Category: Corporate Finance

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Law & Econ’s Influence on Law & Accounting

The hottest book of the century, on corporate law, is in production, thanks to editors Brett McDonnell and Claire Hill, both of Minnesota. As part of a series investigating the economics of particular legal subjects, overseen by Richard Posner and Francesco Perisi, this Research Handbook on the Economics of Corporate Law, promises a comprehensive canvass of the broadest definition of this field of law as it has been structured by economic theories over the past forty years.

My contribution addresses the influence of law and economics on the sub-field of law and accounting, which I suggest takes the form of “two steps forward one step back.”  You can read a draft of my chapter (comments welcome!), available free here, accompanied by the following abstract:

Theory can have profound effects on practice, some intended and desirable, others unintended and undesirable. That’s the story of the influence the field of law and economics has had on the domain of law and accounting. That influence comes primarily from agency theory and modern finance theory, specifically through the efficient capital market hypothesis and capital asset pricing model. Those theories have forged considerable change in federal securities regulation, accounting standard setting, state corporation law, and financial auditing. Affected areas include the nature of disclosure, the measure of financial concepts, the limits of shareholder protection, and the scope of auditor duty.

Analysis reveals how agency theory and finance theory often but not always point to the same policy implications; it reveals how finance theory’s assumptions and limitations are often but not always respected in policy development. As a result, while these theories sometimes produced policy changes that were both intended and desirable, some policy changes were both unintended and undesirable while others were intended but undesirable.  Examination stresses the power of ideas and how they are used and cautions creators and users of ideas to take care to appreciate the limits of theory when shaping practice. That’s vital since the effects of law and economics on law and accounting remain debated in many contexts.

Other contributions to the book similarly available in draft form are by Matt Bodie (St. Louis), David Walker (BU) and Charles Whitehead (Cornell).  The following scholars are also contributing chapters: Bobby Ahdieh (Emory), Steve Bainbridge (UCLA), Margaret Blair (Vandy), Rob Daines (Stanford), Steve Davidoff (Ohio State), Jill Fisch (Penn), Tamar Frankel (BU), Ron Gilson (Stanford/Columbia), Jeff Gordon (Columbia), Sean Griffith (Fordham), Don Langevoort (GT), Ian Lee (Toronto), Richard Painter (Minnesota), Frank Partnoy (SD), Gordon Smith (BYU), Randall Thomas (Vandy), and Bob Thompson (GT).

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GW’s Junior Scholars Finalists

Thanks to my colleague, Lisa Fairfax, GW has finalized the program for this year’s Junior Faculty Business and Financial Law Workshop and Prize (detailed here).   Of the more than 100 papers submitted, the following dozen presenters were chosen.  [Commentators appear in brackets; I’ve shortened some paper titles.]  

 The workshop will take place at GW on April 1 and 2, 2011.  We are delighted by the submissions, congratulate those chosen, and stress that making the selections was difficult because of the volume of amazing papers.  We encourage everyone interested to attend and look forward to the weekend.

Adam Leviton (Georgetown), In Defense of Bailouts [George Geis (Virginia) & Art Wilmarth (GW)]

Jodie Kirshner (Cambridge), A Transatlantic Perspective on Regional Dynamics and Societa Eurpoea [Francesca Bignami (GW) & Theresa Gabaldon (GW)]

Alan White (Valparaiso), Welfare Economics and Regulation of Small-Loan Credit: Lessons from Microlending in Developing Nations [Michael Pagano (Villanova) & Lawrence Mitchell (GW)]

Nicola Sharpe (Illinois), Corporate Board Performance and Organizational Strategy [Deborah Demott (Duke) & Michael Abramowicz (GW)]

Julie Hill (Houston), The Rise of Ad Hoc Bank Capital Requirements [Anna Gelpern (American) & John Buchman (E*Trade Bank & GW Adjunct)]

Michael Simkovic (Seton Hall), The Effects of Ownership and Stock Liquidity on the Timing of Repurchase Transactions [Richard Booth (Villanova) & Henry Butler (Mason)]

Michelle Harner (Maryland), Activist Distressed Debtors [Donna Nagy (Indiana Bloomington) & Lisa Fairfax (GW)]

Saule Omarova (UNC), The Federal Reserve Board’s Use of Exemptive Power [Patricia McCoy (Connecticut) & Arthur Wilmarth (GW)]

Heather Hughes (American), Suburban Sprawl, Finance Law and Environmental Harm [Scott Kieff (GW) & Lawrence Cunningham (GW)]

Robert Jackson (Columbia), Private Equity and Executive Compensation [Norman Veasey (Weil Gotshal) & William Bratton (Penn)]

Brian Quinn (BC), Putting Your Money Where Your Mouth Is: Post Closing Price Adjustments in Merger Agreements? [Gordon Smith (BYU) & John Pollack (Schulte Roth)]

Mehrsa Baradaran (BYU), Reconsidering Wal-Mart’s Bank [Heidi Schooner (Catholic) & Renee Jones (BC)]

This is one of many events sponsored by GW’s Center for Law, Economics and Finance.

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Brazil’s First Insider Trading Conviction?

I find it hard to believe, but apparently so:

Two former executives of Sadia SA, the foodmaker that BRF Brasil Foods SA bought to form the world’s biggest poultry exporter, were sentenced and fined in the country’s first insider trading court ruling.

Former Chief Financial Officer Luiz Gonzaga Murat Jr. was sentenced to 21 months in prison and fined 349,712 reais ($210,100), Brazil’s securities regulator said today in an e- mailed statement. Romano Ancelmo Fontana Filho, a former board member, was sentenced to 17 months and fined 374,941 reais. Both can serve community service in lieu of prison.

Murat, who was Sadia’s CFO for 12 years until resigning in 2006, and Fontana were charged with illegally purchasing American depositary receipts of Perdigao SA before Sadia made a hostile bid to buy the rival in 2006. Murat and Fontana settled similar allegations of insider trading with the U.S. Securities and Exchange Commission in 2007.

The student who passed this along to me seemed relatively confident that the ruling would be overturned on appeal. If anyone out there knows something about Brazilian securities law, sufficient to explain how the market there functioned without a rigorous enforcement regime, please drop on by and comment.  Otherwise, lots of L&E folks will be made very, very happy.

Creating Value

I’ve talked in previous posts about a “closed circuit” economy among the wealthy. A plutonomy at the top increasingly circulates buying power (be it luxury goods, real estate, gold, or securities) among itself. The middle class used to dream that a rising Wall Street tide would lift all boats; as Felix Salmon shows, that hope is fading. Whatever innovations arise out of these companies aren’t doing much for average incomes.

On the other hand, financial innovation has done wonders to extract purchasing power from the broad middle into the closed circuit at the top. Here, for example, is how one of our leading firms created enormous value in 2006:

Consider the tale of Travelport, a Web-based reservations company. [A] private equity firm and a smaller partner bought Travelport in August 2006. They paid $1 billion of their own money and used Travelport’s balance sheet to borrow an additional $3.3 billion to complete the purchase. They doubtless paid themselves hefty investment banking fees, which would also have been billed to Travelport.

After seven months, they laid off 841 workers, which at a reasonable guess of $125,000 all-in cost per employee (salaries, benefits, space, phone, etc.) would represent annual savings of more than $100 million. And then the two partners borrowed $1.1 billion more on Travelport’s balance sheet and paid that money to themselves, presumably as a reward for their hard work. In just seven months, that is, they got their $1 billion fund investment back, plus a markup, plus all those banking fees and annual management fees, and they still owned the company. And note that the annual $100 million in layoff savings would almost exactly cover the debt service on the $1.1 billion. That’s elegant—what the financial press calls “creating value.”

The corporate geniuses at Boeing offer another display of modern-day business acumen.

The more stories like this you read, the more you realize that massive unemployment isn’t a bug in our economic system; it’s a feature. A country can’t have legal rules that permit these moves without expecting to hemorrhage jobs. All the Michael Porter homilies in the world can’t put this Humpty Dumpty back together again.

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The Rule of Flaw: Ibanez and the Too-Big-to-Succeed Problem

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? 

Read More

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Bubble Warning on Facebook, Groupon

The mysterious ways of financial valuation manifest daily. One mystery: Facebook, the social network business, and Groupon, the buying network company, both generate annual revenues of about $1 billion. Yet reported private stock trading indicates that traders are pricing Facebook at about 50 times that while pricing Groupon at about 5 times that.

Perhaps this is attributable to analytical factors, such as observed user growth rates, potential market and revenue sources, perceived capacity to convert the revenue into earnings, competitive threats—or negotiating skill in trading of privately-held shares. But given the wildly varying pricing traders give enterprises like this in recent years, it could be a sign of a bubble.

Financial bubbles recur as a natural, inherent product of human behavior in capitalist economies—from the recent real estate bubble, to the dot-com bubble a decade earlier, and stretching back to the tronics bubble of the 70s and back to Amsterdam tulip bulbs centuries ago.  (I wrote a trade book about this after last decade’s bubble burst.)  By definition, a critical mass cannot recognize the bubble as it is in inflating, though invariably some pessimists detect something. Read More

All That is Liquid Freezes in a Panic

Argue against a complex financial practice, and you’ll hear it sooner or later: the liquidity trump card. Promoters of virtually every form of securitization, leverage, collateralized debt obligations, credit default swaps, swaptions, you name it—will insist that, if their activity is regulated or limited, the markets will lose liquidity. For example, as John Cassidy quotes John Mack, ‘subprime-mortgage bonds . . . “give[] tremendous liquidity to the markets.'” Another private equity executive tells Cassidy, ““Part of the value in a stock is the knowledge that you can sell it this afternoon. Banks provide liquidity.’”

Having authored the perceptive book How Markets Fail, Cassidy looks behind the liquidity talisman and finds it tends to melt into cliche:

“Liquidity” refers to how easy or difficult it is to buy and sell. A share of stock in a company on the Nasdaq is a very liquid asset: using a discount brokerage such as Fidelity, you can sell it in seconds for less than ten dollars. A chocolate factory is an illiquid asset: disposing of it is time-consuming and costly. The classic justification for market-making and other types of trading is that they endow the market with liquidity. . . .

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Treasury’s Prime Directive: Protect the Banks

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,
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Mad Glee-actica: The Virtues of Extreme Recycling

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? Read More

Rule of Law in Russia

This presentation by Bill Browder at the Stanford Graduate School of Business is a pretty astonishing account of the Russian economy over the past two decades. I am familiar with the usual story of oligarch profiteering, but Browder’s experience shows how even the ostensibly sound legal arrangements of today can quickly unfold into a nightmare for investors. As the Stanford GSB news puts it,

Browder soared to fame and fortune investing in Russian equities amid the chaos and corruption of the post-Soviet economy. His hallmark: finding hidden values in Russian companies and driving up their share prices by exposing corporate malfeasance and mismanagement. His widely publicized campaigns for shareholder rights and corporate governance helped propel the Hermitage Fund from $25 million in 1996 to $4 billion a decade later. But eventually the U.S.-born financier ran afoul of the Russian government, which banned him from the country in 2005 as a threat to national security.

According to Browder, “Anyone who would make a long-term investment in Russia right now, almost at any valuation, is completely out of their mind. . . .My situation is not unusual. For every me, there are 100 others suffering in silence.” And for a “bigger picture” presentation about the “disembedded markets” and the types of forces Browder was a victim of, Nancy Fraser’s Storrs Lecture podcast on “Predatory Protections, Tragic Tradeoffs, and Dangerous Liaisons: Dilemmas of Justice in the Context of Capitalist Crisis” is also well worth listening to.