Author: Lawrence Cunningham


Fifteen (Plus) Proposals for Fin Reg Reform

bright ideas.jpgScores of serious and thoughful proposals for financial regulation reform have been published amid the financial crisis. Following is a list with links to a selected fifteen.

In a forthcoming paper, soon to appear on SSRN, David Zaring and I provide a guide to the perplexed amid this proliferation of proposals.

In brief, we (1) caution against excessive exuberance in fashioning reform and (2) develop a framework to evaluate the contending proposals by delineating what amount to only three or four alternative approaches.

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Treatment Differences in US / International Accounting

global and local accounting.jpgAmid continuing enthusiasm for the US to abandon its traditional accounting standards in favor of those set by an international body in London, insufficient attention is paid to differences in how the two treat particular questions and what those different treatments reflect about political realities.

In late August 2008 on this blog, I asked whether readers were aware of lists or charts illustrating treatment differences between US and international accounting standards. Comments and other research yielded modest results. The relevant literature tends to focus on differences in bottom lines between the two systems, not treatment differences.

This gap led Bill Bratton (Georgetown) and I to believe that a list or chart of treatment differences, with contextual analysis, would be useful to the literature (in both accounting and in law). As a result, Prof. Bratton and I prepared a contribution for the Virginia Law Review, commenting on a related paper by Jim Cox (Duke).

Our piece is now available here. The chart of treatment differences appears as the Appendix, at pp. 17-26. The preceding pages synthesize how these differences reflect deeply divergent philosophical and political realities, despite widespread talk of how the two standards are convergent.

The paper’s abstract reads as follows:

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As If Accounting

Do reasonable Americans today regard housing markets, credit markets, stock markets or collectibles markets to reflect accurately the fair value of their homes, corporate bonds/equity and collectibles? My guess is that a large number could honestly and in good faith say “no, that they do not,” whether correctly or incorrectly. Many might say instead that at least some of these markets are at least periodically distressed (or even inactive in the case of collectibles and some housing markets) and that related prices, if any, “really represent distressed sales.”

If so, according to the logic of new accounting rules the country’s independent accounting standard setter adopted last week, valuation of these items may not accurately be ascertained by using recent comparable home sales or trading prices for corporate debt and common stock or auction sales of collectibles. Instead, they could be ascertained by reference to the owner’s own judgments about what those assets would sell for in an “orderly transaction” and “active market.”

The accounting body (the Financial Accounting Standards Board) last week gave analogous authorization to corporate America (and FASB’s London-based counterpart is being pressured to follow suit). In its plain English version of these new rules, FASB says they are designed “to figure out fair values when there is no active market or where the price inputs being used really represent distressed sales.” FASB continues: “The objective is to reflect how much an asset would be sold for in an orderly transaction (as opposed to a distressed or forced transaction) .”

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The Great Repression

Great Repression Human Brain in Cage.jpgAmid contending descriptions of the prevailing economic crisis, and candidates for causes and responses, I nominate The Great Repression and, in doing so, point out how unconscious exclusion of painful realities from the conscious mind caused the crisis and continues to infect policy responses to it.

No consensus appears on what to call the prevailing economic crisis, let alone diagnostics of its causes or prescriptions for cure. It’s not yet so severe to warrant Great Depression II or so mild to be called a mere recession. As something in between, some are tempted to call it a Great Recession.

People seem agreed that an asset price bubble, especially in housing, manifested crisis, but disagree on exact culprits. Consumers and businesses respond by curtailing borrowing and spending, but government’s responses are exactly the opposite.

All candidates for culprits ultimately involve false stories that people—citizens, business people, regulators and politicians alike—told themselves. Exemplars: the American dream of home ownership can be made available to all; housing prices tend inexorably upward; massive current borrowing can be repaid from future assumed prosperity; financial risk can be diversified, hedged, securitized away by carving up underlying financial instruments; regulators can let market participants self-monitor and self-correct; and politicians can safely respond to citizen appetites by sustaining all these false beliefs.

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Delaware Back to Sturdy Doctrine; Good Faith in Coma

death knell for good faith.jpgLast week, the Delaware Supreme Court backed off any notion that directors owe their corporations any special duties of good faith (or absence of bad faith) and retreated to the more traditional standards of corporate duties. In a refreshingly lucid and terse (easily edited to 5 pages of casebook text) opinion, Justice Carolyn Berger, for the Court en banc, clarifies that directors do not have to follow any specific steps when deciding to sell corporate control and that reasonable steps to that end are enough to reject any claim that they failed to act in good faith—even on a motion for summary judgment.

This decision, Lyondell Chemical Co. v. Ryan, is noteworthy because in two other noted opinions in 2006 (Disney and Stone v. Ritter), the Delaware Supreme Court suggested, in dicta, that there were potentially recurring contexts in which directors might fail to act in good faith such that, apart from any other duty, they may be personally liable for that. Delaware’s latest marks return to more familiar doctrinal terrain. The role of good faith, ultimately, is to prevent fiduciaries who engage in particularly egregious conduct, or “conscious disregard of duty,” from avoiding liability for money damages or enjoying corporate indemnification, both under Delaware statutory law.

Of course, given Delaware’s notoriously shifting corporate law, what Justice Berger settles in Lyondell could change in Delaware’s next big case. After all, Delaware courts, consciously seeing themselves as judges in equity, may, on egregious facts, revive the notion of good faith as an independent fiduciary duty or some vital aspect of obligation, such as a component or cognate of the duty of loyalty. But, for now, Lyondell puts the notion of good faith in something of a coma. Not dead, but nary alive.

Where that leaves Delaware corporate fiduciary duty doctrine is on more familiar terrain. The following is a snap shot of that terrain for directors and officers.

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AIG’s Unsupervised Capital Structure Conflicts

Chaos.jpgChaos occurs when government uses private deal making to invest in corporations. AIG gives lessons in this (as William Sjostrom explores) that characterize scores of other deals the New York Federal Reserve and US Treasury have been cooking up for a year, on-the-fly and without any administrative law or other legal supervision (as David Zaring and Steve Davidoff explore).

To see some of the problems, start with the following rundown of AIG’s current capital structure, as constituted by the NY Fed and Treasury without any oversight.

Senior Debt. The NY Fed is AIG’s senior secured lender, with about $50 billion in credit extended, along with other lenders to whom the company owes another $130 billion in long-term debt.

Senior Equity. The US Treasury holds AIG’s senior equity, a series of non-voting, non-convertible preferred for which it paid $40 billion (which AIG used, in turn, to reduce borrowings from the NY Fed). The US Treasury also holds warrants to buy about 2% of AIG’s common. It says it is about to acquire another series of non-voting, non-convertible preferred for $30 billion.

Mezzanine Equity. A Trust whose sole beneficiary is the US Treasury holds convertible preferred stock which, before conversion, commands 77.9% of AIG’s total share voting power.

Junior Equity. Finally, junior equity, the common stock, is held by numerous institutional and other sophisticated investors, with 10% of that held by AIG’s former CEO Maurice Greenberg.

The presumed purpose of this unsupervised intervention is to put voting control in the Trust so that, eventually if AIG is rehabilitated, that controlling interest can be sold in an orderly transaction to private investors, perhaps along with Treasury’s senior equity, and certainly after the NY Fed’s senior debt is repaid. Trouble is, the deal for the Trust’s equity is incomplete, and the overall structure seems replete with conflicts of interest.

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AIG: What “Taxpayers” “Own” and “Invest”

Meaning.jpgTwo shorthand references often used these days are how “US taxpayers own 80% of AIG” and “the government has invested more than $170 billion” in bailing AIG out. There is something in both common expressions. But the entire corporate finance and corporate governance structure put in place, and endlessly changing, is so unorthodox, that these expressions do not reflect their usually meanings.

Using them can be misleading in two different directions: (1) in terms of the 80% ownership notion, “taxpayers” have vastly diminished rights compared to the usual rights of corporate shareholders and (2) in terms of the $170 billion figure, the taxpayers have vastly less invested than that.

As to the ownership notion, a Trust whose sole beneficiary is the Treasury Department owns a series of AIG preferred stock (called Series C) that is convertible into AIG common stock that would represent 77.9% of AIG’s outstanding common shares, if converted. For now, the Trust also gets to vote on proposals to AIG’s common shareholders, including director elections, as if the preferred were converted, and receive dividends paid on common stock, as if it were converted.

But surely the “taxpayers” do not own that stock and certainly have no right to elect AIG’s directors. The Trust does. That Trust, in turn, is managed by three Trustees. These people are appointed by Treasury, not by taxpayers. The Trustees do not stand for election. Further, the Treasury Secretary is not elected by taxpayers, or removable by them, but is appointed by the President, and removable by him. The President, of course, serves a four-year term, whereas corporate director elections occur annually.

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AIG Defends Bonus Payments

Contract.jpgAs a companion to my post , AIG Contracts Questions, consider the following summary analysis of a fascinating memo, undated, unsigned and “produced quickly,” AIG explains the legal and business grounds for why it had to pay $165 million in bonuses to 400 employees of its complex financial contracts business. These payments, which range from $1,000 to $6 million, cover services during 2008, pursuant to employment agreements, and an employee retention plan, all entered into in early 2008.

After defending the payments on legal and business grounds, the memo promises, somewhat incongruously, how AIG will use its best efforts to reduce bonus amounts that may become due for services during 2009. Following is a summary and elementary assessment of these three parts of the memo: legal, business, future efforts.

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AIG Contracts Questions

Contract.jpgUnder what legal theories may an employer refuse to perform promises to pay bonus compensation to employees? That is the contract law question that US President Barak Obama and New York Attorney General Andrew Cuomo pose to the country today. Both seek to prevent AIG, the beleaguered and possibly criminal enterprise, now nearly 80% owned by the US government after its $170 billion bailout, from AIG’s planned payment of $165 million in cash bonuses to various employees.

AIG says it is contractually obligated to make these payments. The President instructs his Treasury Secretary to “pursue every single legal avenue to block these bonuses.” The New York Attorney General is doing so. His letter to AIG today requests copies of the contracts, background on how they were negotiated and descriptions of the job performance of covered employees.

In the spirit of President Obama’s call and Attorney General Cuomo’s quest, following are some admittedly spontaneously developed and potentially speculative legal avenues to block payment of the bonuses. Please feel free to add or subtract from these preliminary notations.

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