Neuroeconomics and Innovation

I'm in LA for the next few days, at the Law, Economics and Neuroscience Conference: Implications for Innovation, sponsored by The Southern California Innovation Project, Theoretical Research in Neuroeconomic Decision-making (TREND) and The Center for Communication Law & Policy. As the press-release says, the idea is to bring together neuroscience researchers, economists, and ordinary law professors and see if the whole is greater than the sum of their parts.

[Gillian] Hadfield [who is organizing the conference on the law side] hopes the symposium will lead to more collaboration among scholars who may appear to have very different goals and backgrounds.

“You don’t usually find scientists, economists and lawyers talking together about the same topic,” Hadfield said. “I think people will find that we can enrich the research agenda of all these disciplines with this kind of cross pollination.”

I hope to blog the conference, or at least my parts in in, over the next few days. I'll be commenting on Mat McCubbins' co-authored paper, The Effect of Institutions on Behavior and Brain Activity: Insights from EEGs and Timed-Response Experiments. In the paper, on Boudreau, Coulson, and McCubbins found that identical cooperative behavior in a trust game seems to arise from distinct neurological mechanisms, depending on whether trust in others arose from incentives or penalties. After the session tomorrow I'll post some of my comments, which intend to connect this paper to the large law review literature on trust.

Posted by Dave Hoffman at 08:15 PM | Comments (0) | TrackBack

Party at Moody's

Anyone interested in the proper balance between market and government in the securities field should check out Roger Loewenstein's article on the ratings agencies from the NYT. Here's the bottom line:

[By 2006], [a]lmost all of . . . subprime loans ended up in securitized pools; indeed, the reason banks were willing to issue so many risky loans is that they could fob them off on Wall Street. But who was evaluating these securities? Who was passing judgment on the quality of the mortgages, on the equity behind them and on myriad other investment considerations? Certainly not the investors. They relied on a credit rating.

Thus the agencies became the de facto watchdog over the mortgage industry. In a practical sense, it was Moody's and Standard & Poor's that set the credit standards that determined which loans Wall Street could repackage and, ultimately, which borrowers would qualify. Effectively, they did the job that was expected of banks and government regulators. And today, they are a central culprit in the mortgage bust, in which the total loss has been projected at $250 billion and possibly much more.

What's particularly interesting here is how the ratings agencies' dominance in their field can be in part attributed to their own failure to foresee the Penn Central collapse:

[S]everal trends coalesced to [improve raters' profits]. The first was the collapse of Penn Central in 1970 -- a shattering event that the credit agencies failed to foresee. It so unnerved investors that they began to pay more attention to credit risk.

Government responded. The Securities and Exchange Commission, faced with the question of how to measure the capital of broker-dealers, decided to penalize brokers for holding bonds that were less than investment-grade (the term applies to Moody's 10 top grades). This prompted a question: investment grade according to whom? The S.E.C. opted to create a new category of officially designated rating agencies, and grandfathered the big three -- S.&P., Moody's and Fitch. In effect, the government outsourced its regulatory function to three for-profit companies.

Bank regulators issued similar rules for banks. Pension funds, mutual funds, insurance regulators followed. Over the '80s and '90s, a latticework of such rules redefined credit markets. Many classes of investors were now forbidden to buy noninvestment-grade bonds at all. Issuers thus were forced to seek credit ratings (or else their bonds would not be marketable). The agencies -- realizing they had a hot product and, what's more, a captive market -- started charging the very organizations whose bonds they were rating.

How to solve the problem? Here's Alan Blinder's view:

Dilip Abreu suggests paying ratings agencies with some of the securities they rate, which they would then have to hold for a while. Robert Pozen, head of MFS Investment Management, wants independent investors in the conduits to hire the agencies instead. Another idea would have a public body, like the S.E.C., hire the agencies, paying the bills with fees levied on issuers. If you have a better idea, write your legislators.

Might some form of liability for reckless ratings also help? One thing is certain: the cozy relationship between the raters and the rated has to end. Frank Partnoy has been writing about this for some time; he's probably one of the few who would be unsurprised by this catalog of conflicts compiled by Aaron Lucchetti:

[By 2006, Moody's] became willing, on occasion, to switch analysts if clients complained. An executive overseeing mortgage ratings went skydiving with a client. . . . [Profits at Moody's] rose 375% in six years. The share price quintupled. . . . As Moody's staff grew to accommodate the surging mortgage market, [a top executive] arranged off-site meetings for employees to get to know each other better. At one, he sung as a Blues Brother, while at another, two Moody's executives entertained by wrestling in fat suits.

When the de facto market regulators are aping Austin Powers movies, something's gotta give.

Posted by Frank Pasquale at 08:28 AM | Comments (0) | TrackBack

Thanks to our Bear Bloggers!

I just wanted to thank Jeff Lipshaw & Jonathan Lipson for contributing to our discussion of the Bear-crisis.

Now that the Delaware-law aspects of the crisis are on ice, we're going to return to our "normal" programming.

Posted by Dave Hoffman at 04:40 PM | Comments (0) | TrackBack

"From Enron to Refco" Podcast Available

A few days ago, I mentioned the program held here at Suffolk, "From Enron to Refco," in which the keynote speaker was Joshua Hochberg, the former head of the Fraud Division of the U.S. Department of Justice, and supervisor of the DOJ teams that assisted in the prosecution of a number of the well-known corporate scandals. Also on the panel were James Rehnquist, a white-collar defense partner at Goodwin Procter in Boston, and John O'Connor, the former Vice-Chairman of PriceWaterhouseCoopers.

A podcast of that program is now available.

Posted by Jeff Lipshaw at 01:06 PM | Comments (0) | TrackBack

Bainbridge on Chemerinsky on the Situation of Practicing Corporate Law

Steve Bainbridge, commenting on Erwin Chemerinsky A law school for the 21st century, objects to Chemerinsky's equation of public interest with public interest lawyering (usually, litigation-focused poverty law). Bainbridge argues:

The trouble with the foregoing, of course, is that it equates the public interest with so-called public interest law. You want to help make society a better place? You want to eliminate poverty? Become a corporate lawyer. Help businesses grow, so that they can create jobs and provide goods and services that make people’s lives better.

A corporate lawyer not only serves the public interest by helping to create new wealth, we also help defend an important social institution from statism. . . . It’s time corporate lawyers stopped letting people like Chemerinsky make us feel guilty about our career choices.

There is much here to agree with; in particular the idea that corporate (transactional) attorneys can serve society, and expand the pie, and push back against creeping statism. There's some to disagree with too: I am probably more likely than Bainbridge to believe that concentrations of wealth pose problems for social stability, and thus more likely to think that distributional inequality is a problem the state has business solving. Thus, good corporate lawyering can easily result in social disharmony.

But no matter. The big idea to agree with here is that it is a terrible fact that law deans, and law professors, continually push out the message that corporate lawyering is a less moral & desirable career path than "public interest" lawyering. The reason isn't that it makes students feel guilty (though it does) but that those students, when in practice, are probably less likely to be ethical because they've been told they've "sold out."

I noticed this last semester in my corporations class. When asked whether they would draft ethically troublesome documents, most students professed to say that they would. Why? Because by going into big firm practice in the first instance, they'd have already decided to be ethically gray. When deans (and well-meaning liberal professors) reinforce the idea that corporate practice is "corrupting and essentially random and beyond your control, and there's not a whole lot you can do about it", students are more likely to let the situation corrupt them. If instead academics were to celebrate the pro-social, professional, aspects of corporate practice, perhaps we'd have less situationally-motivated fraud.

Posted by Dave Hoffman at 12:03 PM | Comments (12) | TrackBack

Shareholder Wealth Maximization in Action

From the WSJ comes an article about how the slow flu season hurt the profits of some companies. The article quotes several executives complaining that Americans (initial) resistance to illness hurt their balance sheets.

Thus, Walgreen CEO Jeffrey Rein, speaking to shareholders, said “If attendees of the meeting needed to cough, he joked, they should leave the room and ‘go to a movie theater or on a bus’ to spread their germs. ‘We’re really hoping for a very strong flu season’.” While P&G CEO A.G. Lafley said on a quarterly analyst call: “Unfortunately, people have not been getting sick at a rate that we would all like yet.” Finally, LifePoint Hospitals CFO David Dill mused that "You have a strong flu season, and the ancillary business is very profitable . . . On the pediatric side, young kids coming into the hospital, that’s a nice margin for us, as well.”

I've got to think that these officers wish they could take some of this back, at least as phrased. And as reader S.B. pointed out, Rein's comments in particular raise red flags. I think it fair to assume that most OTC remedies for the winter flu are sold to concerned parents, despite the recent recall and health warnings. If Walgreen's intends to profit off of the flu season, and in particular in the sale to parents of potentially harmful meds, plaintiffs lawyers should smell blood in the water when bad outcomes occur.

Further, I think the article highlights how invested sectors of the economy are in a status quo of reactive, medicated, health care delivery. I don't mean to be dramatic, but it is worth pointing out that there is quite a bit of money (not to mention employment) riding on the continuing dysfunction of the health care system.

Posted by Dave Hoffman at 01:06 AM | Comments (4) | TrackBack

The Agency Ghetto

Larry Ribstein, commenting about an upcoming meeting of the Section on Agency, Partnerships and Limited Liability Companies at the 2009 AALS meeting, says "Too often the business associations area is basically corporate law with a little agency and partnership thrown in. But as I've said in many ways and venues, this area is too important both intellectually and for training our students to be marginalized in this way." I think this is basically right, and I wonder what set of pressures or incentives brought us to this pass. Is it the (relative) dearth of good cases looking at LLCs? The low-stakes of many classic (clean) agency issues (and thus the low likelihood of an opinion from the Chancery Court)?

In any event, the Section is putting together a great program to highlight the intellectual ferment in the unincorporated world, and has drafted a call for papers:

The Section on Agency, Partnerships and Limited Liability Companies is calling for papers for the 2009 AALS Annual Meeting in San Diego. We are interested in presentations on the application of modern theories and empirical methods of business associations to agency and unincorporated firms. The program has two goals: First, to show how these theories can be enriched by taking them outside the "box" of corporate law; and second, to show the relevance of agency and unincorporated firms to the mainstream of corporate theory and empirics. A non-exhaustive list of possible topics includes the nature and function of fiduciary duties, agency theory, the role and enforcement of contracts, jurisdictional competition and choice of form, the relationship of federal and state law, jurisprudence, international and institutional comparisons, and legal and economic history.Please email either a draft paper if available, or if not an abstract and outline, to Larry E. Ribstein, University of Illinois College of Law, ribstein [at] law.uiuc.edu, by no later than September 1, 2008.

This seems like a good way for corporate folks - especially those who are less senior - to make an impact on an emerging area of law.

Posted by Dave Hoffman at 04:42 PM | Comments (0) | TrackBack

Realism and Idealism in Business Ethics: A Post-Bear Reflection

I suppose that I should start with a disclaimer that this isn't really about Bear, but continues a theme (some called it unduly pointillistic) I started a week or so ago while thinking about Bear. (By the way, for a surprisingly counter-intuitive take on responsibility and victimhood in the sub-prime crisis from a liberal commentator, see Michael Kinsley's endpaper essay in Time last week.)

This past week, we had a successful program at Suffolk, jointly sponsored by the law and business school, entitled "From Enron to Refco" dealing with the criminal liability of service providers to corporations involved in nefarious activities. (Several of the people in the audience reflected an unfortunate aspect of the politics of all of this, which was a confusion between criminal fraud, say like WorldCom, and business judgments that go badly wrong, like Bear, but that's a subject for another discussion.) The keynote speaker was Joshua Hochberg, now a partner at McKenna Long & Aldridge, and formerly the head of the US Department of Justice's Fraud Division, where he supervised some of the major bubble-bursting cases of the last ten years - Enron, Arthur Andersen, etc. Also on the panel were Jim Rehnquist, a partner specializing in white-collar criminal defense at Goodwin Procter here in Boston, as well as John O'Connor, a retired vice-chairman of PriceWaterhouseCoopers (and a Suffolk alum to boot). My role was to be the "audience moderator" which means that I flitted around in the audience with a wireless microphone, doing my Jay Leno thing. I asked a question myself, which failed completely in its purpose of raising the concern expressed below.

The morning after, I had the following reflections on the program (after congratulating all the organizers for its success and somewhat edited for this purpose).

If you listened to a combination of Josh Hochberg, the corporate fraud prosecutor, and Jim Rehnquist, the white-collar defender, it sounded like being co-opted into corruption and fraud was something that happened inexorably in the business world, and there was almost nothing you could do about it - sort of like being a passenger on an airplane and hoping this isn't your unlucky day. I think that's a view steeped in a pessimistic ultra-realism, shaped by careers in which what you do is either prosecute or defend people after the problem has already occurred. It wouldn't surprise me if prison guards also had a generally downcast view of human nature. I'm agnostic on the question - I think there's equally as much evidence that we are innately good as innately bad, and the issue is not capable of resolution.

Yes, it is a reality of the world that all of us can be co-opted by our commitment to ends that begin to blur the edges of our reservations about inappropriate means. That can affect CEOs, prosecutors, police, Secretaries of Defense, university presidents, and law school deans. There's really no cure to that other than trying to reach an honest reflective equilibrium of idealism (what ought to be) and realism (what has to get done) through whatever means are available. But it was troubling to me that the only discussion of values came right at the end, and not from the lawyers, but from John O'Connor, the accountant.

Especially troubling was JIm Rehnquist's not untypical litigator's view of the lawyer's role as advocate. Trust me, when you are sitting in the corporate board room, and there's a difficult decision to make, and it has moral or ethical overtones, the last thing you want to be is an advocate. Your job at that point is to be a counselor, and, if you are effective, to be a counselor that understands the limits of the law and its relationship to other normative rules, whether they be social norms, moral duties, or utilitarian calculations.

Of course, none of the lawyers sitting on the panel had ever been in a corporate management suite or a boardroom except after the crap has hit the fan.

As I said, I was troubled by the message to the students in the audience. It was that the corporate world is corrupting and essentially random and beyond your control, and there's not a whole lot you can do about it, except hope that your figurative airplane doesn't crash. I acknowledge my views on individual freedom and autonomy may not be everybody's, and this is a statement reflecting my strange position of Kantian corporate governance, but there's not much hope if we don't even discuss it.

Posted by Jeff Lipshaw at 05:11 PM | Comments (1) | TrackBack

What Can An Attorney Do To Stop Dubious Business Practice?

New Century Financial was once the second largest subprime lender in the country. It is now in bankruptcy. Michael Missal is the chief examiner in this case and served in the same capacity on the Worldcom bankruptcy. Here is a link to the report. Warning it is a pdf and 581 pages. Apparently the report finds that then general counsel explicitly told his fellow senior managers that the lending practice of evaluating ability to pay based on teaser rates and relying on refinance bets in the following years was unsound and would result in "sticker shock." The question has become whether he and other attorneys should have done more after such an analysis.

So Enron-type discussions will likely flow in the near future. For now I wanted to share the link to the report in case those who write in this area could use it. Still if folks have thoughts on this one or the big changes in financial regulations, please share them in the comments.

Posted by Deven Desai at 12:15 PM | Comments (0) | TrackBack

Smith on Bear Shareholders Litigation

Over at Conglomerate, Gordon Smith has a quick and dirty analysis of the just-filed lawsuit in which pension fund shareholders (Wayne County, Michigan and the Detroit Police and Fire Retirement Funds) seek to enjoin the proposed (and amended) Bear Stearns - J.P. Morgan Chase deal. As does Larry Ribstein at Ideoblog. One of Larry's points is that companies can avoid this kind of mess by selecting an organization form that simply excises the kinds of the duties that are the basis for the litigation. The prime example of this is Blackstone's publicly-traded partnership, in which the disclosures are belt-and-suspenders clear that the unit holders have waived just about anything it's possible to waive.

These latter investments are, in some respects, beyond the law. You buy them because you believe the managers' interests are completely aligned with the equity owners, or because you believe, in a consequentialist way, that managers will do the right thing because they can't afford not to. Indeed, the WSJ has an article this morning about the unchecked ability of Blackstone's managers to set their own compensation, something with which this unit holder has no problem, according to the WSJ:

"I don't have any problem with their compensation system," says Robert Olstein, head of Olstein Capital Management, which owns 1.4 million Blackstone units. "These guys are the crème de la crème. If they make money, I make money."

Posted by Jeff Lipshaw at 08:23 AM | Comments (0) | TrackBack

Lipson on The BS That Didn't Bark: Why Didn't (Doesn't) Bear Stearns Go Into Bankruptcy Part II

This post concludes my colleague Jonathan Lipson's set of observations about Bear's bailout. You can find part I, in which Lipson demonstrates some of the advantages of a bankruptcy for Bear, here. Check out also Ribstein's response, here.

Why Didn't Bear Bark?

So, if the standard arguments against a BS bankruptcy don’t stack up, and in fact it might produce a better result than the hastily structured, poorly-executed deal on the table, why no bankruptcy?

The answer may be that while bankruptcy might benefit shareholders, JPM and other stakeholders, it would not benefit the folks who are in fact most likely responsible for the current state of affairs—BS’ officers and directors, and the managers of the hedge funds with whom they were intimately involved.

In any BS bankruptcy, insider transactions with the company of at least the last year—and probably quite a bit longer—would almost certainly be subjected to a searching inquiry. Most likely, a chapter 11 examiner would be appointed to determine what happened at BS, just as Neal Batson did at Enron.

Batson produced a huge report in Enron. Some would say it was not worth the price—allegedly about $100 million. But others would respond that Batson’s investigation did two very important things that created far greater value. First, his report was used in countless litigations that are said to have brought many times that amount back into the bankruptcy estate.

Second, his report revealed at least some of what really happened at Enron. My research on the use of examiners in chapter 11 cases suggests that this “public” value was, at least in the case of Enron, important because it gave lawyers and other professionals guidance on acceptable conduct well beyond that case.

In BS, scrutiny is likely the last thing that senior managers want. The media assumes that management is suffering along with everyone else because people like CEO Cayne had large share holdings, the value of which has been slashed. But this glosses over two important questions.

First, what did BS senior managers—and the management of the hedge funds they supported—get from BS over the last couple of years, whether in stock they sold for far more than $2 (or $10) per share, or cash bonuses, or compensation of some sort from hedge funds within or proximate to BS? These questions become relevant in bankruptcy because these transactions would certainly be scrutinized, and some may be avoided for the benefit of the bankruptcy estate.

BS’s senior managers doubtless understand this. It may be that for them, keeping last year’s goodie basket is worth far more than what they lose in the JPM deal. In a JPM deal—no matter how bad it gets for today’s shareholders—last years’ executive compensation is safe. Bankruptcy may put some or all of that at risk.

Second, and ultimately more important, there is the simple, cleansing effect of public scrutiny. Today, the question that no one asks—the elephant in the room—is where, exactly, all the money went? Of course, not all of it was real money. There was a lot of marking-to-model, which means that some valuations never really involved cash.

But lots of investors bought toxic securities from or through BS or affiliated hedge funds. And they paid cash. So, where did all that money go? Answering that question could go a long way toward understanding what went wrong in the mortgage crisis generally, and perhaps understanding how to prevent similar problems in the future. Today, thanks to JPM and the Federal Reserve, we won’t know.

In some ways, this is really about Sherlock Holmes famous dog that did not bark. There, after all other explanations were eliminated, only one—silence—made sense. Here, it may be that there are plenty of sound reasons to keep BS out of bankruptcy. But so far, it just looks like only one: the insiders want to keep the muzzle on.

Posted by Dave Hoffman at 10:56 AM | Comments (0) | TrackBack

"That's Why I'm Up Here in the Booth"

Corporate law pundits were abuzz yesterday with the possibility that - oh my god - Wachtell might have had what we used to call a "bust" - just a good old-fashioned mistake in contract drafting. This had to do with what would trigger the end or cancellation of J.P. Morgan's guarantee of Bear Stearns' liabilities. The gist of the buzz was the fact that the guarantee would go on for a year if the BS shareholders voted the deal down, as long as the Bear board did not back down from its recommendation of the deal to the shareholders.

This is all moot now, because there has been a revised deal, and I was too busy trying to get ready for class yesterday to follow it in real time. But without undue contortion to slap myself on the back, I did send this e-mail (just slightly edited to get a term correct) to a number of the pundits last night:

The effect of this is to get a guarantee on one year's worth of covered liabilities. It's not forever.

I don't know much about the securities being guaranteed. Is this a "floating" guarantee under which liabilities are created and discharged on a rolling basis? If so, for how much would JPM be on the hook at any one time?

I could see an argument the Bear board could have made in support of the lockup for one year: in exchange we got a one-year guarantee as long as we didn't change our recommendation, and we could control that. So while we may have blocked other bidders, we may have also insured the survival of the business.

It's possible this was a Wachtell mistake. But I thought I'd take a shot at Larry Solum's principle of charitable interpretation.

This morning other views have surfaced - see Gordon Smith over at Conglomerate and the quotes from Larry Cunningham in the Wall Street Journal this morning that seem to accord with my more "charitable" interpretation of last night. Here's a quote from the article with Larry's comment:

The measure "seems rational," given the circumstances at the time, when J.P. Morgan was trying to signal to the market that it would stand by Bear's obligations, says Lawrence Cunningham, a law professor at George Washington University. "Bear was fighting for its life and a handful of forces were at play and it makes sense that J.P. Morgan would want to add credibility to the deal by giving a big guarantee." Observers add that J.P. Morgan might not have anticipated the shareholder resistance that surfaced to the original deal.

In any event, it does demonstrate, as the ex-football coaches who do color commentary observe from time to time, it's a lot easier to be up in the booth providing analysis than down on the field making the decisions!

Posted by Jeff Lipshaw at 06:35 AM | Comments (0) | TrackBack

The Ben Behind Bear's Curtain

In the new Bear deal, as Steven Davidoff points out,

"Delaware law at this point seems largely irrelevant to JPMorgan and Wachtell Lipton Rosen & Katz. This is a deal that they appear to think they can force through the Delaware courts based on its extraordinary posture."

You might ask yourself (and I have) what justifies this extraordinarily level of chutzpah and brinkmanship with the DE courts. The answer seems to to be Ben Bernake's hidden hand. We now know, for instance, that the laughably low $2 original merger price was limited at the Fed's insistence. Why? You might think the deal's pricing had something to do with fundamental values, or risk-adjusted-return, or even the fed's worry about taking on bad debt. Nope. It was the optics:

"As part of the original deal, the Fed guaranteed to take on $30 billion of Bear’s most toxic assets. The central bank also directed JPMorgan to pay no more than $2 a share for Bear to assure that it would not appear that the Bear shareholders were being rescued, according to people involved in the negotiations."

Well, that worked out well.

(Image Source: Wikicommons, "An illustration by W. W. Denslow from The Wonderful Wizard of Oz, also known as The Wizard of Oz, a 1900 children's novel by L. Frank Baum.")

Posted by Dave Hoffman at 08:48 PM | Comments (0) | TrackBack

Lipson on The BS That Didn't Bark: Why Didn't (Doesn't) Bear Stearns Go Into Bankruptcy

My colleague, Jonathan Lipson, is an incredibly astute observer of bankruptcy law and practice. I was talking with him the other day about Bear's bailout, and he offered some characteristically interesting thoughts. I invited him to share them in written form with our audience, and will be posting his comments in two parts today and tomorrow.

What’s so bad about bankruptcy?

Today’s New York Times reports that both shareholders and lock-up acquiror JP Morgan-Chase have threatened to put the financial firm into bankruptcy if the other doesn’t blink.

But, if bankruptcy is the only thing both sides agree on, why doesn’t the board authorize a chapter 11 filing?

Two classes of arguments have been made against a BS bankruptcy, one about market disruption, the other about value maximization. The cost, delay and uncertainty of bankruptcy could bring the whole system down, the theory goes. In any case, it would wipe out shareholders’ entire interest.

These are, of course, possible outcomes. But they’re not as likely as people think. In any case, the important question is not whether bankruptcy would do this, but whether ex ante we think bankruptcy would be worse than the current deal.

There is some reason to think bankruptcy might actually be better. If so, then something else may explain why BS, JPM and the Fed would rather spend the next couple of years in Delaware Chancery Court than the U.S. Bankruptcy Court for the Southern District of New York.

Market Disruption

Consider first the claim that a BS bankruptcy would irreparably disrupt fragile capital markets. A domino effect is possible, of course: First BS, then Lehman, then JPM, then Citigroup, until only Goldman remains to drool over the carcasses. Bear Stearns is, the thinking goes, simply “too big to fail.”

But this position loses force if we actually think about a how bankruptcy would likely play out.

First, bankruptcy would simply not touch at least some BS entities and many of their larger, system-sustaining transactions. Entities that are banks or insurance companies generally cannot be debtors under the Bankruptcy Code. While this would not keep the public parent company out of the tank, it would appear that at least some subsidiaries would be outside the reach of bankruptcy.

So, too for the major swap, derivative or repo transactions to which the company was party if it went into bankruptcy. These were the sorts of deals that were thought “too big to fail.” A BS bankruptcy would surely disrupt these trillion-dollar deals, the claim goes, thereby annihilating the economy and all of civilization.

But the reality is that’s not how it would work. In 2005, large financial institutions succeeded in having complex “netting” provisions added to the Bankruptcy Code (or expanding ones that already existed) precisely so that the bankruptcy of a major financial institution—e.g., Bear Stearns—would not otherwise disrupt the larger capital markets. These provisions do this by permitting non-debtor parties to close (“net”) out their positions without risk of the cost or delay of a bankruptcy. It would be as though bankruptcy never happened so far as those deals, and those counterparties, were concerned.

In any case, while the too-big-to-fail mantra may have resonance when applied to major commercial banks, it didn’t (at least in the past) send the Fed to rescue non-bank financial firms. Drexel Burnham was too big to fail, too, remember? But we seem to have gotten through their bankruptcy.

Second, to the extent that BS subsidiaries were statutory broker-dealers, bankruptcy would have to be a comparatively quick liquidation under special provisions of chapter 7, not the longer, more drawn out “reorganizations” we typically think of when we think of business bankruptcy.

True, a BS bankruptcy would probably halt future deal flow. But didn’t events leading up to (and including) the announcement of the JPM deal kill that activity? Bankruptcy can’t kill a dead dog twice.

Value Maximization
If bankruptcy law exempts truly system-critical transactions, and those were much of what BS did, what would a BS bankruptcy add? The answer is value maximization—or at least competitive valuation of some sort for those portions of the business that would go through bankruptcy, including the parent company.

This goes to the second argument usually advanced against a BS bankruptcy--it would kill shareholder value. Often, that’s true. But given the appallingly low price offered—even $10/share is a small fraction of its recent close—it is not surprising that many shareholders would prefer a gamble in bankruptcy.

Why? Because in bankruptcy, any major deal to sell or reorganize the company would likely result in some sort of competitive process that would drive the price closer to market. Committees of creditors (and probably) equity holders would vet any deal and object to a process that seemed to dampen value. For example, they might challenge the so-called “Bear Put”, which appears to permit JPM to keep the deal in play until shareholders finally give up. It might also put BS’s valuable real estate on the auction block, rather than give it to JPM no matter what, even as a breakup fee.

Because bankruptcy is increasingly a venue for the sale of assets—rather than traditional reorganizations—a court may well approve a controlled liquidation of the company. But it would almost certainly require a meaningful market test, to assure that the assets received the highest and best price. Today, even with JPM sweetening its offer, we have no idea what the real market value of the company is. The JPM process appears designed to make sure we never find out.

A related argument is that bankruptcy is a costly and time-consuming process. But here, too, there is less than meets the eye.

Those who would make this claim cite Enron, which took several years and hundreds of millions of dollars in professional fees. But the important question is not whether bankruptcy is costly—it is. Rather, the important question is whether, ex ante, it appears to cost more than the current deal.

Given the litigation that the JPM deal is likely to spawn, it is not clear why a well-managed (a big caveat, that) bankruptcy would be any worse. Is one or more roundtrips through Delaware Supreme Court likely to be quicker and cheaper than time on Bowling Green? Perhaps. But more than a half-dozen years of Disney litigation does not bode well.

A final (somewhat incongruous) argument is that bankruptcy would scare off JPM and/or the Fed, who have thrown a lifeline to BS. That may be, but given the deal's reception, it looks more like an anchor than a float was at the receiving end of the line.

More important, there is simply no reason JPM and the Fed could not have walked into bankruptcy court, arm in arm with BS, proposing the exact same deal that was inked March 16. The only difference would be that it would be subject to court approval. The fact that JPM head Dimon now “threatens” bankruptcy suggests he may understand this.

Indeed, the fact that this didn’t happen is especially baffling when you think about how much bankruptcy might actually benefit JPM. If they really were offering the best deal around—one that a competitive auction in bankruptcy would confirm—then they would also get the benefit of a discharge of most pre-bankruptcy BS liabilities. This means they would not have to worry about unanticipated liabilities—like lawsuits--haunting them after the fact. True, JPM agreed to guarantee a variety of BS obligations in connection with the acquisition. But that could all have been part of the deal run through—and approved by—the bankruptcy court. If it was the best deal going.

Posted by Dave Hoffman at 05:17 PM | Comments (5) | TrackBack

Reverse Robin Hood: The $30 Billion Question

Remember the controversies over the State Children's Health Insurance Program (SCHIP) last fall? The Bush Administration was very concerned that spending an additional $30 billion over the next five years to cover more children would put the country on the road to "socialized medicine." Even if economic reports indicated that only one in five families in the coverage expansion would drop private insurance to purchase government sponsored insurance, that was seen as far too high a cost to pay to allow even a bit more publicly-financed insurance to "pollute" children's health care.

Yet the administration has recently endorsed the Fed's $30 billion guarantee for JP Morgan as it purchases Bear Sterns. I'll let the accountants figure out exactly how much of that money will end up being provided by taxpayers, but I think it's safe to assume that more guarantees like this are coming, and that the market itself priced it in in response to the toxic subprime securities Bear still counts as "assets."

So what are the practical consequences when a country allows millions of kids to go uninsured, but structures financial regulation so that leaders of banking firms face nearly no downside, and high upside, on extraordinarily risky investment strategies? It appears that we only worry about moral hazard in the health care arena (where it has been largely discredited), and not in the financial world (where it has been amply confirmed). Internationally, the US is looking less like a leader in financial innovation and more like a haven for crony capitalism. The New York Times describes the situation as "socialized compensation" for the connected:

Bankers operate under a system that provides stellar rewards when the investment strategies do well yet puts a floor on their losses when they go bad. They might have to forgo a bonus if investments turn sour. They might even be fired. Their equity might become worthless — or not, if the Fed feels it must step in. But as a rule, they won’t have to return the money they made in the good days when they were making all the crazy bets that eventually took their banks down.

The costs of such a lopsided system of incentives are by now clear. Better regulation of mortgage markets would help avoid repeating current excesses. But more fundamental correctives are needed to curb financiers’ appetite for walking a tightrope. Some economists have suggested making their remuneration contingent on the performance of their investments over several years — releasing their compensation gradually.

In a recent hearing questioning the extraordinary gains at top financial firms (for pioneering strategies that now may lead to massive government bailouts), Henry Waxman suggested that current policies may lead to a crisis of faith in the market system:

“There seem to be two economic realities operating in our country today. Most Americans live in a world where economic security is precarious and there are real economic consequences for failure. But our nation’s top executives seem to live by a different set of rules.”

To contexualize Waxman's point, here is Paul Krugman with the back story:

[By the 1990s], Wall Street chafed at regulations that limited risk, but also limited potential profits. And little by little it wriggled free — partly by persuading politicians to relax the rules, but mainly by creating a “shadow banking system” that relied on complex financial arrangements to bypass regulations designed to ensure that banking was safe.

For example, in the old system, savers had federally insured deposits in tightly regulated savings banks, and banks used that money to make home loans. Over time, however, this was partly replaced by a system in which savers put their money in funds that bought asset-backed commercial paper from special investment vehicles that bought collateralized debt obligations created from securitized mortgages — with nary a regulator in sight.

As the years went by, the shadow banking system took over more and more of the banking business, because the unregulated players in this system seemed to offer better deals than conventional banks. Meanwhile, those who worried about the fact that this brave new world of finance lacked a safety net were dismissed as hopelessly old-fashioned.

Fortunately, it is now market fundamentalism that can be "dismissed as hopelessly old-fashioned."

Finally, I want to provide readers with an extended quote from David Cay Johnston's book Free Lunch, which chronicles the way in which government policies systematically redistribute income regressively. After surveying a panoply of such policies, he sketches their effect on the distribution of income in today's economy:

To appreciate fully how much the fruits of economic growth are, under current government policies, being concentrated in the hands of the few, it is useful to . . . examine the ratio of income growth between different groups over several long periods of time, starting with a comparison between the lower 90 percent, our "vast majority," and the top 1 percent.

Let's consider three eras. The first would be from 1950 to 1975, a quarter century when a rising tide did lift all boats and the nation was transformed into a land of broad prosperity. Setting the second era from 1960 to 1985 allows us to incorporate an early part of the era in which government began changing its policies in ways favored by many of the rich. Finally, it would be good to compare 1980 with 2005, but that will not work mathematically because the ratio would include negative numbers, since the income of the vast majority declined slightly. So instead we will use 1981, a recession year, to compare to 2005. The vast majority's average annual income was $114 higher at the end of those 24 years.

The measure is a ratio. For each additional dollar going to each person in the vast majority, how many went to each of those in the top 1 percent? For 1950 to 1975, the ratio is four dollars more at the top for each dollar going to the vast majority. For 1960 through 1985, the ratio is $17. And for 1981 through 2005, it is almost $5,000.

Dramatic as those numbers are, they understate the concentration of income. Let's now compare income growth for the vast majority with the top 1/100 of 1 percent, those 30,000 Americans at the very top of the income ladder. For 1950 to 1975, the ratio was $36 to one. For 1960 through 1985, it was $459. And for 1981 through 2005, it was $141,000 to the dollar.

It's probably safe to say that all of the executives at Waxman's hearing were in the top 1% at some point (and may well be kept there by capital gains on their current wealth). It's likely that they were in the top one hundredth of one percent during the boom.

When will the ratio of gains between those at the top and the "vast majority" become so great that academic defenders of inequality (like Greg Mankiw) will become concerned? Is a 10,000 to 1 ratio too much? 100,000 to 1? And at what point will conventional economic theory recognize the extraordinary importance of relative position to economic welfare? It's currently clear that inequality of income affects such important goods as education, housing, and access to the political sphere. If the fall of the dollar continues and commodity prices continue rising, more brutal consequences of inequality are sure to come to the fore.

PS: Here is one more reminder, from Thomas Pogge, on why, in an era of increasing inequality, it is very misleading to focus on growth alone in economic policy generally:

Consider what difference such a pro-poor assessment of economic growth would make to an economic planner—in a high-inequality country, say, such as Bolivia. If such a planner focuses on (per capita) GNI, she will ignore the poorest decile who, though they make up 10 percent of the national population, constitute just 0.3 percent of the national economy. One percent more income growth for the poorest decile adds 0.003 percent to national growth—one percent more income growth for the richest decile adds 0.472 percent. But if such a planner assesses her performance in terms of the economic position of the poor, she will realize that substantial improvements in the position of the poor are possible at tiny opportunity cost to the rich.

Perhaps by focusing too much on GNP as a measure of economic well-being, the US has inadvertently prioritized income growth for the richest decile.

Posted by Frank Pasquale at 07:24 AM | Comments (2) | TrackBack

Exuberant Bulls, Rueful Bears, and Rational Frogs

Yesterday, James Dimon, the CEO of JPMorgan Chase, visited the Bear Stearns headquarters, and met with 400 Bear executives, described in the New York Times this morning as "seething, fearful and to their dismay, far poorer than they were a week ago." What struck me was the emotional and personal language of the dialogue, something I'm not surprised to hear, but which may take some reconciling for theoretical observers. As this is a blog post, I'll again offer some not-quite-random thoughts.

1. One of my favorite lines in all of academic writing is Richard Posner's allusion to the rational actor in neo-classical economic theory. In this variant of consequentialism, reason does not determine ends; the end for any actor is always happiness, measured in units of utility. Reason is instrument and practical - it is a slave to this particular passion. Hence, we assume all actors choose rationally those actions calculated to be most likely to maximize utility. Judge Posner says, therefore, it would not be solecism to speak of a rational frog. We don't need to dissect it [the frog, get it?] because we can assume it to be a black box whose actions demonstrate, overall, an internal utility calculation consistent with the theory. The model, of course, is simple and useful as a tool, but it has significant limitations as a theory of everything; hence, the rise of behavioral economics to try to explain all choices, even when the frog seems to be acting irrationally. For more on this, see the debate between Judge Posner and Cass Sunstein, et al., in the Stanford Law Review a few years back.

2. So here we have Jamie Dimon (he can't be James in this context) telling the Bear executives "I don't think Bear did anything to deserve this. Our hearts go out to you." Does he really mean that? Do their hearts really go out? Do they have hearts?

3. In response, according to the Times, a Bear executive "with anger in his voice" asks, "In this room are people who have built this firm and lost a lot, our fortunes. What will you do to make us whole?" To which Dimon "gingerly" replies, "You're acting like it's our fault, and it's not. If you stay we will make you happy."

4. In the Boston Globe this morning, Barney Frank, one of our locals, talks about greater regulation of investment banks. Steven Syre, the Globe business columnist observes there is a gap between conservative banking regulation administered by the Fed and the "heightened risk and reward" environment of Wall Street bankers who underwrite and trade securities. Says Syre, "They made huge fortunes in good times and had every incentive to take big risks, usually by betting with lots of borrowed money." What he is describing is leverage (or "gearing" for our British readers), and leverage is not strictly a Wall Street phenomenon. Anybody who buys a house with 20% down (i.e. equity) and an 80% mortgage is engaged in financial leverage (and if you buy the house with a subprime mortgage, putting 5% down, you just leverage up more). All companies seek an optimum level of leverage in their capital structure - they are always balancing financial risk with financial reward.

5. Now let's talk about foresight and hindsight, and particularly what the behavioralists call "hindsight bias." When you engage in business and take significant risk, and it doesn't pan out, and you look at the whole mess in retrospect, it may be that you are affected by hindsight bias, which means that the bad result, which may have been a 40-60 shot ex ante, is now 100% certain, and doesn't feel like a 40-60 shot any more.

6. I spent five years of my career, from 1992 to 1997, at a company called AlliedSignal. It merged with, and took the name, Honeywell. Those were the boom years in the stock market. The level of the ocean was rising, and if you kept your boat from leaking, much less turbocharging it, you tended to rise with the rest of the boats. We did okay (well, maybe more than okay) in stock compensation, but most of us were significantly (by virtue of the stock plan limitations or by unwise lack of diversification) tied to the fortune of the company's stock as a measure of our personal net worth. We were just like the Bear executives, except we were luckier. We didn't have to deal with hindsight bias except in this regard, which was just the opposite: if you exercised your options or sold your stock, and then watched the company outperform the market, you had exactly the OPPOSITE hindsight bias.

Larry Bossidy, long-time second in command to Jack Welch at GE, was the CEO of AlliedSignal in those years. I can't recall how many times, at employee meetings, the rank-and-file white and blue collars would ask why they couldn't get stock options (they could get stock in their 401(k) plans, and the company's match was in stock). Bossidy's response was always the same: you'll like the stock if it keeps going up, but it's a risk-reward proposition, and my experience is that rank-and-file like the reward, but don't like the risk.

6. Finally, there is the quote from Alan Schwartz, Bear's CEO: "We are a collective victim of violence. It's natural to be angry, and you're not sure who to be angry at. But we have to put it behind us." This is a very interesting statement, because it gets to the heart of a philosophical dilemma that in some areas was resolved 250 years ago, but pops up whenever we again encounter any kind of disaster. Since Rousseau, we have separated the concepts of natural evil and moral evil. We may attribute blame to people for their response, or preparation, or negligence about the safeguards against hurricane damage, but we don't connect (I suppose except in the global warming sense) natural disaster to human agency anymore. People aren't to blame for Hurricane Katrina, or the Tsunami, or the Lisbon Earthquake of 1755.

But we have, and this is part of what Kant brought to the table, a natural inclination, by virtue of our reason, to want to link what is with what ought to be. My simplest illustration of the process by which most of us immediately separate ourselves from random bad consequence by virtue of our agency is how I always wonder, when I hear about a traffic death, whether the people had their seat belts fastened. My friend Susan Neiman uses the example of criminals in the Nazi concentration camps. There is some evidence that they fared better than most because at least they understood why they were there.

Schwartz's comment suggests that what occurred at Bear was a kind of evil - a violence in the form of a bank run - that might be moral (did somebody trigger it purposely?) or natural (panics are a part, for better or worse, of economic cycles).

7. So the dialogue, Dimon's comments, the executives' anger, Schwartz's shaken explanation of what happened, are indeed typical human reactions to great disaster, and they are attempts, as always, to reconcile what did happen with our ideals of what should have happened. This, it seems to me, is the great challenge of mature and reasoned discussion about economic life, and the balancing of our desire to be happy (materially) with our desire to be fair. When I was just getting started at being an academic, and still flush with the perspective of a corporate executive, I wrote this in a footnote at the end of an article about how lawyers used contracts as one very limited way of dealing with contingency:

I am willing to concede the simultaneous operation of economic laws and moral laws. They are, respectively, the embodiments of the critical distinction in Kant between the nature of instrumentality and the nature of free will or autonomy. Our needs in everyday life are fulfilled by instrumental relationships all the time. Physical and economic laws are discernible that govern the satisfaction of what Kant calls our inclinations (our tangible and intangible needs). The principle of microeconomics that a rational firm shuts down the plant when the marginal cost exceeds the marginal revenue is morally neutral (at least it is to me, but I recognize others, socialist or critical legal theorists, for example, may disagree). The moral question, on the other hand, is: are they people or things to you morally at the time the real world makes you do that? How do you handle the layoffs? Do you provide outplacement? Is the severance sufficient? Have you developed your employees so they have transferable marketable skills?

I'm no "progressive" (in part because I don't know what it means), but sight unseen, I'll recommend a piece just recently up on SSRN by Kent Greenfield that seems to want to encourage this kind of discussion. The abstract follows the fold.

Here's the abstract of Reclaiming Corporate Law in a New Gilded Age:

Corporate law matters. Traditionally seen as the narrow study of the relationship between managers and shareholders, corporate law has frequently been relegated to the margins of legal discussion and political debate. The marginalization of corporate law has been especially prevalent among those who count themselves as progressives. While this has not always been true, in the last generation or so progressives have focused on constitutional law and other areas of so-called public law, and have left corporate law to adherents of neoclassical law and economics. To the extent that the behavior of businesses has been a matter of concern, that concern has been aimed at adjusting the rules of environmental law, administrative law, employment law, and the like.

The time has come to reclaim corporate law as a topic of wide debate and progressive concern. Instead of being a narrow discipline with limited implications, corporate law determines the rules governing the organization, purposes, and limitations of some of the largest and most powerful institutions in the world. By establishing the obligations and priorities of companies and their management, corporate law affects everything from employees' wage rates, to whether companies will try to skirt environmental laws, to whether they will tend to look the other way when doing business with governments that violate human rights. Corporate law also determines whether corporations will look at the long term or the short term, whether they will see themselves as owing any responsibilities to stakeholders other than shareholders, and indeed whether they consider themselves to be constrained by law at all.

The main thesis of this article is that corporate law is much more important than most progressives realize. Corporate law can be part of the wider task of regulating corporations in particular and business in general. The rules that govern corporations should more expressly take into account the fact that corporations are collective enterprises that demand investment from a number of different sources. These investments come in various forms: inflows of capital from shareholders and creditors; cash inflows from customers; infrastructural support from governments and communities; and effort, intelligence, and direction from employees. Whereas corporate law presently focuses on the financial investments of shareholders only, it could, and should, be adjusted to take into account the contributions of non-equity investors. Adjusted in this way, corporate law will make it more possible for corporations to serve their purpose of facilitating the creation of wealth, broadly defined and distributed.

Posted by Jeff Lipshaw at 10:33 AM | Comments (6) | TrackBack

Bear(ish) Blogging

As Larry Ribstein, Gordon Smith, Jeff Lipshaw (below) and others have pointed out, the rise of Bear Stearns' stock price after the announcement of its deal with J.P. Morgan creates some really complex corporate law problems. Today's close, $5.33, is around 2.5 times the offer price (2.30 a share). Whether the Delaware Chancery Court will enforce "Bear's Put" (as Steven Davidoff coined it) seems to me to be underdetermined by caselaw and instead likely will depend on the state of the financial markets. In a less edgy environment, normal rules - like Quickturn - should apply and DE Courts inclined to strike down the clause, even over the Fed’s objection. Indeed, the case would be a good platform to reassert Delaware's dominance! But if current market volatility remains unabated when these issues are decided, I imagine that the no-shop, multiple-vote, clause will be upheld. Thus, J.P. Morgan would be wise to push hard to close the deal sooner, while the market remains turbulent and a potential jurist pliant. (I’m rooting for assignment to V.C. Strine, if we want a wide-ranging opinion to teach in a few years). Useless speculation? Sure!

A distinct part of this evolving story is the buyers of Bear's stock. Some are probably bondholders. Another group, according to today's W$J, are Bear's employees, free (now) to trade and encourage others to buy up the firm. They are reported to believe that several hedge funds, having shorted Bear several weeks and months ago, then broke the bank by withdrawing business from its prime brokerage in the last week or so. Those withdrawals in turn resulted in downgrading Bear's investment rating and putting its ability to trade in jeopardy. (It's the Enron story, but without a Fastow or JEDI, that we know of.) Maybe they think that the SEC will bring some kind of market manipulation case against the shorting funds, which seems like a long-shot. Another possibility could be civil suits seeking disgorgement from the funds, on the theory that they have some kind of fiduciary duty not to provoke a bank run. On what theory such a lawsuit would proceed, I can’t imagine, but I wouldn’t underestimate the creative power of a hungry mob of lawyers. Finally, we’ll almost certainly see a lawsuit against Bear’s directors. I, like Lipshaw, have "some sympathy" for these folks, especially those on the outside, who can't possibly have foreseen the magnitude of the events that overwhelmed the institution.

Third, as many have noted, Bear’s executives aren’t going to walk away with much cash. Their options are under-water, and their guaranteed compensation has been intentionally set at a low level to promote firm performance. Now, some, including Jack Dolmat-Connell, an executive compensation expert, are criticizing this equity-heavy pay schedule for encouraging Bear “to take on too much business risk.” (Again, from today’s W$J). I don’t buy this. Is the idea that if their pay were fixed, they’d have been more risk averse because their upside would have been limited? This seems (to me) to be an unrealistic account how investment bank executives are likely to behave. More than most, such executives are the product of the tournament model, likely to be extremely overconfident and risk-seeking no matter what their compensation structure. (The easy cite here, of course, is Liar's Poker.)

Finally, you've got to wonder what lessons to draw from the last two weeks. In 1966, Henry Manne argued that legalizing insider trading would have several pro-social consequences, among them that it would lead to more accurate prices and thus substitute for public disclosure in circumstances where it might not otherwise occur. There is (admittedly) limited empirical evidence that insider purchases have strong price effects, but insider sales are generally stronger signals. Last Monday, investors valued Bear at between $60 and $70 a share, but there was obviously non-public information that made the price unsustainable. Maybe had insiders been permitted to trade on their knowledge of Bear's financial condition, its decline would have been less precipitous, giving the bank more time to approach the Fed for help before its fire sale became necessary. [Update: Paul Krugman's analogy is a good one. In describing the run on Bear and other like institutions, he says "In other cases, the bank is fundamentally unsound — but the bank run magnifies its losses. It’s as if someone calls “Fire!” in a crowded theater, and there really is a fire — but the stampede kills people who would have survived an orderly evacuation." Exactly - would insider trading have made the run more orderly?] Just a thought, as folks start to think about ways to avert tomorrow’s crisis.

Posted by Dave Hoffman at 08:28 PM | Comments (2) | TrackBack

Bear Stearns - Is the World Coming to an End?

David Hoffman graciously invited me back to comment on the Bear Stearns meltdown. As I mentioned to him, I'm no expert in financial institutions, but I was a deal lawyer, and I spent a lot of time with boards of directors, so the dynamics of the deal process are very, very interesting to me. (I'm also an investor in the market generally, thankfully diversified, but probably reflect the mood of the country generally - even though it makes no difference in the short or long run, yesterday I deferred the purchase of a new Apple MacBook.)

The usual pundits are commenting - Steve Davidoff of M&A Prof Blog and the New York Times Dealbook did us all a service by posting the Bear Stearns - J.P. Morgan merger agreement, and got into a nice little debate with Larry Ribstein. I have posted a few observations in various spots around the blogosphere, and I thought I'd consolidate and update them here.

1. When the deal was first announced, I didn't realize from the newspaper accounts that it was not a cash deal at $2.00 a share. It's a stock-for-stock deal that pegged $2.00 to the J.P. Morgan stock on an exchange ratio of just over .054 shares of JPM for each share of Bear. The market, at least on Tuesday, was not persuaded that this was a done deal - indeed, the stock price for Bear tripled or quadrupled during the day on arbitrage activity. Once the deal is viewed as done, the Bear shareholders will continue to ride up or down depending on the markets' reactions generally, but tied to what JPM does.

2. The fairness opinion on the price will come from Lazard Freres. That should be an interesting read.

3. The hot issue among experts in Delaware law on takeover matters is the fact that the agreement locks out an alternative proposal for a year. Let me put this in context for non-corporate types. What the buyer in a friendly deal tries to do is lock up the deal to the limits permitted by Delaware case law with respect to the directors' obligation to obtain the highest price for the company once it is "in play." So the merger agreement, as here, always has a "fiduciary out" (although that may not be necessary if the agreement follows a full auction for the company). Indeed, the fiduciary out is a way of ameliorating the effect of a non-auction deal. The trick is in putting in as many roadblocks to an alternative proposal without crossing the line after which the Delaware Chancery Courts think that the board of the target company has breached its duty to get the best price. One such tactic is for the buyer to demand the ability to force a shareholder vote even over a "Change in Recommendation" if there is an "Alternative Proposal." Not surprisingly, a "force the vote" is a win for the acquiring company, as you'd expect here. This agreement takes one step further, giving JPM another bite at the apple, and gives JPM one year to complete a deal to the exclusion of other suitors who pop up. Gordon Smith at Conglomerate has commentary on this.

Obviously, the "asset option" to buy the headquarters, which would survive even an alternative deal is another way to lock down the deal.

4. The deal was reported as being "locked down" in terms of J.P. Morgan's ability to get out. That appears to be true. There is no MAC ("material adverse change") provision as a condition of closing. The representations and warranties are made only as of the date of signing and not as of the closing. The "bring down" certificate as to the continued accuracy of the representations and warranties in the closing conditions applies only to the bare minimum: that JPM is getting pretty much all of the stock, that the deal is authorized, that nobody other than Lazard Freres is a broker, and that Lazard Freres will issue a fairness opinion. It just goes to show how little you need to make a deal when you gotta make a deal!

5. One commentator mentioned to me in an e-mail that the purpose of doing this as a stock deal was to be able to eliminate dissenters' rights under Delaware corporation law (i.e. if you vote against the merger, you get to invoke an appraisal of the value of your shares). This is because there is an exception to the appraisal right provision if the consideration in the merger is the stock of a company traded on a national exchange. The comment ended sarcastically "nice guys!" I'm less cynical, I guess. The only significant closing condition here is getting all the Bear shares. If you do a deal for cash with appraisal rights, a buyer can reasonably ask for a condition of closing that it be able to get out of the deal if more than X% of the shares exercise their appraisal rights. I can't believe either the Fed or Bear wanted that to occur.

6. There has been some discussion of the impact on employees. The WSJ reports this morning that Bear senior management will get very little out of this deal because so much of their compensation was in stock, and they don't have much in the way of golden parachutes. My level of sympathy is inversely related to the employee's rank in the company, and Paul Secunda has already commented here about the problem of employee non-diversification.

There's two different issues, one evoking more sympathy than the other. I'm speculating on the facts here, so take this with a grain of salt. I don't know how it broke down at Bear, but there's usually a dividing line in most big companies between those employees who are incentive compensation eligible and those who are not. If you are granted stock options or restricted stock, moreover, it has a vesting schedule. Holding the stock once you have vested is an employee diversification issue.

One feels for the executives who may have lost the value in their restricted stock, although chances are the plan has a change in control provision so they'll end up with JPM stock at the exchange ration. I realize that's cold comfort, but they are executives and have, I think, less claim on our sympathy than the employees in the other category, which is those (assuming Bear did it) either got their 401(k) match in Bear stock, or worse, actually selected Bear stock as a place to put their own money, again a diversification error, and one I think employees make a lot.

7. The Bear directors have the standard continuation of D&O insurance. Again, I have to admit some sympathy for them. I'm convinced that great success is generally serendipitous, as is great disaster. You can always dissect it looking backwards, but predicting it is radically uncertain. I can only imagine what it was like for an outside director of Bear, operating in good faith and appropriate diligence over the last week (assuming they have been so operating up to this point, which I do). There is, in that light, something to be said for thinking this case lies somewhere between the deference given to boards by the business judgment rule and the more exacting standards of Revlon and progeny, in which the directors' action are held to a higher level of scrutiny.

Finally, as long as I'm here on a limited brief I'm going to use the opportunity to link up my observations on the art of the elevator speech and the oral arguments in District of Columbia v. Heller!

Posted by Jeff Lipshaw at 12:05 PM | Comments (2) | TrackBack

An Example of Bear Sterns's Conduct?

One might wonder, what type of conduct could decimate an 85 year old bank like Bear Sterns? A recent consumer protection case described by Rebecca Tushnet suggests an answer (though I note for all our non-lawyer readers that a complaint merely alleges, and does not prove, facts like these):

Plaintiffs are suing over allegedly abusive mortgage practices. Plaintiffs speak, read, and write only in Spanish; they were contacted by Yazmin Esparza, who told them she represented a company called Fastlink and promised to consolidate their existing home loans in a mortgage with monthly payments under $2700 and other favorable features. Though plaintiffs told Esparza they wanted a 5-year fixed-rate loan with interest-only payments, and she promised to get it for them, she gave them loan documents to sign that were actually for an adjustable rate mortgage with monthly payments of nearly $3400, as well as a second mortgage. These documents were written in English, but Esparza—who knew of plaintiffs’ status as Spanish-only speakers—assured them that the documents reflected their requests. Plaintiffs signed. Bear Sterns was the lender, and the complaint alleged that Bear Sterns paid Esparza and Fastlink nearly $7400 as an incentive for switching plaintiffs to the more expensive loan.

To the extent this type of conduct was widespread, we need to seriously consider state laws like the New Jersey Home Ownership Security Act of 2002. Analyzed in this article by Baher Azmy and David Reiss, the Act at least attempted to resolve the "inherent tension between increasing consumer protections and preserving vibrant consumer credit markets."

Posted by Frank Pasquale at 08:42 PM | Comments (3) | TrackBack

A Trillion Here, a Trillion There. . .

and, as a latter-day Everett Dirksen might say, soon you're talking real money. As Bilmes and Stiglitz have estimated, the Iraq War will likely ultimately cost three trillion dollars. Today's Krugman column in the NYT suggests that the cost of bailing out ailing US financial institutions may approach these figures:

The U.S. savings and loan crisis of the 1980s ended up costing taxpayers 3.2 percent of G.D.P., the equivalent of $450 billion today. Some estimates put the fiscal cost of Japan’s post-bubble cleanup at more than 20 percent of G.D.P. — the equivalent of $3 trillion for the United States. If these numbers shock you, they should. But the big bailout is coming.

Krug