permission from the court to buy them to hedge some of its open contracts, so that it can lock in the profits it has made since filing for bankruptcy.

Move now to the accounting problem. While sometimes the fair value of a derivative can be precisely determined, at other times it must be derived from murky markets and models that leave considerable room for interpretation. That gives the holders of derivatives a lot of bookkeeping discretion, which is troubling because changes in fair value flow through earnings — every day, every quarter, every year — and alter the carrying amounts of receivables and payables on the balance sheet.

The subjectivity involved in derivatives accounting also means that the counterparties in a contract may come up with very different values for it. Indeed, you will be forgiven if you immediately suspect that each party to a derivatives contract could simultaneously claim a gain on it — which should be a mathematical impossibility. In fact, we have a weird tale, gleaned from court documents, supporting that suspicion. It involves Lehman, Bank of America, and J.P. Morgan, and suggests how far some of those “terminated” contracts are from being truly settled.

That last point—that both parties could “simultaneously claim a gain” on what had to be zero-sum arrangements—is critical to understanding the risks posed by black box finance. It explains why deal complexity is often pursued for its own sake, and not for a genuine economic or investment purpose. Webs of debt become a smokescreen for what is really going on: institutions are rendered more and more vulnerable (both individually and collectively) so that privileged parties within them can reap enormous incomes from fees and bonuses. Formalities didn’t matter: as Stephen Lubben notes, “many credit default swaps were assigned to new protection buyers without the prior consent of the seller,” even though the ISDA Master Agreement governing such deals forbids this. Murky accounting kept Chuck Prince’s famous “music” playing ever longer, as a mountain of leverage and misallocated capital accumulated.

It Gets Worse: BAPCA’s Ugly Legacy

According to Simkovic, 2005 amendments to the Bankruptcy Code under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCPA”) have exacerbated the problem. This law assured that “derivatives counterparties effectively bear no risk of loss to the extent that the debtor posts collateral to cover its obligations.” Simkovic describes the rush of creditors to take advantage of its provisions, a stampede that made it “harder for those creditors to communicate with one another and monitor debtors’ leverage.” AIG was the poster child for overleveraged indebtedness, selling $440 billion in “protection” on CDOs. According to Lynn Turner, “In one year, the disclosures from the company had gone from not losing a dollar to over $26 billion in valuation losses and counter parties that to this day have not been disclosed demanding over $16 billion in collateral.” Since the Treasury Department believed that “the global economy was on the brink of collapse” when the the magnitude of the problem became clear, the government stepped in to bail out AIG (and, thus, its counterparties).

(Turner, former chief SEC accountant, describes how opaque AIG’s procedures were. The recent book Fatal Risk gives the “tick tock” details, chronicling the deepening unease of AIG’s auditors as the mark-to-fantasy approach of its subsidiary AIGFP became clear.)

From 2000-2008, AIG made $66 billion in profit, but in 2008, it had a $99.3 billion loss. The employees and execs who benefited in the boom years have kept nearly all their cashed out compensation. By January, 2011, according to the FCIC report, AIG had cost US taxpayers $152 billion (FCIC Report, 350). It’s an incredible sum for a process whose only social contribution, so far as I can see, was a marginal (and likely temporary) bump upwards in the rate of homeownership.

Simkovic describes financial sector creditors consumed by a desire for positional advantage, ignoring the slow erosion of the viability of the system as a whole. It’s an “I’ll be gone, you’ll be gone” culture, where accountability has largely vanished. If we really want to understand the recent investor rush to gold and commodities, it’s better to look beyond the central banks’ “printing money” and to think hard about why they’ve had to do so. Do you really want to park much money—be it in stocks, bonds, or some other instrument—at institutions staffed and run by people who bear virtually no pain in case of their collapse?

Picking Up Pennies in Front of a Bulldozer

Asymmetric compensation schemes are common in finance: managers enjoy substantial upside (perhaps even a life of leisure) if things go well; there is very limited downside if things go badly. Simkovic analyzes how opacity, corporate law, and bankruptcy code provisions help preserve this lack of accountability at the core of finance. The usual Wall Street metaphor for behavior like AIG’s is “picking up pennies in front of a bulldozer.” But the agency problems (and amounts involved) flesh out the metaphor: financial institutions are like wheezing couch potatoes, suddenly running to pick up suitcases of cash in front of a bulldozer of risk, and delivering most of the proceeds to high-flying managers lounging on settees by the side of the road. When the financial institution finally ends up getting a hand or arm caught under the bulldozer, it faces the horror of an impromptu amputation or annihilation. The managers will surely rue the untimely death or disability of their “runner,” but they’ll walk away with cash they’ve “earned,” and almost certainly find some other institutional form to renew the game another day. Even if some don’t, they may have made enough while the getting was good to fund an early retirement to the Caribbean.

At a recent event on the LSE report on the Future of Finance, panelists and audience members suggested that rent-seeking, as well as tax, accounting, legal, and agency distortions, are driving finance sector transactions more than the real economic substance of deals. Simkovic helps us understand the full extent of the problem. The bankruptcy code is becoming the tail that is wagging the dog of investment decisions. He argues that we need to “revive recordation,” as Hernando de Soto and other luminaries have urged. Perhaps real financial reform will ultimately depend on more radical approaches. But I see no way of significantly improving the situation without regulators taking seriously the problems Simkovic has described. In my next post on the issue, I will look at Michael Greenberger’s relatively optimistic take, and Arthur Wilmarth’s pessimistic view, on whether aspects of Dodd-Frank can address Simkovic’s concerns. Early developments have not been promising.

X-Posted: The Pareto Commons.

In her essay, Zubaty argues that the English appeals court in Rubin v. Eurofinance missed an opportunity to modernize English rules on the recognition of foreign bankruptcy judgments.  Instead, the essay describes how the court seized on the special bankruptcy circumstances of the case to overcome traditional barriers to recognition of the original foreign judgment by a U.S. bankruptcy court.  Zubaty argues that the court’s decision will have “the immediate practical effect of subjecting any person who may have any property or interest worth attaching in the U.K. to the [...]]]> Columbia Law Review’s Sidebar is pleased to announce the publication of Rubin v. Eurofinance:  Universal Bankruptcy Jurisdiction or a Comity of Errors? by Rebecca R. Zubaty of Paul, Weiss, Rifkind, Wharton & Garrison LLP.

In her essay, Zubaty argues that the English appeals court in Rubin v. Eurofinance missed an opportunity to modernize English rules on the recognition of foreign bankruptcy judgments.  Instead, the essay describes how the court seized on the special bankruptcy circumstances of the case to overcome traditional barriers to recognition of the original foreign judgment by a U.S. bankruptcy court.  Zubaty argues that the court’s decision will have “the immediate practical effect of subjecting any person who may have any property or interest worth attaching in the U.K. to the jurisdiction of all bankruptcy courts worldwide.”  The decision may even have broader ramifications, such as “empower[ing] courts faced with novel conflicts questions to dispense with all conventions, foreign and domestic, to achieve what they deem to be the right outcome.”

Whatever the merits of that view, the GFC did highlight debilitating trends in US finance infrastructure that have been intensifying for years. In this week’s Businessweek, Hernando de Soto (with Karen Weise) highlights one of the most important: the opacity of key markets and relationships. With scant exaggeration, de Soto warns that the US is on its way to levels of uncertainty more common in developing and communist countries:

During the second half of the 19th century, the world’s [...]]]> In his press conference last week, Ben Bernanke concluded on an upbeat note. He had high hopes for a US recovery, since he believed that the Great Financial Crisis (GFC) of 2008 hadn’t taken from the US any of its basic productive capacity.

Whatever the merits of that view, the GFC did highlight debilitating trends in US finance infrastructure that have been intensifying for years. In this week’s Businessweek, Hernando de Soto (with Karen Weise) highlights one of the most important: the opacity of key markets and relationships. With scant exaggeration, de Soto warns that the US is on its way to levels of uncertainty more common in developing and communist countries:

During the second half of the 19th century, the world’s biggest economies endured a series of brutal recessions. At the time, most forms of reliable economic knowledge were organized within feudal, patrimonial, and tribal relationships. . . . The result was a huge rift between the old, fragmented social order and the needs of a rising, globalizing market economy.

To prevent the breakdown of industrial and commercial progress, hundreds of creative reformers concluded that the world needed a shared set of facts. . . . The result was the invention of the first massive “public memory systems” to record and classify—in rule-bound, certified, and publicly accessible registries, titles, balance sheets, and statements of account—all the relevant knowledge available, whether intangible (stocks, commercial paper, [etc]), or tangible (land, buildings, boats, machines, etc.). Knowing who owned and owed, and fixing that information in public records, made it possible for investors to infer value, take risks, and track results. The final product was a revolutionary form of knowledge: “economic facts.”

Over the past 20 years, Americans and Europeans have quietly gone about destroying these facts. The very systems that could have provided markets and governments with the means to understand the global financial crisis—and to prevent another one—are being eroded. Governments have allowed shadow markets to develop and reach a size beyond comprehension. . . . In a few short decades the West undercut 150 years of legal reforms that made the global economy possible.

de Soto gives a number of concrete examples of how we are kept in the dark about the “thousands of filaments that businesses are creating between themselves,” including:

1) Mortgage Bundling: Law professor Christopher L. Peterson observes that, “For the first time in the nation’s history, there is no longer an authoritative, public record of who owns land in each county.”

2) Default Swaps: “these risks have slipped outside the public memory systems, making it very difficult to know who ultimately bears the risk and where it is.” And you can count on Tim Geithner to exacerbate the problem. McClatchy’s Greg Gordon identified the problem in 2009:

Cayman Islands deals . . . . became key links in a chain of exotic insurance-like bets called credit-default swaps that worsened the global economic collapse by enabling major financial institutions to take bigger and bigger risks without counting them on their balance sheets. The full cost of the deals, some of which could still blow up on investors, may never be known.

3) Exemptions: “Businesses are left to figure out [accounting realities] on the basis of connections, influence, and private information. Just like we do in developing and former communist countries.”

4) Off-Balance-Sheet Accounting: “In the 1990s governments began . . . allowing companies in financial difficulty to pass facts concerning debts from their public balance sheet to a less visible memory system called a special purpose entity (SPE) (or to sweep debt information into the balance sheet’s footnotes in words so obtuse that the statements cease being factual).”

5) Government Use of Swaps and Repo Markets: “Gary Norton at the Brookings Institution has argued that we still do not have the vaguest idea of the size of the repo market.”

6) Rating Agencies: We need “to consider whether overreliance on ratings based on co-variance formulas is a trustworthy substitute for facts. Any reform effort must keep in mind the difference between facts, which can be tested for truth, and opinions, such as ratings, which can’t. Facts are not simply about transparency; facts are about empirical truth.”

de Soto has long been a hero of conservative property rights groups. Unfortunately, the official Republican position on finance reform appears not merely to tolerate, but to affirmatively encourage the “destruction of economic facts” that de Soto laments. Leaders like Spencer Bachus want to reduce funding for the SEC, the Office for Financial Research and the Office of Credit Ratings (or kill the latter offices outright).

Some might be astonished that a political movement based on the rhetoric of “property rights” sees fit to undermine the very institutions necessary for us to understand who owns (and owes) what. But perhaps we shouldn’t be surprised, since rapidly increasing opacity in political donations makes it very difficult to understand what dominant donor classes are demanding. Just as the Koch-allied groups have largely drown out other libertarian voices on monetary policy, so too can veiled money flows trump the doux commerce ideal of an invisible hand. Who wants to be on the wrong side of Rove’s Crossroads group? There is a much broader “process of social control” at work here.

Ideas for Reform

de Soto gives several brief suggestions for reform; more are developed in detail in the Roosevelt Institute report “Make Markets Be Markets.” For example, Joshua Rosner elaborates on worries about bundled mortgages, and proposes a solution:

[K]ey terms that define contractual obligations are not standardized across the industry, across issuers of securities with the same type of collateral (e.g. RMBS, CMBS or RMBS based CDOs) or even by issuer (each issuer often had several different Pooling and Servicing Agreements and Representation and Warranty Agreements).

The lack of standardization and the length of the documentation effectively created opacity, which contributed to the problems in the securitization market. When panic set in and investors began to question the value of their securities, they knew that they did not have the time to read all of the different several- hundred page deal agreements. This reinforced the rush to liquidate positions. . . .

In order to accurately price securities, investors need timely loan-level performance data on the assets backing each deal. We need loan-level data on a daily, or at least monthly, basis in both the primary and secondary markets. Without frequently updated and standardized disclosure of loan-level data, market participants can’t independently analyze and credibly value asset-backed securities based on full information.

I think these are very good points, but reformers will need to overcome much entrenched dogma about the sanctity of trade secrets and proprietary information. In coming weeks, I’ll be focusing on other solutions, suggested in sources ranging from the de Larosiere report to Eric J. Weiner’s book The Shadow Market. I’ll also look at journalists’ ideas of their role, ranging from Gillian Tett’s pre-crisis “Iceberg Memos” (which warned FT managers that they were only covering the tip of an increasingly murky financial world) to Joe Nocera’s recent declaration that journalists have a fundamentally different role than, say, law enforcement, because they lack surveillance tools.

Consumer Combat: Crouching Exceptions, Hidden Fees

I have one more big picture point to make: “gotcha capitalism” extends from the highest levels of finance down to the consumer end of the economy. As Nathalie Martin recently noted:

I heard a humorous radio program this morning in which Europeans were complaining about how you never know the real price of anything in America. Things seem cheap, but once you consider the taxes, the tipping, the hidden ad-ons, the price is so much more. There is no transparency. Boy, they don’t know the half of it. At times it seems everywhere you turn, you find a scam or an unauthorized fee.

I have been following efforts to improve transparency in health insurance contracts, especially those sponsored by the Center for Consumer Information & Insurance Oversight. Recently, Daniel Schwarcz has demonstrated the need for more clarity in homeowners’ insurance policies, too:

The current personal lines insurance marketplace is largely organized around a myth. That myth is that personal lines insurance policies are completely uniform. This myth explains regulatory rules that do nothing to promote insurance contract transparency. It explains the ignorance of most information intermediaries about the details of contract terms. And, to a substantial degree, it explains the willingness of courts to treat insurance policies as ordinary contracts. . . .

[The situation] reflects the efforts of carriers to limit coverage relative to the presumptive industry baseline. These insurers have actively hidden and obscured this trend, in notable contrast to the comparatively transparent marketing of the few carriers who have departed from standardized policies to improve coverage. If regulators do not act to substantially improve consumer protection in this domain, then it can be expected that coverage will continue to degrade for most carriers, in a modern day reenactment of the race to the bottom in fire insurance that triggered the first‐wave of standardized insurance policies.

Many commentators have worried that consumer protection has been a neglected goal of bank and insurance regulators, whose primary goal was promoting credit and industry. Consumer protections in the financial world have too often been treated as a distraction from the primary goals of regulators, rather than as a critical part of their mission. As work from de Soto’s to Schwarcz’s shows, that attitude is impossible to sustain. Practices that harmed borrowers contributed to a larger crisis of confidence that threatened to initiate a chain reaction of catastrophic consequences for the finance system. In 2010, legislators realized that the regulatory arbitrage persistent in the financial sector—where the Office of Thrift Supervision, Office of the Comptroller of the Currency, and other regulators competed to offer the most lax regulatory regime—served neither consumers nor the larger economy. The Dodd-Frank Act addresses both concerns by establishing a Financial Stability Oversight Council, the Consumer Financial Protection Bureau, and the Office of Financial Research. Each could help rebuild institutions devoted to the “economic fact-finding” that de Soto recommends.

Photo Credit: Autovac.

Volume 58, Issue 3 (February 2011)

Articles

Comments

Why the difference? Is the economic recovery helping the Big 3? Is chapter 11 bankruptcy the reason for the apparent rebirth of General Motors and Chrysler? If so, what explains Ford’s current success (for some interesting perspectives on this, see here and here)?

Many commentators have analyzed the General Motors and Chrysler bankruptcy cases, and they thoughtfully [...]]]> The PR departments of the Big 3 automakers are working overtime. With the public opening of the North American International Auto Show just days away, Ford, General Motors and Chrysler released financial results showing a significant increase in sales in 2010 and promising outlooks for 2011. And the flurry of news coverage certainly has a different feel than the doom and gloom of the coverage just two years ago (see, e.g., here).

Why the difference? Is the economic recovery helping the Big 3? Is chapter 11 bankruptcy the reason for the apparent rebirth of General Motors and Chrysler? If so, what explains Ford’s current success (for some interesting perspectives on this, see here and here)?

Many commentators have analyzed the General Motors and Chrysler bankruptcy cases, and they thoughtfully dissect what was novel, not so novel and somewhat troubling about those cases (see, e.g., here, here and here). It is difficult to assess exactly what role chapter 11 played in General Motors’ and Chrysler’s recoveries, other than to state the obvious that both companies used the process to reduce overhead and balance sheet liabilities significantly. That certainly can provide new life to a company; the question then becomes what the company does with the opportunity.

This is where I see an interesting, common thread among the Big 3’s recoveries—management changes that preceded or accompanied the financial restructurings. (For a thoughtful study on CEO pay and turnover in reorganizations, see here.) Bill Ford, Jr. stepped down and decided to hire Alan Mulally (see here), who made bold decisions regarding Ford’s operations. The government very publicly ousted General Motors’ CEO, Rick Wagoner, and some touted management change as one of the advantages to the Fiat/Chrysler deal (see, e.g., here). Given the connection between the Big 3’s financial problems and their business models, management change as a catalyst of recovery makes sense.  (For an interesting discussion of competitive advantage that touches on the auto industry, see here.) But can they sustain this success?

At the moment, all three seem focused on market demand, controlling costs and improving the bottom line—things of which they arguably lost sight in the not so distant past. And they all have potential opportunity in R&D and their new fuel-efficient cars (see, e.g., here and here) as experts predict gas prices to soar to new highs and Toyota continues to struggle to regain market share. But can management stay on track, and do their boards have the fortitude to make another change at the top if necessary? (For a recent example of board/CEO conflict, see here.)  Only time will tell but it certainly will be an interesting ride.

Ibanez held that, according to well-established Massachusetts precedent, a mortgagee cannot foreclose unless — surprise, surprise — it actually isthe mortgagee, or a legitimate assignee thereof.  In Ibanez,  lenders or servicers had foreclosed mortgages prior to completing (or commencing) the process of taking assignment of the note and  mortgage  on which they foreclosed.  When they later sought to clear title, Massachusetts courts balked.   “Utter carelessness,” Justice Cordy scolded the plaintiffs.

mistakes were made

This is potentially a huge [...]]]> The Massachusetts Supreme Judicial Court’s recent ruling in U.S. Bank v. Ibanez  is the latest and loudest salvo in what may be the most engaging and gruesome legal aspect of the credit crisis yet:  The day of reckoning for the staggering sloppiness that infected virtually every step of the mortgage-securitization process.

Ibanez held that, according to well-established Massachusetts precedent, a mortgagee cannot foreclose unless — surprise, surprise — it actually isthe mortgagee, or a legitimate assignee thereof.  In Ibanez,  lenders or servicers had foreclosed mortgages prior to completing (or commencing) the process of taking assignment of the note and  mortgage  on which they foreclosed.  When they later sought to clear title, Massachusetts courts balked.   “Utter carelessness,” Justice Cordy scolded the plaintiffs.

mistakes were made

This is potentially a huge problem for mortgage servicers (among others), given the long and convoluted chains of title through which mortgages may have passed in order to create mortgage-backed securities (MBS).   Not surprisingly, many observers are apoplectic, warning that this will lead to the end of the financial markets as we know them. 

How did this happen? 

There are probably several answers, but I think one is that the elite financial services sector (EFSS) that created the MBS is (or believes itself to be) a unique institutional force, unchallengeable by the ordinary legal or political mechanisms that keep institutions in check.  It is immune from the rules and norms  that apply to the rest of us.  But we know that spoilt children often lack discipline, so persistent failures of scrutiny have led inevitably to failures of competence. The drip, drip, drip of deregulation left us with firms that are not only too big to fail: they’re also too big to succeed. 

What will happen next? 

We can expect that the EFSS will respond to Ibanez as it always has after suffering any set-back: It will run to Congress for help. With a newly purchased Republican majority in the House, it will likely get it. 

The important questions for those concerned about the power of the EFSS should therefore be: 

1.  What power does Congress have to remedy these mistakes—especially in a world where, Republicans would tell us, we are bound to a Constitution whose “original” understanding would probably not tolerate federal intrusion into state power over real property conveyancing? and

2.  What will we get in exchange for fixing yet another mess created by the EFSS?

Others have already begun to address the former question, and the latter will play out in the media if (when) Congress takes up the question in the future.  I think many (not all) would agree that we should not permit portfolios of MBS to collapse further, or void (technically flawed) foreclosure sales to bona fide purchasers.  But simply sweeping aside state foreclosure law (as Congress nearly did last term) is probably not the answer, either.

In the meantime, what no one seems to have noticed is the larger point here:  We have, for many years, made “the rule of law” a core objective at home and abroad.    What this means generally — and whether it is sound policy — are debates above my pay grade.  Yet, whatever else it may mean, it would appear that from bailout to whiteout, when it comes to the EFSS, it is the rule of flaw — not the rule of law — that counts.

Sounds like a dream coming true, right? Unfortunately, for many lottery winners, winning the lottery eventually leads to bankruptcy (see here, here and here). Statistics tend to show that a good portion of lottery winners file chapter 7 or chapter 13 personal bankruptcy cases within five years of receiving their jackpots (see here and here). In one sense, the tale of doom attached to big lottery winnings seems similar to the ploy of telling a bride that rain on her wedding day signals good luck—it makes those of us who [...]]]> Two lucky people woke up this morning mega millionaires. After yesterday’s lottery ticket buying frenzy, one winning ticket was sold in Idaho and the other in Washington (see here). The winners will share equally the $355 million jackpot.

Sounds like a dream coming true, right? Unfortunately, for many lottery winners, winning the lottery eventually leads to bankruptcy (see here, here and here). Statistics tend to show that a good portion of lottery winners file chapter 7 or chapter 13 personal bankruptcy cases within five years of receiving their jackpots (see here and here). In one sense, the tale of doom attached to big lottery winnings seems similar to the ploy of telling a bride that rain on her wedding day signals good luck—it makes those of us who didn’t win feel a little better. In another sense, however, it highlights a real problem in our approach to financial education.

Yesterday, the American Bankruptcy Institute reported a significant increase in overall personal bankruptcy filings. Undoubtedly, some of those filings are the direct result of the recession, and some filings stem from similar unforeseen changes in circumstances, such as divorce and serious health problems. But many personal bankruptcies involve honest, unsophisticated individuals who simply do not understand or have the skill set to manage their personal finances. Yes, these individuals should take responsibility for their finances, but they also need training and resources to be successful in that endeavor. Studies suggest that many high school graduates do not understand how credit cards and other basic financial instruments work (see here, here and here), yet most carry credit and debit cards in their wallets.

I appreciate the enormous challenges facing the U.S. education system. As we evaluate these challenges, however, we need to consider financial education as part of the core curriculum. We also need to continue working to provide meaningful financial education to adults (for an interesting study concerning financial education and bankruptcy, see here). Although the 2005 amendments to the U.S. Bankruptcy Code incorporate a consumer education component, that requirement has become little more than the potential debtor sitting in front of a computer screen and answering a few questions in order to be able to file her bankruptcy petition (for other perspectives, see here, here and here; for an excellent study regarding the impact of the 2005 amendments on consumer debtors, see here). I hope that as the economy recovers, so too do our financial education initiatives  (see here and here) so that more individuals have a real chance at sustainable financial health.

Consider, for example, Borders, which recently announced that it was suspending payments to vendors and trying to refinance its debt obligations (see here and here). Borders, like its competitor Barnes & Noble, is struggling to compete with big box retailers that offer steep discounts on traditional books and the growing popularity of e-Books (see here, here and here). Also like many retailers, Borders was hit hard by the economic recession (see here).

Some may say that Borders is a victim of the recession and [...]]]> In my opening post, I referenced the slow pace of change and how it can be exceedingly painful for individual consumers. I want to follow up on that concept in the business context, where slow change—or the failure to change at all—can be fatal.

Consider, for example, Borders, which recently announced that it was suspending payments to vendors and trying to refinance its debt obligations (see here and here). Borders, like its competitor Barnes & Noble, is struggling to compete with big box retailers that offer steep discounts on traditional books and the growing popularity of e-Books (see here, here and here). Also like many retailers, Borders was hit hard by the economic recession (see here).

Some may say that Borders is a victim of the recession and creative destruction. And that may, in part, be accurate. (For interesting perspectives on the utility of recessions and creative destruction, see here and here.) But anyone who follows the retail industry or is an avid reader had some sense that this was coming (see here, here and here). So why didn’t Borders’ management? Or rather, why didn’t they react more quickly to the changing market and economy?

As a former corporate restructuring lawyer, I often ponder this and similar questions. Why do managers try so hard to salvage rather than innovate? And why is it so hard for them to admit that change—perhaps both financial and operational innovation—is necessary? (For a discussion of the denial often accompanying financial distress, see here.)

Admittedly, it is easy to throw out questions from the cheap seats and much harder to make the calls from the sidelines (or boardroom). I have worked with, and truly appreciate the challenges and difficult decisions faced by, the management of troubled companies. I am not trying to assess blame; I am simply suggesting that we recast creative destruction as creative reconstruction.

Creative reconstruction is not my phrase. Others have used it in a variety of ways, including Chrysler’s CEO, Sergio Marchionne (see here). I use the phrase to describe a company seizing upon the change agents typically associated with creative destruction to reduce inefficiencies or modernize operations. Rather than those change agents destroying the company, they motivate the company to reinvent itself. (For another perspective on creative destruction and firm success, see here.) All too often, those outside of the restructuring community view corporate reorganizations solely as balance sheet restructurings—only to prolong the inevitable. Corporate America and the U.S. bankruptcy system can and should do better (see here).

I will reflect on whether creative reconstruction is working for Chrysler (and GM) in a future post, as well as its prospects under the resolution authority contemplated by the Dodd-Frank Act. (For another perspective on creative destruction and the Dodd-Frank Act, see here.) The concept may not work for every company; some companies should fail. Nevertheless, if the approach encourages troubled companies to analyze their problems sooner and consider implementing change more quickly, it is worth a try.

First off, he lamented the fact that we have been holding hearings like this since 2007. “Every year we have another set of hearings, and you can add 2 million foreclosures” to the bottom line. Nothing gets fixed, despite all kinds of documented evidence that the banks and servicers have committed fraud. Levitin’s position is that the servicers should be banned from the loan modification business entirely, because they don’t have any interest in it except as a profit-maximization scheme, and they have massive conflicts of interest that cut [...]]]> Adam Levitin has been one of the most courageous and compelling commentators on the financial crisis. So it’s not much of a surprise to see this report on his latest testimony before the Senate Banking Committee:

First off, he lamented the fact that we have been holding hearings like this since 2007. “Every year we have another set of hearings, and you can add 2 million foreclosures” to the bottom line. Nothing gets fixed, despite all kinds of documented evidence that the banks and servicers have committed fraud. Levitin’s position is that the servicers should be banned from the loan modification business entirely, because they don’t have any interest in it except as a profit-maximization scheme, and they have massive conflicts of interest that cut against doing right by the borrowers (and even the investors for whom they work).

Levitin said that we don’t have the full data sets from the servicers, or any comprehensive data to see whether there is a full-on crisis of unclear title and improper mortgage assignment. In other words, we don’t quite know the full extent of the problem. Levitin said, essentially, “The federal regulators don’t want to get info from servicers, because then they’d have to do something about it.” They don’t want to recognize the scope of the problem because it would require them to act. And Levitin in particular singled out the Treasury Department. “The prime directive coming out of Treasury is ‘protect the banks’ and don’t force them to recognize their losses.”

While I’m sure the FCIC will issue a nuanced report on the web of causes behind the foreclosure crisis, Levitin sees the spider. It looks like courts are beginning to identify it, too. As Kate Berry reported in the American Banker,

Countrywide, the mortgage giant that’s now part of Bank of America Corp., routinely didn’t bother to transfer essential documents for loans sold to investors, an employee testified. The testimony — which a New Jersey bankruptcy judge cited in dismissing a B of A claim against a debtor — could complicate attempts by the company to foreclose on soured loans that Countrywide originated and sold in better times.

The B of A employee’s admission that the lender customarily held on to promissory notes could also undermine the industry’s position that document transfers to securitization trusts are fundamentally sound. O. Max Gardner, a North Carolina consumer bankruptcy lawyer who was not involved in the case, called the testimony “a major problem” for B of A, which acquired Countrywide, the country’s largest servicer of residential mortgages, in 2008. “These original notes were supposed to be transferred and delivered all the way up the line and for this witness to admit they were never transferred is pretty amazing,” Gardner said. “I’ve never see this admitted anywhere.”

I guess there’s a reason why so much financial activity nowadays goes on in the “shadow banking system.” And as Gillian Tett notes, what’s more worrisome is the role of the “shadow, shadow banking” system propping it up:

[M]any things about the modern financial system remain mysterious – even today. On the edges of [their diagram of the extant shadow banking system], NY Fed economists list all the government programmes that have supported the system since 2007 (and, in effect, replaced shadow banks when they suffered runs). This “shadow, shadow bank system” – as it might be called – looks complex and baffling too. And in practical terms, the sheer breadth and complexity of that box makes it hard to know what will happen if – or when – government aid disappears.

Commentators on the left and the right realize the magnitude of the problem. Perhaps Levitin will help the “sensible middle” connect foreclosure fraud, systemic risk, and a struthious Treasury Department.

For the last several years, I’ve posted recaps of the Annual Empirical Studies Conference.  (See me, @ Cornell, @ USC).  This year, as promised, will be no different.  Yale hosted CELS V, and the committee did a bang up job: the food was tasty; there were no technical snafus of note; and the panels appeared to have a high degree of internal validity & congruence. Richard Brooks, Alan Gerber, Dan Kahan, Yair Listokin, Tracey Meares, and (especially) Roberta Romano are all due a round of applause, or, better yet, supersized computer monitors so they can see their data better.  In this post, I’m going to provide a running diary of the conference.  It will be like you [...]]]>

Data Collection Makes Everyone Grumpy and Hunched Over

For the last several years, I’ve posted recaps of the Annual Empirical Studies Conference.  (See me, @ Cornell, @ USC).  This year, as promised, will be no different.  Yale hosted CELS V, and the committee did a bang up job: the food was tasty; there were no technical snafus of note; and the panels appeared to have a high degree of internal validity & congruence. Richard Brooks, Alan Gerber, Dan Kahan, Yair Listokin, Tracey Meares, and (especially) Roberta Romano are all due a round of applause, or, better yet, supersized computer monitors so they can see their data better.  In this post, I’m going to provide a running diary of the conference.  It will be like you were there with me, except you don’t have to suffer through my bouts of social anxiety!

Unfortunately, I missed the hottest ticket of the conference, Bruce Ackerman’s commentary on Law/Versteeg’s The Evolution and Ideology of Global Constitutionalism.  From all reports, Ackerman said something like: “wrong questions, wrong data, wrong theory,” and then imploded in frustration.  Instead of watching those fireworks, I was watching Yair Listokin present The Meaning of Contractual Silence: A Field Experiment [Here’s an older version of the paper].  Listokin ran a field experiment selling ipods on ebay, some with a warranty, some as-is, and some silent on the warranty term. He found that individuals paid attention to the contract, and there was some evidence that the UCC default was about what they thought silence meant.  As he admitted, there were problems with the design of the study – particularly, (1) small & skewed samples; and (2) a lack of clarity about how much buyers know about ebay’s unique and self-contained dispute resolution system.  As someone remarked after the presentation, it would have been interesting had Listokin sold all the customers bad ipods (instead of good ones) and studied how the contract terms influenced behavior post-“breach”.  Then again, who needs that IRB hassle?

I then saw three cool experimental papers at a Law and Psychology panel. The stone-cold coolest was by Sah/Loewenstein/Cain, and presented by SOM’s Daylian Cain.  The central claim in The Burden of Disclosure is that there is a “previously unrecognized perverse effect of disclosure: Disclosure of an advisor’s conflict of interest can decrease advisees’ trust in the advice while simultaneously increasing pressure to comply with that advice. This compliance pressure comes from two mechanisms: (1) recipients fear signaling distrust of the advisor, and (2) recipients feel an increased pressure to help their advisor when the advisor’s personal interests have been disclosed.”  Here’s the set-up.  Apparently, the experimenters have truck that they drive around town.  They lure people into the truck.  Once inside, subjects are paired.  One member of the pair is told they can roll one of two dice.  Each dice has a lottery attached to how it lands (i.e., if it lands on one, you get a starbucks card; two a snack; etc.)  One of the dice-lotteries has a higher expected payoff.  Now, they have the non-rolling subject advise the choosing subject on which die to pick.  (The non-picker has no special knowledge.)  Sometimes, the advisor has a conflict – s/he gets the good lottery if the picker picks the bad die.  Not surprisingly, that conflict leads the advisor to suggest picking the bad die, and because people are suggestible, the advice is taken more often than not.  But the wild manipulation happens when the advisor discloses this conflict to the picker. Notwithstanding the obvious truth that the advisor now has told the picker than they are motivated to give bad advice, the picker actually accepts the recommendation more often!  As Daylain explained, the mechanism might be a form of interpersonal conflict-avoidance: we don’t want to look someone else in the face and tell them that we think they are corrupt.  (Dan Simon, commenting, suggested that the mechanism might simply be a dictator game-like fairness norm.)

What’s troubling about this experiment is that disclosure is the law’s preferred solutions to many conflict problems.  This perverse effect has the potential to be at play in many real-world situations – lawyers, doctors, brokers, managers, shareholders – where we expect the disclosure to clean otherwise fouled waters.  And maybe it isn’t limited to the situation where the disclosing party makes a disclosure that is obviously against their self-interest. What about when journalists disclose their political contributions as a way of legitimizing them?  Though this would seem to clarify their ideology & perhaps cause us to think carefully about how they construct stories, maybe it is, instead, making us trust them more.  (Evidence against Olbermann?)  Similarly, political regulation seems to have shifted decisively away from substantive checks toward a sunlight/disinfectant model.  This research agenda suggests a host of pretty deep problems with that approach.

Moving right along, Yale apparently spent something like $500M on the poster session, because the overall production quality has now approached that of a drug-company-funded science convention.  Highlights included (1) Bermant/Barness-Blakeman’s Beyond Ownership: Lessees and Idiosyncratic Valuation, which extends the endowment effect literature to mere tenants; (2) Estreicher/Heise/Nash’s Examining the Instrumental Use of Pro Bono Projects by Law Firms: Preliminary Evidence, which suggests that pro bono hours are in part a function of firm health & that over time, firms  have increasingly used pro bono for training purposes; and (3) Buccafusco/Sprigman’s The Creativity Effect, reporting on an endowment/creation experiment. Yale also spent tons of money on food, but I’d caution future organizers that the make-your-own-bruschetta trend is a bad one, especially when you are in a roomful of socially and physically awkward people.

I chaired a panel Saturday, and failed to keep Dan Simon or Dan Kahan to the time they were allotted.  Simon’s presentation on Simon/Stenstrom/Read’s The Spontaneous Arousal of Hot Cognitions in the Course of Deciding Criminal Cases was still pretty fun, even as I stewed at my lack of power. Unfortunately, chairing the panel meant I had to miss Cohen’s Expeditiousnesses and Delay in State Courts: An Exploration of Case Processing Time in Civil Trials, which I heard was great, and Bilz/Gold’s An Experimental Test of Civil Recourse Theory, which I know is awesome and which sheds some pretty useful light on why recourse theory might (and might not) explain private law doctrine.  (The paper doesn’t appear available online – email Bilz if you are interested in reading it.)  I then saw the Cohen/Lawless paper, Less Forgiven: Race and Chapter 13, which suggests that attorneys are pushing black (but not white) clients into making suboptimal choices in bankruptcy.  The best part of the paper was a survey-experiment (in the nature of a name/resume study) administered to bankruptcy attorneys nationwide.  This is the kind of work that ought to make national news & promote law reform.

I then presented Boyd/Hoffman, Litigating Toward Settlement, with Ted Eisenberg commenting.  As it turns out, you can get through 25 slides in less than 18 minutes. You just need to be nervous enough to talk very, very fast.  I saw a few more excellent papers (e.g., Pardo/Nash’s Ideological Voting in Bankruptcy) and called it a conference.

Presenter: CELS XXI

Some themes:

(1)        More experiments & psychologists at the conference than in past years.  It seemed that John Darley was on every other panel.  There were relatively fewer (I thought) case-counting projects, though this could be just the panels I went to.

(2)        More co-authorship between law professors & folks from other disciplines (rather than people from other disciplines coming in to talk about law, or law professors banding together).

(3)        The overall quality of the methods was quite sophisticated.  To the extent that the conference once billed itself as a place for people who needed help to get better … well, that’s not exactly what’s happening today.  The level of polish and gloss is high.  If if I were a junior scholar with incomplete data or methods, I don’t know that I’d feel comfortable presenting at CELS.  I do think that schools would do well to send empirically minded junior scholars to watch the panels – you can learn tons from watching error!

(4)        I only saw one paper that manifested Leiter’s claim that ELS practictioners use datasets to chase questions.  And that is exactly what the paper’s commentator said, though in much nicer terms.  Self-policing is alive and well.

(5)        CELS VI will be at Northwestern.  Will Lee Epstein make a push against powerpoint and toward whatever cool software she uses to run presentations?  Now’s her chance to make it happen!

(6)      After the dinner speech by Orly Ashenfelter, I know much more about wine pricing than I used to.  Good cocktail party conversation information.

Where's the goo?

They are, in short, evidence of the virtues of extreme recycling.

Just imagine the pitch meeting for Galactica:  We’ll take what has to have been one of the dumbest pop-culture packing peanuts ever and make it stronger, faster, better:  How about an allegory about civil liberties and faith after 9/11 using Cylons and vats of [...]]]> I don’t watch much TV.  So, I am hardly the person to make strong claims about its quality or trends.  That said, I find it fascinating that three of the best shows of the past few years—Battlestar Galactica, Madmen, and Glee—share a really odd structural feature:  They have all taken ridiculously bad ideas from cringe-able eras and turned them around completely, made them not only fresh, but evocative, disturbing, intriguing.

Where's the goo?

They are, in short, evidence of the virtues of extreme recycling.

Just imagine the pitch meeting for Galactica:  We’ll take what has to have been one of the dumbest pop-culture packing peanuts ever and make it stronger, faster, better:  How about an allegory about civil liberties and faith after 9/11 using Cylons and vats of goo?

Or what about Madmen:  Let’s explore the most virulent cancers on our culture with lovingly pornographic attention to detail, to demonstrate the complex symbiosis among banality, beauty, evil and exculpation.  Madmen is the money shot of commodity fetishism, proving once again the truth of Chomsky’s admonition that if you want to learn what’s wrong with capitalism, don’t read The Nation, read the Wall Street Journal.

And Glee?  Well, all I can say is:  Don’t Stop Believing.

Which may lead you to this question:  No one really takes the “and everything else” part of CoOps’s desktop mantra seriously, so what the frak does this have to do with law?

Two things.  First, it is a way to understand what’s wrong with the system-salvation provisions of Dodd-Frank.  Second, it describes what (imho) courts will have to do with the likely coming wave of lender liability (and similar) claims falling out from the credit crisis.

Dodd-Frank has already seen more than its fair share of attention, much of it centered on the instability built into the resolution powers given to the executive branch for systemically important (TBTF) firms.  No doubt, these powers might be threatening to capital market participants long accustomed to profound (and in some cases profoundly expensive) government obeisance.  Not only do we now know that the federal government, through the Financial Stability Oversight Council, really has the power to do what it said it couldn’t do (but sort of did anyway with Bear Stearns, AIG, GM, and, depending on your version of the story, Washington Mutual): we also know that the scope and use of these powers is almost entirely unpredictable ex ante.

What is extreme here is the failure to recycle, the failure to learn from history that lasting, effective regulatory restructuring requires years of investigation, analysis and horse-trading.  The Dodd-Frank Congress has tried to do in about a year what it took Roosevelt and his Congresses nearly a decade to do.  We may be faster, but I am not sure that we are that much smarter.  (I note, here, the one important exception to this criticism:  the creation of the Consumer Financial Protection Bureau.  While it was not based on massive, multi-year studies of the sort William O Douglas developed to support securities and bankruptcy reform, it nevertheless was backed by outstanding empirical and normative legal scholarship from two people (Warren and Bar Gill) who—while they may have an axe to grind—understand how properly to hone blades).

A form of extreme legal recycling I think we may see will involve the rebirth of the lender liability lawsuit.  During the 1970s and ‘80s—you know, when we had proto-Galactica and Journey—courts occasionally held lenders liable to borrowers or their creditors for enforcing their rights too aggressively (e.g., foreclosing for mere technical defaults), actions that may have been within the four walls of the contract, but nevertheless lacked “good faith.”

These cases largely collapsed under the convulsive contractarian logic of Frank Easterbrook in Kham & Nate’s No. 2:  Lender liability, Easterbrook told us, is an oxymoron, and courts have no business policing aggressive, but contractually contemplated, collection practices.

This may have made sense in the early 1990s, when lenders were banks trying to collect loans from borrowers whose technical defaults may (or may not) have signaled serious risk of payment default.  Today, I have argued to anyone who will listen, the world is fundamentally different:   We have a Shadow Bankruptcy System, which means, in part, that we have sophisticated, aggressive (largely) unregulated investors (hedge funds, etc) trading in a (largely) unregulated secondary market for distressed debt.  With credit derivatives, equity short sales, and a variety of important gaps in securities, bankruptcy and commercial law, opportunities for opportunistic behavior, I have argued here, appear to be rich and alluring.

Since Dodd-Frank won’t deal with this–Too Small To Matter?–the solution, I have also argued, is another kind of recycling:  build a newer, faster, better form of good faith review of distress investor behavior.  I don’t need to get into the details here.  Suffice to say, if you didn’t like “good faith” in the lender liability cases of the 1970s and 1980s, I’ve got something else you might want to think about.

To paraphrase Faulkner:  The past isn’t prologue—it isn’t even past.

Extremely Recycled Cylon courtesy of Wikimedia

And the existence of one of them, Ernst & Young, is threatened, as it faces the prospect of billion dollar liability for botched audits of Lehman Brothers, the defunct investment bank struggling in bankruptcy. It is an eerie echo of the fate of erstwhile big auditing firm Arthur Andersen, which dissolved after its culpability in 2001’s Enron fraud emerged.

Today, only four auditing firms have the resources and expertise to audit the vast majority of thousands of large public [...]]]> If you thought the 2008 credit crisis that temporarily froze global debt markets wrought havoc, watch out for the next shoe to drop.  At stake is the viability of global equity and other financial markets that could freeze if one of the four large auditing firms goes extinct.

And the existence of one of them, Ernst & Young, is threatened, as it faces the prospect of billion dollar liability for botched audits of Lehman Brothers, the defunct investment bank struggling in bankruptcy. It is an eerie echo of the fate of erstwhile big auditing firm Arthur Andersen, which dissolved after its culpability in 2001’s Enron fraud emerged.

Today, only four auditing firms have the resources and expertise to audit the vast majority of thousands of large public corporations. If one of those dissolved, its clients would have to scramble to find a replacement. Some of the remaining three lack requisite expertise for some of those corporations and others would be disqualified from auditing due to consulting work they do for them.

The result would be hundreds, possibly thousands, of large corporations who could not get their financial statements audited as required by US federal securities law. Stock markets could go berserk, along with other financial markets. The costs now, of moving from four firms to three, would dwarf those incurred when Andersen’s dissolution moved the total from five to four.

It does not appear that the US government, specifically its Securities and Exchange Commission, has any plans to deal with this prospect. It should. And it should announce them promptly to get ahead of any market crisis the failure of E&Y, or of the other three, would wreak. 

If not, the credit crisis of 2008 will look mild in comparison. After all, the credit crisis was readily addressed by government pumping enormous amounts of capital to rejuvenate liquidity; an auditing crisis cannot by solved by throwing money at it.

Allegations against E&Y are credible, making liability risk meaningful. The magnitude of potential loss certainly approaches $1 billion and may be much higher—alleged manipulations at Lehman ran to scores of billions of dollars.  E&Y, which self-insures against such risks and is unable to obtain significant external insurance, would face dissolution if compelled to pay such amounts.

The SEC should promptly prepare and announce steps to address that possibility. Alternatives, none of which is attractive and all pose costs, include:

* quickly seeking to break up the remaining three firms to eliminate conflicts of interest;

*quickly hiving off partners and resources of the existing E&Y (or other threatened firm) commanding expertise other firms lack, to enable them to continue auditing such clients; and/or

* relaxing auditing requirements or standards, by extending corporate audit deadlines or rules governing requisite auditor independence.

Though none of these is attractive or cost-free, they are far less costly than the probable costs  of market havoc that could result if no plans are made.    Longer term, I have laid out a series of prescriptions, in an article written a few years ago warning of the pending problem.

Observers should also watch the SEC closely as it participates in addressing the allegations against E&Y. SEC Commissioners, whose duties are to protect investors, will face a dilemma in evaluating how tough to be on the firm.

A tough line would be warranted in the name of protecting investors in Lehman Brothers, and signaling a commitment to audits of high quality.

But too tough a line would risk extinguishing E&Y, jeopardizing audit availability, and even equity market efficacy, for at least a meaningful period of time, wreaking havoc on investors.

January 2010 | Volume 119, Issue 4

On Tuesday, March 23, 2010, The Yale Law Journal Online will join with the Yale Law School Supreme Court Advocacy Clinic to host the concluding segment of “Important Questions of Federal Law: Assessing the Supreme Court’s Case Selection Process.”  The panel will bring together federal judges, members of the legal academia, [...]]]>

January 2010 | Volume 119, Issue 4

On Tuesday, March 23, 2010, The Yale Law Journal Online will join with the Yale Law School Supreme Court Advocacy Clinic to host the concluding segment of “Important Questions of Federal Law: Assessing the Supreme Court’s Case Selection Process.”  The panel will bring together federal judges, members of the legal academia, and practitioners to discuss potential reforms to the Supreme Court’s certiorari process. All events will be held at Yale Law School’s Sterling Law Building in New Haven, CT. Please click here for more information.

IMPORTANT QUESTIONS OF FEDERAL LAW
Yale Law School | New Haven, CT | March 23, 2010

Panel I: The Judge’s Perspective: Is the Court Taking the “Right” Cases?
4:10pm‐5:30pm, Room 129

Moderator: Linda Greenhouse (Yale Law School)
Panelists:
The Honorable José Cabranes (2d Cir.)
Drew Days (Yale Law School)
The Honorable Brett Kavanaugh (D.C. Cir.)
The Honorable Sandra Lynch (1st Cir.)

Panel II: The Practitioners’ Perspective: What Makes An Issue “Important” to the Court?
5:40pm‐6:55pm, Room 127

Moderator: Charles Rothfeld (Mayer Brown LLP and Yale Law School)
Panelists:
John Elwood (Vinson & Elkins LLP)
Orin Kerr (George Washington University Law School)
Patricia Millett (Akin Gump LLP)
Judith Resnik (Yale Law School)

I asked Jonathan Lipson, who previously owned the credit crisis for us, for his thoughts on a really interesting story involving the Philadelphia Inquirer’s bankruptcy process.  His (pretty cool, even for non-bankruptcy geeks) thoughts follow:

Like other markets for company control, the one created by Chapter 11 of the Bankruptcy Code is largely about information:  If you control the story, there’s a good chance you will control the outcome.

So it’s not surprising that The Philadelphia Inquirer has used its own storied assets—the paper and website–to try to sell readers on management’s plan to save the company from rapacious hedge funds and, in their words, “keep it local.”

As you may recall, Brian Tierney, who owns an advertising firm in the Philadelphia suburbs, [...]]]>

Our Roving Bankruptcy Correspondent

I asked Jonathan Lipson, who previously owned the credit crisis for us, for his thoughts on a really interesting story involving the Philadelphia Inquirer’s bankruptcy process.  His (pretty cool, even for non-bankruptcy geeks) thoughts follow:

Like other markets for company control, the one created by Chapter 11 of the Bankruptcy Code is largely about information:  If you control the story, there’s a good chance you will control the outcome.

So it’s not surprising that The Philadelphia Inquirer has used its own storied assets—the paper and website–to try to sell readers on management’s plan to save the company from rapacious hedge funds and, in their words, “keep it local.”

As you may recall, Brian Tierney, who owns an advertising firm in the Philadelphia suburbs, acquired The Inquirer and its related properties (The Daily News and Philly.com, their collective website), from the McClatchy papers in 2006 for about half a billion dollars.

Like several other newspapers, including The Chicago Tribune, The Inquirer could not service its massive acquisition debt.  Thus, in February 2009, the paper (and its affiliates) filed a Chapter 11 case in Philadelphia.  In August, management filed a proposed reorganization plan where Tierney (who manages the papers and owns some equity) and some of his supporters would buy the papers out of bankruptcy, for about $90 million, leaving most large creditors—i.e., the ones holding the acquisition debt–with a very small recovery.  The management buyout would be subject to higher and better offers.

According to the official Creditors’ Committee in the case, the Inquirer’s “keep it local” campaign is designed to make sure there are no better offers.  Management’s ad campaign warns of dire consequences “[i]f out-of-towners were to seize control.”  Allegedly hailing from such illiterate venues as New York, Beverly Hills “and even Lausanne, Switzerland, these out of towners would feel little commitment to, or understanding of, [Philadelphia’s] local non-profit needs.”

This may be true.  But, of course, The Inquirer is at least purportedly a for-profit venture.  Thus, the more realistic concern is that outside investors would further cut an already thin staff, and perhaps eliminate The Daily News entirely in order to boost their own dividends and management fees. “Keeping it local” is, at least in part, about preserving jobs in Philadelphia.

Not surprisingly, the Creditors’ Committee—which wants higher and better bids for the paper–has objected to the advertising campaign, and filed a motion asking the Court to enjoin it.  “This entire campaign is designed to dissuade otherwise interested bidders, who will think twice before participating in the auction . . . . This is bid chilling, plain and simple.”

Three things are ironic about all of this.

The Committee Objection

First, the Committee’s objection is as interesting for what it omits as what it says.  Thus, while it gets at the basic issue—bid chilling—it misses the easiest objection, which is that the ad campaign is a bald attempt to solicit votes on a reorganization plan before a disclosure statement for the plan has been approved.

At the risk of asking CoOp readers to become bankruptcy geeks, the basic idea here is that a plan (such as management’s) can only be approved if a sufficient number and amount of creditors vote for it.  But they cannot vote on it without having first received a court-approved “disclosure statement”.  Until the court approves a disclosure statement, you are not supposed to solicit votes on a plan.  So, if management wants to tell the story that its plan beats any alternative, it can only do so through an approved disclosure statement.  Not adjacent the editorial page.

While management has filed a disclosure statement, it has not, so far as I can tell, been approved.

Maybe the Committee omitted the argument because of the Third Circuit’s controversial 1988 opinion in a case known as Century Glove.  There, Judge Roth gave a fairly relaxed interpretation to these rules, holding in essence that a creditor with a competing plan could solicit particular creditors to oppose the debtor’s plan and support its own instead.  Century Glove, Inc. v. First Am. Bank of New York, 860 F.2d 94, 101 (3d Cir.1988)

But even Century Glove acknowledged that the Bankruptcy Code “bars certain solicitation activities, regardless of the intent of the actor. Whether that provision is violated is not a matter left to the discretion of the bankruptcy court, but is a matter of fact and law.”  860 F.2d, at 97.  The point of Century Glove was to permit creditors and debtors to negotiate about potential plans notwithstanding the requirement that there be a disclosure statement in place.  That’s not what’s happening here.

To be sure, the ad campaign contains the disclaimer you’d expect: “The statements and information contained herein are . . . not intended to solicit and are not provided for the purpose of soliciting or otherwise obtaining approval of a plan of reorganization.”  (Interestingly, the disclaimer does not print from the web).  And, it goes to the world—not just creditors.  Still, it’s hard to see what it is if not a request to support management’s plan.

Similarly, but perhaps not surprisingly, the Committee does not identify any actual or potential bidders who might be chilled here.  This may be because they don’t exist.  Newspapers are not exactly hot investments these days.  Moreover, it is difficult to imagine hedge fund managers in Switzerland (or Beverly Hills) saying “you know, let’s not bid for The Inquirer.  True, it could make us rich.  But that ad campaign has really made us think twice.”

In any case, the real play here may be for the banks that lent Tierney the half-billion dollars in 2006 to do what’s called “credit bid” for the assets.  This essentially means they would foreclose on the newspapers unless someone paid them in full.  Explaining whether that is likely to happen, and what it would mean, would tax the endurance of even the most-die-hard CoOp reader.

Venue Choice

The second thing to note is that the whole case could be viewed as an ironic data point in the raging academic debate about venue choice in Chapter 11 cases.

The venue rules which govern where a company can file a Chapter 11 case are quite liberal. They permit a debtor to file where any company in the group is incorporated.  So it is usually not hard to find a connection to New York or Delaware, which happen to have the two most popular bankruptcy courts, so far as Chapter 11 cases are concerned.  Thus, the Chicago Tribune case is in Delaware, not Chicago; GM and Chrysler are in Manhattan, not Detroit.

UCLA law professor Lynn LoPucki has argued that, as with corporate law in Delaware, there has been a “race to the bottom” in the selection of courts that hear large Chapter 11 cases.  According to LoPucki, the Manhattan and Wilmington bankruptcy courts have captured most of the large bankruptcy cases because, among other things, company managers and bankruptcy professionals in those cities believe they can get away with anything in those courts, no matter how harmful to investors or employees.  These courts permit this sort of behavior because they want the notoriety and excitement of large and complex cases.

Others, in particular Penn law professor David Skeel, have responded that venue choice in Manhattan and Delaware isn’t evidence of anything nefarious.  It’s just the market for Chapter 11 cases.  These courts have the most sophisticated lawyers and judges, and (thus) produce the best results under the circumstances.

There is no doubt that the largest cases often do end up in Manhattan or Wilmington—and not in Philadelphia, or wherever the debtor’s “local” operations are.  What we can infer from that, however, is a more complex proposition.  I have avoided wading into the debate, in part because I am not sure it really asks the right questions.

But if you do think Chapter 11’s venue rules are too liberal, and the process would better serve investors and employees if conducted in the “local” venue of the debtor, then you may want to think about what’s been going with The Inquirer.

Here, we have expensive lawyers from large, far-away firms (Proskauer-Chicago and O’Melveny-Los Angeles, respectively), representing the company and Creditors’ Committee, locked in what appears to be a scorched-earth battle to control the fate of these papers.  Insiders and professionals may do well in this process.  The newspapers—and the “locals”?  Not so much.

Who Cares?

The third irony is that all this squabbling may not matter much.  Even if Tierney and his group want to keep the papers afloat—and even if that is the best deal going—they may not succeed.

If we are to believe Philadelphia’s Mayor, Michael Nutter, the city is on the brink of experiencing its worst financial shock in modern history due to shenanigans in the state legislature that have left Pennsylvania the only state in the union without a budget.  If the worst comes to pass—and it might—Nutter says he will have to eliminate 3000 jobs and severely curtail city services.

If Harrisburg tells Philadelphia to drop dead, it is hard to see who will be left to read any newspapers, whether the owners live in Philadelphia or Lausanne.