Author: Lawrence Cunningham


Two Ways to do Government Corp Fin

Money Bags.jpgThe United States government is one of the largest, and few, investors in corporate finance deals these days. Congress authorized Treasury to use up to $350 billion in government funds to invest in corporate America (with a contingent increase of another $350 billion). Its authorization to Treasury is very broad, and has allowed it to make any form of investment (mostly but not exclusively in financial institutions), on such terms as the Treasury Secretary deems advisable.

The approach to investing these funds appears strikingly different between Bush Administration Treasury Secretary Hank Paulson and Obama Treasury Secretary Tim Geithner.

Paulson took a tailored, deal by deal approach. He never published clear guidelines concerning in which companies he would invest. Sometimes he invested by lending and sometimes in preferred stock. Sometimes he’d negotiate for covenants from the other side and sometimes he would not. He did not publicize resulting investment contracts. In general, he did not impose covenants on investees, such as restrictions on making asset distributions to common stockholders, although in some cases he did extract those concessions (e.g., with General Motors Acceptance Corporation).

Geithner on Tuesday issued a general template for his investment program. He has published guidelines for what investees must do to earn his investments. They have to explain how they will use funds, requiring that they be used to run the business, not hoarded, meaning, for banks, lending money to customers. Investees have to make monthly reports to Treasury showing how they used the funds to make loans or support loans made by other institutions. Investees must undergo a threshold financial stress test, assessing their financial position, and capital needs.

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Case of the Mistaken (Illusory) Investment

Sherwood v Walker.jpgCan a spouse rescind a divorce settlement contract if it turns out that the valuation assigned to assets the spouse retained in exchange for a cash payment to the other was inflated due to fraud by a third party?

Several years ago, Husband, a prominent New York real estate attorney at a large firm, and Wife, entered into a contract as part of an uncontested divorce. In the negotiations, the two listed their marital assets, including several homes, and divided them roughly fifty-fifty.

The homes aside, it appeared that the couples’ total assets to split amounted to $13.2 million. The agreement apparently provided that Husband would retain these assets, in their extant form, in exchange for making a cash payment to Wife in the amount of $6.6 million.

It turns out, several years later, that the value of these other assets was overstated by $5.4 million. That portion of the assets are actually worth zero, because they were held in an investment account managed by Bernard Madoff, whose fund turned out to be a Ponzi scheme.

According to the New York Daily News, Husband seeks rescission and reformation of that part of the contract, along with restitution from Wife in the amount of $2.7 million (half the amount of the original valuation of that account). Can he? What grounds are available to do so?

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Little Interest in Global Accounting (IFRS)

globe.jpgThe Securities and Exchange Commission under prevoius Chair, Chris Cox, spent considerable resources in a quixotic plan to switch the US from its own accounting standards to international ones. Right before he left office last month, in mid-November, Cox had the SEC issue a release for public comment concerning a proposal to compel the switch by 2014 (calling the proposal a “Roadmap”).

Not surprisingly, few constituents consider this a good time to make any such switch or even a good time to comment on the proposal. Companies and investors have far more important matters to attend to than this bit of folly on which the previous SEC Chair spent so much time the past two years. Many comment letters on the proposal forthrightly declare that companies find it terribly inconvenient to comment now and that they need more time to consider such a fantastic proposal.

A few companies somehow have found the time to explain numerous concerns and problems, many of which I address in my newly-published article in North Carolina Law Review, which the SEC, under Chair Cox, simply overlooked or discounted.

Illustrative are the following excerpts from the comment letter contributed by Marriott, dated Monday. (References to IFRS are to International Financial Reporting Standards and to IASB are to the International Accounting Standards Board, the self-appointed private organization that put itself in charge ot setting global accounting standards.)

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Watching Clouds in Delaware: Gantler v. Stephens

clouds.jpgFifteen years ago, I and my colleague Chuck Yablon, wrote the following about Delaware corporate law (in 49 Business Lawyer 1593 (1994)):

[P]redicting developments in Delaware law has always been a somewhat foolish enterprise. Many learned commentators have written careful and lucid analyses predicting the trend of Delaware case law, only to have doctrinal prognostications shattered by the next big case. Predicting the course of Delaware law from prior case law is like watching clouds. They seem, at times, to take on recognizable shapes and forms, even to resemble something familiar. But you know that whatever shapes you think you see can vanish in a puff of wind.

I can’t make the same complaint about a Delaware Supreme Court opinion released last week, Gantler v. Stephens, that’s receiving surprising attention, despite saying little or nothing new. (One champion and devotee of the minutiae of Delaware corporate law even calls it, peculiarly, “very momentous” and a “major decision.”)

True, as Usha Rodriques at Conglomerate fairly notes, the case says that corporate officers owe their corporations the same fiduciary duties that directors do. But the court makes that point by citing Delaware opinions from 1939 and 1993 and Gantler is most about directors, not officers. Scholars may have paid inadequate attention to officer duties, but this case will not likely change the focus (though Professor Rodriques’s new article on the subject in Florida Law Review may do so.)

Also true, as a Paul Weiss client report sensibly notes, the opinion clarifies that shareholders can’t be held to ratify director actions, that statute requires them to approve, except through the statutory approval process.

Other than that, the opinion is doctrinally of little moment, as the following principal points show:

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Forms May Fail Big Four Auditing Firms

org chart.jpgA common form of business organization designed to limit liability of participants may have failed the four largest auditing firms, according to a judicial opinion last week refusing a motion for summary judgment based on the design. The case, involving claims by defrauded investors in the Italian company, Parmalat, seeks to hold liable affiliates of the Italian accounting firm found culpable in the fraud, Deloitte S.p.A. The court refused to dismiss the latter’s US affiliate, Deloitte Touche LLP, and the Swiss entity that unites them, Deloitte Touche Tohmatsu.

If sustained after further fact resolution, the result would expose Deloitte US to crushing legal liability—and likewise expand the liability exposure of the other three large auditing firms that use similar structures (Ernst & Young; KPMG; and PriceWaterhouseCoopers). That, in turn, could increase the risks that one of those four firms may soon fail, which would make it difficult or impossible for many large publicly-listed companies to find outside auditors as required by federal securities laws. Ultimately, this could mean US federal governmental takeover of the traditional process of private audits of listed companies.

At issue in the Parmalat securities case against Deloitte is the standard structure that the four large auditing firms use. They operate as networks of scores of member firms organized as separate legal entities in jurisdictions where they practice. They enter into agreements that enable identifying members with the global brand name and practice of a global firm. These structures are designed to promote a recognizable professional identity while insulating each member from the others’ liabilities. The delicacy of the balance appears in how the court last week questioned its liability limiting efficacy.

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NYT Columnist Wants Keynes on Steroids

Big G.jpgThe February 1, 2009, print edition of the Sunday New York Times Magazine will run a long opinion piece, The Big Fix, by staff writer, David Leonhardt. The piece, already available on line, reads as an exuberant, unqualified endorsement of a massive and immediate increase in the role and size of the US federal government—as the only solution to current challenges.

The piece offers a few serious reflections and suggestions, including promoting national investment in education. But it is overall both intemperate and naïve. For some, it may even be irresponsible. Certainly, it contains no acknowledgement of any limitations on its diagnosis of current problems or prescription for curing them.

Mr. Leonhardt encourages any kind of immediate large government spending, for any reason. He writes, seriously, that: “Employing people to dig ditches and fill them up again would” be good government policy. He adds: “Even the construction of a mob museum in Las Vegas, a project that was crossed off the [Obama Administration’s] list after Republicans mocked it, would work to stimulate the economy, so long as ground was broken soon.” He concludes: “Pork and stimulus are not mutually exclusive.”

Are these suggestions seriously responsible? Less fancifully, Mr. Leonhardt says that John Maynard Keynes was right, that government, with its “enormous resources,” is the only force that can catapult a nation out of a deep financial crisis. Sensibly, Mr. Leonhardt says, any such catapult must be designed to increase the nation’s economic growth rate in short order so that enough return is generated to repay debts that any bold government spending plan entails.

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Hello Ms. Schapiro

SEC Seal.gifThe Senate on Thursday confirmed President Barack Obama’s nomination of Mary Schapiro as Chair of the Securities and Exchange Commission. In Ms. Schapiro’s written answers to questions posed by Senator Carl Levin, she indicates a refreshingly sharp break with many policies of her predecessor, Chris Cox.

Differences appear on numerous particular subjects. These reflect a general orientation to re-dedicate the agency to its primary mission of investor protection. Examples from Ms. Schapiro’s letter follow (with full text available here from Investment News):

1. Corporate Governance. Ms. Schapiro favors (a) rules letting shareholders (at least significant, long-time holders) nominate candidates for corporate boards of directors; and (b) rules allowing shareholders to express advisory opinions and votes on executive compensation .

2. International Accounting. Ms. Schapiro, unlike Mr. Cox: (a) does not believe that the International Accounting Standards Board meets US legal criteria and is not prepared to delegate authority to it; and (b) believes that US authorities must oversee foreign auditing firms auditing financial statements of companies with securities listed in the US.

3. Internal Controls. Ms. Schapiro, unlike Mr. Cox, would enforce laws requiring internal controls as to small and large public companies alike.

4. Accounting. Ms. Schapiro also believes in: (a) maintaining the independence of the US accounting standard setter, the Financial Accounting Standards Board; (b) cracking down against abuses of off-balance sheet accounting; and (c) continuing the requirement that stock options be accounted for as compensation expense.

5. Regulatory Scope. Ms. Schapiro favors: (a) regulating hedge funds; (b) strengthening capital requirements for securities brokers; and (c) strengthening regulation of rating agencies.

So far so great.


Two Visions on Financial Reform

We may have more ideas than money, judging by the proliferation of proposals for financial system reform amid continuing declines in our personal and societal net worths. At least five notable formulations for financial reform are in circulation. Others are forthcoming, including two that I’m working on (one a law review article with David Zaring and another a Washington-based policy formulation project).

Perhaps the most prominent and detailed proposals yet are two that may be seen as arch-competitors: one created by former Bush Treasury Secretary Hank Paulson and another led by former Fed Chair and Obama advisor Paul Volcker.

In addition, the Committee on Capital Markets Regulation (Harvard law professor, Hal Scott) offers

proposals that tend to resemble many of those Paulson endorsed. The Center for Capital Markets Competiveness (Chamber of Commerce) lays out some broad goals and policy preferences and the Government Accountability Office contributes general statements of principle that should guide reform design.

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Good Bye Mr. Cox

SEC Seal.gifYesterday was Christopher Cox’s last day of a 3.5 year term as Chair of the Securities and Exchange Commission, the United States federal agency charged with investor protection. Investors may be tempted to feel some relief. He leaves the agency weakened and its staff demoralized. But he also leaves its continued existence in doubt, given its manifest failures and contributions to the global financial crisis. It may be undiplomatic to say, but it is possible that his tenure was among the worst in the agency’s history.

Despite the agency’s primary mission of investor protection, Mr. Cox mostly ignored or subordinated that mission in preference to elevating other goals, such as promoting capital formation and engagement with technology and globalization. Headline dramas illustrating these problems include how, during Mr. Cox’s tenure, the SEC:

• failed to interdict Bernard Madoff’s Ponzi scheme despite warnings, costing investors billions, with Mr. Cox later saying he was “deeply troubled” that he didn’t catch it;

• failed in its oversight of the investment banking industry, which led to its extinction, costing investors hundreds of billions more (with multiplied costs for the rest of the economy and probably permanently impairing the economy of New York City, the country’s center of investment capital), with Mr. Cox later describing the SEC’s oversight program as a total failure;

• reduced enforcement intensity for securities law violations (measured by year-to-year reductions in fines and restitution of about 2/3), with uncertain but probably significant future costs for investors from reduced deterrence; and

• reversed major parts of the 2002 Sarbanes-Oxley Act’s implementation concerning corporate internal controls, the costs and fallout from which will not be known for months or years when accounting scandals emerge as a result of the increased opportunities for fraud, although the costs may again run to billions of dollars.

In addition, as Chair of the SEC, Mr. Cox concentrated considerable personal and institutional resources on two subjects that subordinated investor interests to pursue projects that Mr. Cox believed in for some other reasons. In particular, Mr. Cox and the SEC Staff at his direction:

• spent thousands of hours and enormous other resources pushing an ill-advised campaign to eliminate US accounting standards in favor of global ones, although this was fortunately delayed in the final months of his term in response to investor and academic criticism; and

spent considerable resources promoting policies to let non-US enterprises access US capital markets, without any US regulatory oversight or legal enforcement, so long as they are overseen at home by authorities deemed comparable, also an idea that luckily has gained little traction and may die on the vine.

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Notes on Financial Reform

boardroom.jpgFinancial system reform debates are about to take place in earnest. For some, these may involve standard oppositions between those with more confidence in markets compared to those with more confidence in regulation. But superior policy may result from substantive analysis of issues that transcend such philosophical, political or ideological dispositions.

Two of the more important proposals may appear to be competitors reflecting polar dispositions. One, championed by outgoing Treasury Secretary, Henry Paulson, imagines a consolidated oversight structure with considerable latitude to promote US capital market competiveness. Another, championed by incoming Obama advisor, Paul Volcker, former Federal Reserve Chair, likewise outlines a consolidated structure, but with far more stringent controls intended to limit the size and risks of US financial institutions.

Despite the evident philosophical and perhaps political opposition that the Paulson and Volcker proposals may reflect, astute participants in policy debate will recognize both as essentially opening positions in the forthcoming public policy negotiations. For them, needed is balance between spontaneous market coordination and planned regulatory moderation. The exact balance may differ across different kinds of markets and constituents. In general, the following clusters of topics will be implicated.

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