Monthly Archives: April 2009

Subprime-Related Securities Litigation: Early Trends

This post is based on a client memorandum by Jonathan C. Dickey and Aric H. Wu of Gibson, Dunn & Crutcher LLP.

I. Introduction

What began in late 2006 as a disruption in the market for subprime mortgage-backed securities, collateralized mortgage obligations (“CMOs”), and collateralized debt obligations (“CDOs”) has metastasized into a global financial crisis that has plunged much of the world into recession and brought down some of the world’s largest financial institutions. These adverse developments have generated a wave of private securities litigation, as well as regulatory inquiries by federal and state authorities.

In September 2008, the government takeover of mortgage giants Fannie Mae and Freddie Mac was followed by the collapse of Lehman Brothers, the acquisition of Merrill Lynch by Bank of America and an $85 billion (and now $170 billion) government investment in American International Group. With the stock market in freefall, the Treasury Department proposed a $700 billion “Troubled Asset Relief Program” (“TARP”) to buy toxic assets from the nation’s banks in order to shore up their balance sheets and restore confidence to the financial system. The proposal was initially rejected by the House of Representatives, but passed in early October in a modified form that initially released $350 billion, with Congress retaining the discretion to release or withhold the remainder. As of February 6, 2009, nearly 400 financial institutions had received assistance under this program.[1]

Concluding that prior government responses to the financial crisis were “late and inadequate,” the Obama administration in February 2009 announced a comprehensive “Financial Stability Plan.”[2] The plan provides for the establishment of a Financial Stability Trust, a Public-Private Investment Fund designed to “cleanse” financial institutions’ balance sheets of legacy assets, and initiatives to support loan securitization and community lending while preventing foreclosures.[3] The Financial Stability Plan also promises to impose accountability and transparency on financial institutions that receive government aid by subjecting them to a “stress test” before they may participate in the Financial Stability Trust and requiring them to limit executive compensation and dividends, mitigate foreclosures and expand public reporting.[4] The initial reaction of the markets to the Financial Stability Plan was underwhelming. On the day the plan was announced, the Dow Jones Industrial Average dropped 4.6%.[5]

On February 17, 2009, President Obama signed the American Recovery and Reinvestment Act (the “Stimulus Act”), which provides $787 billion in government spending and tax cuts and also codifies (and in some cases expands) the Treasury Department’s restrictions on executive compensation.[6] Under the Stimulus Act, recipients of TARP funds must eliminate incentives that encourage executives to “take unnecessary and excessive risks” or manipulate reported earnings; recover any bonus or other compensation awarded based on financial statements later found to have been materially inaccurate; eliminate “golden parachute” payments to top executives; limit most bonuses to top executives to one-third of an executive’s total annual compensation; and permit nonbinding shareholder votes on executive compensation.[7] Originally, all recipients of TARP funds were to be subject to the Stimulus Act’s executive compensation restrictions. Following the signing of the Stimulus Act, the Treasury Department announced that the requirements would not apply to recipients of TARP funds through the Term Asset-Backed Securities Loan Facility (“TALF”), which is designed to increase lending to consumers and small businesses on more favorable terms by encouraging investment in highly-rated asset-backed securities. The decision to exempt TALF participants from the Stimulus Act’s executive compensation restrictions appears to have been made out of concern that the requirements could chill participation in TALF.[8] Following the signing of the Stimulus Act, the Obama administration announced it also would spend $75 billion to encourage home mortgage lenders to modify loans for borrowers in foreclosure or at risk of foreclosure, and up to $200 billion to allow homeowners to refinance through Fannie Mae or Freddie Mac.[9]

In the meantime, activist shareholders are on the warpath. In December 2008, after the Securities and Exchange Commission (“SEC”) concurred in the exclusion of shareholder proposals seeking greater disclosure of risks related to mortgage investments at Washington Mutual, a coalition of over 60 investors called on then President-Elect Obama to limit the ability of companies to exclude shareholder proposals related to corporate risk evaluation.[10] The corporate governance challenges for the companies being targeted by these activist shareholders no doubt will be intense for the foreseeable future.


Seventh Circuit Rejects Merger Litigation

This post is based on a client memorandum by Adam O. Emmerich and William Savitt of Wachtell, Lipton, Rosen & Katz.

Long after Sam Zell’s decision to sell Equity Office Properties (EOP) at the market top in an all-cash deal was followed by a near-complete collapse of the market for REITs and commercial office space, shareholder plaintiffs continued to pursue litigation claiming that they were ill-served by the transaction. In a decision of the United States Court of Appeals for the Seventh Circuit issued last Friday, Judge Richard Posner decisively rejected these claims. The opinion, which primarily affirms the dismissal of claims that EOP’s proxy solicitation was misleading, also touches on the appropriate role that break-up fee arrangements play in merger transactions as a matter of economic logic and fiduciary duty, and re-affirms the limited scope of the judicial process in supervising both the federal proxy rules and state-law fiduciary matters, correctly characterizing the plaintiff’s purpose as seeking to “sink[] the process of corporate acquisition into a sea of molasses.” Beck v. Dobrowski, et al., 2009 WL 723172 (7th Cir. March 20, 2009).

The case arose out of Blackstone’s all-cash deal to acquire EOP for $55.50 per share in early 2007. Blackstone clinched the deal only after a protracted bidding battle, and with the protection of a termination fee that was negotiated upwards to $720 million by the time the Blackstone’s prevailing bid was ultimately accepted. The shareholder plaintiff brought suit under § 14(a) of the Securities Exchange Act, alleging that the merger proxy should have included additional back-up valuation information and details on the benefits that top EOP executives were to receive in the Blackstone transaction, and complaining generally about the terms of the transaction and the conduct of the sale process. The complaint tacked on supplemental state law claims alleging that EOP’s directors breached their fiduciary duties, notwithstanding that fiduciary duty litigation was already pending in the courts of Maryland, the state of EOP’s incorporation.

The appeals court rejected the plaintiffs claims. As to the § 14(a) claim, Judge Posner confirmed that “the antifraud provisions of the federal securities laws are not a general charter of shareholder protection,” which, the court made clear, remains the proper province of state fiduciary duty law. (The court went out of its way, however, to note that the termination fees about which plaintiff complained are “not. . . generally improper under any body of law with which we are familiar.”) Then, applying the Supreme Court’s 2007 decision in Bell Atlantic v. Twombly with full force to the merger litigation context, the panel ruled that plaintiff’s merger proxy claims “were too feeble to allow the suit to go forward.” The court noted that “there is nothing in the complaint to suggest that any shareholder was misled or was likely to misled,” and no suggestion that any “shareholder drew a wrong inference” from any of the alleged factual omissions. Under Twombly, defendants “should not be burdened with the heavy costs of pretrial discovery. . . unless the complaint indicates that the plaintiff’s case is a substantial one.”

Turning to plaintiff’s supplemental state law claims, the panel struck a blow for judicial efficiency by affirming the district court’s determination to stay the Maryland fiduciary claims. To permit such claims to proceed in federal court while identical claims were pending in state court would allow “different members of what should be a single class [to] file identical suits in federal and state courts to increase their chances of a favorable settlement.” As Judge Posner observed, “[t]he state-law issues that our plaintiff has presented to the federal court will be definitively resolved by the courts of the state whose law governs these issues, and our court would be required to defer to that resolution because state courts are the authoritative expositors of their own state’s laws.” The court thus resolved the increasingly frequent problem of multi-jurisdiction merger litigation with a bright-line ruling in favor of the courts of the incorporating state.

The Beck decision constitutes a decisive affirmation of the business judgment rule. The complaint failed because “any evidence that the plaintiff would have presented . . . concerning the optimal strategy for EOP to have pursued would have been heavy on hindsight and speculation, light on verifiable fact.” Such second-guessing of directors remains impermissible in the courts, state or federal, and insufficient to state a claim challenging a merger agreement entered into in good faith.

Bankruptcy v. Bailouts

This post comes to us from David Skeel of the University of Pennsylvania Law School and Ken Ayotte of Northwestern University School of Law.

Almost the only thing CEO’s, politicians and most commentators have agreed on during the current financial crisis is that bankruptcy cannot possibly be used to resolve the financial distress of a troubled financial institution. Indeed, the Chapter 11 filing by Lehman Brothers has been singled out by many as the primary cause of the severe economic and financial contraction that followed, and as proof that bankruptcy is disorderly and ineffective. Ad hoc rescue lending is widely viewed as a superior response.

In our article entitled “Bankruptcy or Bailouts?“, we provide a detailed analysis of the costs and benefits of the two approaches, and conclude that the preference for bailouts is not easily justified. We begin by showing that the bankruptcy laws address many of the most pressing concerns with troubled financial firms, such as the need for financing and the danger that creditors will race to grab the firm’s assets. We illustrate the effectiveness of bankruptcy both with historical case studies and with an analysis of the recent crisis. The most important historical precedent is Drexel Burnham, which filed for bankruptcy in 1990. Drexel’s bankruptcy shows that Chapter 11 can be used both for quick sales of time sensitive assets and for a more leisurely disposition of other assets. We also argue that the conventional wisdom about Lehman is deeply mistaken. The negative effects of Lehman’s financial distress were caused not by bankruptcy, but by the government’s last minute decision not to provide financial support and by the revelation that Lehman was in financial distress.

We do not claim that bankruptcy is always the best option. If a firm is suffering from a liquidity crisis and default will have serious spillover effects (such as harm to the market as a whole), a rescue loan may sometimes be preferable to bankruptcy. But rescue loans have several significant downside costs. The most obvious is that the prospect of rescue loans creates moral hazard—the incentive to engage in risky behavior is magnified if the consequences of the risktaking will be borne by the government. Although the government counteracted shareholder moral hazard by forcing the shareholders of Bear Stearns and AIG to take significant losses in connection with those bailouts, creditors were made whole in both cases– which magnified creditor moral hazard. In addition to creating moral hazard, bailouts also distort the corporate governance of the affected firms. Governance decisions are made not by the firm and its stakeholders, but by regulators, who often are influenced principally by public opinion. Bankruptcy avoids many of these distortions. Moreover, even in cases where government intervention is justified—as perhaps to guarantee the warranty obligations of General Motors—this often can be done in bankruptcy.

In the final section of the Article, we consider the treatment of derivatives in bankruptcy, which has played an important role in the recent crisis. Under current law, derivatives are exempt from many of the core provisions of bankruptcy, such as the stay on enforcement of contractual rights. Although these provisions were justified as a way to reduce the systemic consequences of a bankruptcy filing, we argue that they can sometimes have precisely the opposite effect. Bankruptcy might prove even more effective if these rules will altered by Congress.

Overall, our Article suggests that bankruptcy is a far more effective mechanism for resolving the financial distress than has been recognized.

The full paper is available for download here.

A Theory of Mergers

This post comes from Gary Gorton of Yale University, Matthias Kahl of the University of North Carolina at Chapel Hill, and Richard J. Rosen from the Federal Reserve Bank of Chicago.

In our forthcoming Journal of Finance article Eat or Be Eaten: A Theory of Mergers and Firm Size we propose a theory of mergers that combines managerial merger motives with an industry-level regime shift that may lead to value-increasing merger opportunities. Two of the most important stylized facts about mergers are the following: First, the stock price of the acquirer in a merger decreases on average when the merger is announced. Second, mergers concentrate in industries that have experienced regime shifts in technology or regulation. The view that mergers are an efficient response to regime shifts by value-maximizing managers, the so-called neoclassical merger theory, can explain this second stylized fact. However, it has difficulties explaining negative abnormal returns to acquirers. Theories based on managerial self-interest such as a desire for larger firm size and diversification can explain negative acquirer returns. However, they cannot explain why mergers are concentrated in industries undergoing a regime shift. Our theory of mergers is able to reconcile both of these stylized facts.

The basic elements of our theory are as follows: First, we assume that managers derive private benefits from operating a firm in addition to the value of any ownership share of the firm they have. Second, we assume that there is a regime shift that creates potential synergies. The regime shift makes it more likely that some future mergers will create value, with larger targets being more attractive merger partners due to economies of scale. Third, we assume that a firm can only acquire a smaller firm, which is consistent with the majority of actual market acquisitions.

In our models, the anticipation of potential mergers after the regime shift creates incentives to engage in additional mergers. We show that a race to increase firm size through mergers can ensue for either defensive or “positioning” reasons. Defensive mergers occur because when managers care sufficiently about staying in control, they may want to acquire other firms to avoid being acquired themselves. By growing larger through acquisition, a firm is less likely to be acquired as it becomes bigger than some rivals. This defensive merger motive is self-reinforcing and hence gives rise to merger waves: one firm’s defensive acquisition makes other firms more vulnerable as takeover targets, which induces them to make defensive acquisitions themselves. This leads to an “eat-or-be-eaten” scenario, whereby unprofitable defensive acquisitions preempt some or all profitable acquisitions. We show that in industries in which many firms are of similar size to the largest firm, defensive mergers are likely to occur.

A central implication of our models is that the firm size distribution in an industry matters for merger dynamics. In particular, our models predict that acquisition profitability is positively correlated with the ratio of the size of the largest firm in an industry to the size of other firms in the industry. Additionally, it predicts that firms in industries with more medium-sized firms have a higher probability of making acquisitions. We use data on U.S. mergers during the period from 1982 to 2000 to test these hypotheses and find support for them.

The full paper is available for download here.

Treasury’s Framework for Regulatory Reform

This post is based on client memorandum by Randall Guynn, Annette Nazareth, and Margaret Tahyar of Davis Polk & Wardwell.

It has been obvious for some time that the outdated US system of financial regulation is badly in need of reform. There have, however, been limited opportunities to unblock the political obstacles to reform, despite valiant attempts by the Paulson Treasury to spur debate with its Blueprint for a Modernized Financial Regulatory Structure and also by many other groups, private, public and academic. The silver lining in the financial crisis may be that at least some elements of reform can now be achieved. Secretary Geithner’s carefully calibrated announcements last week—timed to become public just in advance of the G-20 meetings scheduled in London this week—are an attempt to stage regulatory reform in such a way that those elements where there is the deepest consensus are treated first before more divisive proposals. The need for increased systemic risk regulation and the need for resolution authority for a wide range of systemically important financial institutions are among those priority proposals.

In announcing his new “rules of the road,” Secretary Geithner identified four major axes of reform: addressing systemic risk, protecting consumers and investors, eliminating gaps in the regulatory structure and fostering international coordination. The most detailed elements of the reform package involved systemic risk, including proposed legislation for the resolution of systemically important financial institutions. More detailed frameworks for the other three areas are promised in the coming weeks.

Our recent memorandum, entitled “Treasury’s Rules of the Road for Regulatory Reform,” describes Treasury’s framework for regulatory reform, focusing on the comparatively more detailed proposals for addressing systemic risk, and sets forth some of the issues the government and the private sector may consider as the details are hammered out. A companion memorandum by Randall Guynn, entitled “Treasury’s Proposed Resolution Authority for Systemically Significant Financial Companies” discusses Treasury’s proposed legislation for resolution authority.

The memorandum entitled “Treasury’s Rules of the Road for Regulatory Reform” is available here, and the memorandum entitled “Treasury’s Proposed Resolution Authority for Systemically Significant Financial Companies” is available here.

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