Category: Bankruptcy


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

lipson.JPGThis 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.


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

lipson.JPGMy 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.

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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.

Krugman pins the blame squarely on a market fundamentalism that blinded regulators to extraordinary risks accumulating over the past five years:

Between 2002 and 2007, false beliefs in the private sector — the belief that home prices only go up, that financial innovation had made risk go away, that a triple-A rating really meant that an investment was safe — led to an epidemic of bad lending. Meanwhile, false beliefs in the political arena — the belief of Alan Greenspan and his friends in the Bush administration that the market is always right and regulation always a bad thing — led Washington to ignore the warning signs.

The deep irony here is that the same ideological movement that promised deep tax cuts for all may be delivering a staggering national debt that will assure everyone higher tax bills–paid out in large part to foreign owners of our national debt.

As I’ve mentioned earlier on this blog, Bob Kuttner has harkened back to the 1933 Pecora Hearings as an analogue for the type of fundamental re-evaluation of the financial order that we may need to do today. After having a decade of policy mirroring 1920s era laissez-faire, I hope we aren’t in for a replay of the 1930s.


The New Hall Monitors

The front page of today’s Washington Post reports on a recent explosion in the number of corporate “monitorships,” noting a sevenfold increase since 2001. In these cases, the article reports, federal prosecutors direct contracts to private parties, who are given responsibility to oversee sometimes radical reconstructions of companies charged with fraud or other wrongdoing. The often hefty bill, of course, goes to the relevant company.

Much of the analysis in the article speaks to potential corruption/favoritism in the appointment of individuals to fill these lucrative positions. The article notes the appointment of “various former prosecutors and SEC officials with ties to President Bush, his father and other Republican luminaries,” before focusing on a particular case out of New Jersey. (Which choice I saw, as a perhaps overly defensive temporary resident, to play on pernicious stereotypes of this fair state…)

I was more interested, however, to think about the nature of the institution of “monitors” more generally. What, I wondered, were potential analogies in our schemes of law and governance? Court-appointed special masters immediately came to mind. Naturally, there’s some whiff of our sorely missed independent counsels. Perhaps given my international interests, I somehow thought of the U.N. trusteeship system as well, which in turn brought to mind the various uses of private trustees in the U.S. bankruptcy system.

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Predatory Lending: Meet Jonathan Swift

plalogo.gifAt the new website of the Predatory Lending Association, aspiring lenders can find concentrations of “working poor” customers in their neighborhood, calculate effectively usurious loans, not blacklist crusaders against payday lending, including Liz Warren, and learn all the arguments that goo-goos will make against high-interest borrowing. One Q&A in particular should be familiar to contracts professors (or maybe just those, like me, who use Randy Barnett’s Perspectives book):

Myth: Payday lending is comparable to selling yourself into slavery.

Reality: Although there is a market need for slavery, people do not choose to sell themselves into slavery. Free choice is the difference between payday lending and slavery.

(There is even a neat chart to make the connection more clear.) On the discussion boards, you can share your thoughts with other predatory lenders. Sure, it all seems a little too cute, but it’s worth checking out anyway.

The Fear Economy

missingclass.jpgMany commentators worried that the 2005 bankruptcy law would discourage entrepreneurs from taking risks. Now it appears to be accelerating the housing downturn:

A new bankruptcy law, approved by Congress in 2005 after years of debate, makes it much harder for households to get out from under their consumer debt. The result: More people being forced to walk away from their homes, leaving lenders holding the bag. Perversely, a law intended to help the financial industry may be damaging the housing sector, creditors and borrowers alike.

Another recent BusinessWeek article shows just how weak bankruptcy protections may be becoming in the wake of a voracious debt-collection business and slow-footed credit bureaus.

In the 1990s, businesses adept at tracking and trading consumer debt expanded their reach to dabble in accounts enmeshed in bankruptcy. That dabbling has grown into a robust market. Some of the trade in so-called bankruptcy paper involves debts that remain collectible. What’s troubling is that the market now also includes billions in discharged debts, which ought to have no dollar value. Owners of canceled liabilities can revive their value in two main ways: by directly pressuring consumers to cough up cash or by gaming the credit system. . . .

After Chapter 7 cases, “debtors expect their credit is going to become pristine,” [one commentator] notes. “But now you have people who buy the debts, even bankruptcy debts, and all of a sudden, new people are supplying information to the credit bureaus.” She adds: “The way the system is working now, it doesn’t give [debtors] that fresh start.”

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“Cops” for Commercial Law Profs

Today in my Article 9 class, we reached one of my favorite parts of the course: the law of the repo man. I have blogged before about the philosophical significance of the repo man, but today we focused on the more mundane issue of what constitutes a breach of the peace under UCC 9-609. Fortunately, YouTube came to my rescue. It turns out that there is a whole YouTube genre of repo-men (and a few women) filming and posting their work. Its like “Cops” for commercial law profs. (Warning: profanity)

My class was pretty unanimous in their belief that this constituted a breach of the peace, but — I am happy to say — could not agree on when the breach actually happened. Now if I could find some YouTube videos on the Statute of Frauds.

The Care/Profit Tradeoff in Nursing Homes

We’re often told that inequality helps keep the US economy efficient. Cut regulation and give high rewards to those at the top, and they’ll work hard to cut costs and compete on quality, providing better and cheaper goods and services for all. Private equity firms like Carlyle Group might be considered the apotheosis of such a market-based approach, taking over companies and forcing them to meet market imperatives.

Here’s a fascinating NYT study of their influence on the nursing home industry, which “compared investor-owned homes against national averages in multiple categories, including complaints received by regulators, health and safety violations cited by regulators, fines levied, [and] the performance of homes as reported in a national database known as the Minimum Data Set Repository.” The findings describe an extraordinary combination of business efficiency and deflection of legal responsibility:

The Times analysis shows that . . . managers at many . . . nursing homes acquired by large private investors have cut expenses and staff, sometimes below minimum legal requirements. Regulators say residents at these homes have suffered. At facilities owned by private investment firms, residents on average have fared more poorly than occupants of other homes in common problems like depression, loss of mobility and loss of ability to dress and bathe themselves, according to data collected by the Centers for Medicare and Medicaid Services. The typical nursing home acquired by a large investment company before 2006 scored worse than national rates in 12 of 14 indicators that regulators use to track ailments of long-term residents.

The law plays an important role in preventing accountability here; “private investment companies have made it very difficult for plaintiffs to succeed in court and for regulators to levy chainwide fines by creating complex corporate structures that obscure who controls their nursing homes.” So perhaps the key “innovation” here was the decision to aggressively reduce care and skillfully deploy legal strategies to prevent any liability for injuries that reduced care caused. It certainly worked well for investors; “A prominent nursing home industry analyst, Steve Monroe, estimates that [one investment group’s] gains from [its sale of a nursing home chain] were more than $500 million in just four years.”

I have to confess that I’ve always wondered what business practices could “create the value” that’s resulted in such extraordinary gains at the top of the income scale. The Times has done us a great service by putting a human face on some of them. . . and on the legal strategies that make them possible.


Shylock and Article 9 of the U.C.C. (with some thoughts on bankruptcy)

shylock.gifShakespeare’s A Merchant of Venice (1598) is often misidentified as an anti-Semitic play about a contract. This is not technically correct, as the transaction at the heart of the drama seems to be a secured loan. (Albeit an anti-Semitic one.) Furthermore, contrary to Shakespeare’s conclusion, I believe that the security agreement is most likely enforceable, at least under Article 9 of the Uniform Commercial Code, a point that I hope to make to my secured transactions class. Here is Shylock’s description of the loan agreement between himself and Antonio, a Venetian merchant:

SHYLOCK: This kindness will I show; go with me to a notary; seal me there your single bond, and – in merry sport – if you repay me not on such a day, in such a place, such sum or sums as are expressed in the condition, let the forfeit be nominated for an equal pound Of your fair flesh, to be cut off and taken In what part of your body pleaseth me. (I.3.141-149)

It seems fairly clear from the passage that there is a debt. Antonio promises to pay “such sum or sums as are expressed in the condition.” However, without a valid security interest Shylock has only a personal right of action against Antonio. Indeed, even if Antonio promises the pound of flesh, all that Shylock gets in the event of a failure to deliver the bloody bond is a right to money damages. Section 9-109, however, teaches us that Article 9 governs “a transaction, regardless of form, that creates a security interest in personal property . . . by contract.” Such seems to be the case here. Indeed, Shylock casts the transaction in the form of a bond, ie a promise to deliver the pound of flesh, with a condition, ie payment of the debt, that defeats the bond, a classic pre-Code security arrangement, and the “pound of . . . fair flesh” falls under 9-102(a)(44)’s definition of “goods” (“all things that are moveable when a security interest attaches”), bringing it within the personal property requirement of 9-109.

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