Category: Corporate Finance

Deceptive by Design: Derivatives as Secret Liens

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

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

I’m looking for some good examples of movie clips from recent films in which the presence (or absence) of transactional lawyering is key to the action.  The best example I’ve got so far is from the Social Network.  Recognizing that showing clips of business lawyering isn’t for everyone, I’d still appreciate your tips.  Negotiation scenes, drafting discussions, closings — anything that would motivate student excitement about transactional practice.

Invisible Hand or Hidden Fist?

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

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

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

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

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Targeting Odious Top Pay Contracts

Cross-posted at Harvard Law School’s Corporate Governance blog, this summarizes in some detail my new paper on applying simple contract principles to police odioius executive pay contracts:

Executive pay has skyrocketed in recent decades, in absolute terms and compared to average wages. The area of largest growth has been in stock-based components, including stock options, often tending to focus on the short-term, with associated risks we’ve seen. A vigorous academic debate has run for more than a decade, becoming a popular political discussion amid the financial crisis exposing arcane debate to public scrutiny.

Growth could be laudable, explained as creating proper incentives to align manager interests with shareholder interests and to promote optimal risk taking. In this view, if there is a problem, it is narrow and limited. Critics are skeptical whether this story holds up. They worry that managerial power has strengthened to enable top executives to control setting their own compensation. In this view, the problem is pervasive and warrants a comprehensive response—and proposals abound.

I come down in the middle. There are problems in at least an important number of cases, and current proposals to redress them are unlikely to work. So I seek a new approach—contract unconscionability—to police extreme cases. The proposal must surmount some hurdles but isn’t as radical as it sounds.

A good way to summarize the debate highlights a three-pronged theory that promotes much of prevailing executive compensation, especially stock-based components, and contrasts it with limits on each prong.

First: in optimal contracting theory, boards design manager contracts to minimize agency costs. But when managers dominate the process, the managerial power thesis suggests this ideal may not be met.

Second: with efficient stock markets, stock price is a good proxy for the shareholder interest and a mirror of managerial performance. But stock price can differ from business value for sustained periods, fogging both.

Third: stock-based pay could align managerial incentives with shareholder interests if designed right and markets work well. But otherwise they create perverse effects. Read More

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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? 

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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