Ideoblog

Hot off the press: Litigating in LLCs

My article, Litigating in LLCs, has been published in The Business Lawyer. Here's the abstract:

One of the most important issues involving limited liability companies is the appropriate way to characterize and handle disputes among members. Courts and legislatures borrowed the derivative suit remedy from corporations and limited partnerships and applied it to LLCs without adequately considering whether this application was appropriate. In fact, this remedy is not suited to the typical business associations for which LLC statutes are designed—that is, closely held fi rms in which members generally participate directly in management. In this setting, the derivative remedy creates costs and complications that are unnecessary because more appropriate remedies are available, including member- authorized suits on behalf of the entity, direct suits by the injured parties, and contractual arbitration. Accordingly, the derivative suit should not be a default remedy for LLCs. More generally, this analysis provides an example of the potential risks of borrowing LLC rules from other types of business associations.

Off to Scotland

For the next couple of weeks here's where I'll be.

No, not in the cemetary, but looking at it.  Sort of a momento mori.  Anyway, this gives a good picture of my internet access.  So probably no blogging until July 5. 

Obama proposes SOX II

Here's a nifty summary, and Bainbridge's early critique.

I haven't evaluated the proposal closely, and won't be able to for awhile because I'm about to get out of range for a couple of weeks. But I do have a few quick thoughts on particular elements of interest. 

First, we have to keep in mind that this isn't really a legislative package, but a kind of starting gun to let the intense lobbying begin.  It will be interesting to compare the proposal to the sausage that emerges at the other end of the grinder.

Second, since we're about to embark on SOX II, wouldn't it be useful to look again at what happened with SOX I?  Here's Butler and my analysis.  At the end of our book we have some suggestions for regulatory humility, such as optional provisions and sunsetting.  I fear that in the end we will find that we learned very little from the SOX debacle.

Third, the Obama proposal suggests (p. 13) requiring hedge fund registration under the Investment Advisers Act overseen by the SEC.  It also proposes that hedge funds be required to make reports on funds under management sufficient to indicate whether they pose a threat to financial stability. 

This is particularly misguided.  The best commentator on that is Houman Shadab.  See here and here.  The bottom line is that hedge funds are more a solution to problems of the financial system than a cause. 

The "systemic risk" argument is totally misguided.  As Jon Macey has noted, hedge funds actually combat systemic risk by, essentially, betting against the "system."  One way to make them part of the problem is to force enough disclosure that other financial institutions can follow them off any cliffs they seek to explore.  See Macey, PROMISES KEPT, PROMISES BROKEN 265-72(2008).

And what's with this regulation by the SEC?  Are we satisfied with the great job that agency did supervising Madoff?  See here (detailing the SEC's massive regulatory incompetence in Madoff) and here (suggesting that the SEC was actually Madoff's unwitting accomplice). 

Fourth, the proposal calls for (p. 40) "increased national uniformity through either a federal charter or effective action by the states." Butler and I show that this objective in insurance regulation is misguided and offer a better alternative.

Finally, let's keep in mind that the US is no longer alone in the world.  Regulatory overkill here could be a boon for places like Singapore and Hong Kong.

Conglomerate book club: Street Fighters

Over at the Glom, they're having a discussion of Kate Kelly's Street Fighters about the last days of Bear Stearns. Here's my entry on who killed the Bear.

Volcker talking sense on hedge funds

Volcker told the International INstitute of Finance meeting in Beijing June 11:

Hedge funds and private-equity funds have an entirely legitimate role to play in providing liquidity and innovation in our capital markets. I do not believe they need to be so closely supervised and regulated as depository institutions. A presumption of government protection and support for financial institutions outside the "safety net" should be avoided.

Nor by the same token should hedge funds or private-equity funds indirectly benefit from official support by sponsorship or ownership by a banking institution. The possibility that failure of a large hedge fund or trading organization might present a systemic risk can be reduced by way of speeding timely resolution of troubled nonbanking institutions. Such authority already exists in the United States for insured banking institutions by means of appointing a "conservator" or "receiver" empowered to maintain continuity of services pending a more lasting resolution of a failing institution.

There is a growing international consensus that hedge funds and equity funds beyond some de minimus size should at least be required to register, with the implication of limited reporting requirements. There may be a few instances in which such funds become so large as to suggest official capital and leverage requirements would be appropriate. Hedge and private-equity funds are necessarily dependent on banks for credit and operational needs. Encouraged by supervisory and risk-management processes, such funds could be appropriately monitored and controlled through those banking relationships.

Indeed, I would go farther. The increasing perversity of bank regulation, including the implicit guarantee of large banking institutions I discussed yesterday,  increases the need for institutions outside that system to keep financial markets honest.

Dismantling capitalism: substituting government decisions for market prices

The WSJ has an interesting article on what it means to insert the government into decisions that used to be made by the price system.

• Cabela, the hunting goods store, got TALF money. So now it’s encouraging customers to buy more guns to shoot gophers, etc.
• Deere bought a bank so it got a government guarantee on $2 billion of its debt. But Caterpillar didn’t own a bank. So its trade group got TALF expanded to include Caterpillar and other equipment makers. Funny how government backing of credit cards turned into a government subsidy of equipment makers.
• But smaller equipment-leasing firms that can't get the high ratings didn’t qualify and now must pay four percentage points more than higher-rated firms to borrow – a three points higher gap than before the crisis. One company that didn’t qualify “is slashing expenses by about 25% to try to stay alive.”
• Small insurance companies that could qualify to buy thrifts got bank bailout money. Others missed the cut.  So insurance company survival will now depend on whether they own banks.
• Spending on lobbying this year is 80% higher than 2002, when businesses were fighting SOX.
• A California telecom entrepreneur scrapped his plan to sell equipment in emerging markets and hired Patton Boggs to figure out how to get government money to build broadband networks in the U.S.
• And now "systemically important" institutions will get money at lower rates but with more regulation, including of executive pay. (Here's the WSJ on the questions surrounding the latter plan, as well as Bebchuk's proposal). So now firms, instead of just deciding whether to make money, will have to decide whether they want to be systemically important, whatever that turns out to mean.

Dismantling capitalism: The hidden costs of the government's implicit guarantee

In the film Other People’s Money, Larry the Liquidator Garfiled said: “You can change all the laws you want. You can't stop the game. I'll still be here. I adapt.”

Well, maybe, but John Carney notes a special problem with the government’s guarantee implicit in letting ten big banks out of TARP. It’s not just moral hazard, but the “calculational chaos” that results when the market no longer fully prices the risk of failure. The cost of failure still exists, but if market participants don’t feel it then the market can’t send the right signals in response to banks’ decisions. 

And the government can’t simply reverse this decision, because that could cause the very panic it was trying to prevent by the initial action.

Messing with markets isn’t as much fun as it might seem.

Dismantling capitalism: the hidden costs of Chrysler's 363 sale

Saturday’s WSJ notes that the “363 sale” used in Chrysler (referring to Section 363 of the Bankruptcy Code) is

typically used to shed assets * * * that need[] to be sold quickly to maximize its value, and can be done without creditor approval. But critics said Chrysler used the procedure to restructure the entire company.

Now a hockey team is trying it. Where does it end?

Bankruptcy and financial professionals said such scenarios, if successful, could make investors demand higher interest rates on debt amid uncertainty over how they might fare should the firm encounter financial difficulties.

"The concern is that you have thousands of lenders, hedge funds, insurance companies who model their investments on rules and laws," said Stephen Lerner, a lawyer for a committee of Chrysler dealers. "How do these folks make investment decisions when they're faced with bankruptcy courts that appear to disregard the rules?"

* * * Lawyers who represent banks, hedge funds and other creditors fear the Chrysler precedent could be used to allow companies to get around established rules for reorganizations, and not just in extraordinary circumstances.

Update:  Mark Roe has an article in Forbes on the bankruptcy law issues in Chrysler.

The significance of the Cravath deferrals

The Law Blog and ATL, among others, are reporting deferrals at Cravath. The payment terms are generous. Cravath is supposedly saying its business is fine, it just has too many associates and summer clerks because of a high acceptance rate.

Yet Cravath is not only offering a deferral option to its current associate class of 09, but a mandatory deferral of its entire 2010 class with less generous terms. Moreover, these layoffs come as the economy is showing signs of life. This seems like more than a minor glitch in the acceptance rate.

Why is this big news, given how many other layoffs, etc, we’ve been seeing lately? Because Cravath has been touted as the epitome of the traditional high-reputation law firm, the type most likely to survive the current upheavals. See, e.g., this recent Henderson & Bierman paper.

This latest news supports my assertion that the problems with Big Law are fundamental to the business model and not just recession fallout.

Private equity-backed IPOs

Private equity bashing is inevitable as entrenched interest groups defend their corporate turf. They will try to show that substitutes are hazardous – despite the manifest difficulties with corporate governance we’ve observed, especially lately.

Consider in that light a recent report by the Investor Responsibility Research Center Institute. The report shows, per Dealbook, that “on average, private-equity-backed companies that go public are more likely to have takeover defenses and less likely to link pay to performance — just the kind of things that usually have activist investors up in arms.”

The study, per its executive summary, “makes no claims about the actual performance of companies with these structures” and doesn’t try to explain these features. The apparent idea is that, just because these IPO firms don’t look like standard corporations, this must be a problem.

But as Dealbook notes, "the whole issue becomes more complicated, however, when you consider that private equity firms generally keep a large ownership stake in their portfolio companies for years after they take them public."

I’ve pointed out in my Uncorporating the Large Firm:

A “reverse leveraged buyout” involves a public offering by a firm that had been taken private. The resulting firm appears to be a conventional publicly held corporation. However, the firm retains a key uncorporation-type high-powered incentive characteristic of the privately held firm -- manager-ownership. A leading study of these transactions notes that after the public offering the buyout group retains on average a 38% stake, while its managers and directors retain an average 36% share (citing Jerry X. Cao & Josh Lerner, The Performance of Reverse Leveraged Buyouts).

And more generally, let's keep in mind, as I say in my more recent and shorter paper on this subject, "courts [and regulators!] need to consider the firm’s entire bundle of rights and obligations before applying corporate restrictions on contracting."

Shareholders, bank pay and systemic risk

From Bloomberg via Dealbook,

The Obama administration intends to seek new powers for the Securities and Exchange Commission to force financial firms to give shareholders votes on executive pay packages, people familiar with the matter told Bloomberg News. * * * The changes aim to ensure that even financial companies that free themselves of government stakes will be subject to universal guidelines aimed at reducing systemic risks, the news service reported.

Now we see that bank pay regulation is politically motivated populist-feeding, and not really about systemic risk. The systemic risk argument for regulation assumes that this risk is an externality not taken into account by banks’ owners. If the owners care about the risks their banks pose to the financial system enough to micromanage pay to reduce these risks, then why can’t we trust the shareholders to manage the banks in other ways to contain these risks? Conversely, if we need systemic risk regulation because we can’t trust the shareholders, then why give the shareholders the power to control pay?

Another thing:  why should the SEC be the agency to dictate shareholder control over bank pay? Isn’t that agency supposed to be about disclosure?

Dismantling capitalism: executive compensation

The government thinks it ought to micromanage the compensation of firms getting government money. Here’s links to my previous thoughts on these pay restrictions.

Of course a big problem with these restrictions is that they defeat the purpose of the bailouts by discouraging financial institutions from taking or keeping the money the government thinks they need to boost the recovery. So the banks are rushing to repay.

How to solve that? Of course: regulate non-recipients too. Here’s today’s NYT on these plans.

“This is the government trying to tell the TARP banks not to worry, because everyone else’s compensation will be monitored, too,” Gustavo Dolfino, president of the WhiteRock Group, a financial recruiter, said of the industrywide principles. “We’re in a world of TARP and non-TARP.”

The endgame, I fear, is to use the financial crisis as an excuse to put into effect all of those wacky and ill-supported ideas about pay that have been kicking around for years. 

Remember the good old days when it was supposedly just all about disclosure? 

Teaching the basic business associations course

So here I am at the AALS mid-year conference on business associations. This morning I moderate the first panel: “Role of Basic Course: What it is and where it is going.” The speakers are Bill Carney (Emory), my colleague Christine Hurt, my co-author Jeff Lipshaw (Suffolk), Bob Thompson (Vanderbilt, visiting Georgetown) and Cheryl Wade (St. John’s). Bob is going to open with the results of a survey he did on who’s doing what in the basic course.

I plan to to pose something like the following question to provoke discussion at this plenary session and in the ensuing small groups:

The basic business associations course is the only exposure some law students (how many?) get to the foundation of business law. Yet some (how many?) of these "intro-only" students end up practicing a significant amount of business law. How well do we prepare these students for their careers?

Here are some specifics that I hope this morning's discussion will address:

1. From the standpoint of adequately preparing the intro-only students, does the basic course unduly stress publicly held over closely held firms? Corporations over unincorporated firms? Litigation over transactional? Basic theory over doctrine or on-the-ground practical considerations?

2. Do intro-only students get enough business background to enable them to fully appreciate the law taught in the course?

3. Do corporate law teachers tend to shape their courses to what they’re most interested in talking about, to what is the most fun to teach or learn, or to what the intro-only students need to know for practice?

4. Should the intro-only students drive the content of the course, or should the course instead be designed as a platform for more advanced business courses?  What tradeoffs does this choice entail?

5. How do recent events in the business world affect what ought to be taught in the basic course?

Update:  It occurs to me after some coffee that all of these boil down to one multipart question:  Are we training the Main Street lawyers of tomorrow to be the Wall Street lawyers of yesterday and, if so, why? 

Off to the AALS

I'll be at the AALS mid-year Business Associations meeting for the next few days. More later!

The NYT on the White & Case meltdown

The NYT has a fairly mundane article on the Big Law meltdown, focusing on White & Case.

So why are big law firms suddenly shrinking? Partly, the Times says, because “in the first quarter of 2009, demand for legal services in New York decreased by nearly 10 percent over 2008, according to the Hildebrandt International Peer Monitor Index.”

Demand is down.  Duh.

We’re also told that

Big Law — especially in competitive New York — is facing a potential paradigm shift as fundamental as the one that has hit investment banks and the auto industry. Big, as a business model (let alone as an expression of the national mood), seems bound for obsolescence.

What is that “paradigm shift”? Partly it’s the bursting of the financial bubble, leaving firms with too many associates. Again, demand is down.  But that sounds like what’s hitting everybody, not a “paradigm shift” for big law.

The article also says:

But the natural order of this world has been set on end by the economic crisis and the possible disappearance of fixtures like the pyramid system (under which associates are thrown en masse at certain cases, fattening the fees), and the billable hour itself (increasingly replaced by flat rates or retainers in a client’s market). The tectonic plates have begun to shift in a nauseating manner, bringing fear, ambiguity and psychological scars.

Well, yes, but these are symptoms. What is the cause?

Philip K. Howard [the famous lawyer and author] says that market forces are taking over from “the emotional and professional commitment that goes along with being an adviser and a solver of problems.” This is the old saw about law suddenly being a business. But that's hardly a recent phenomenon.

How about this, from a W & C partner:

The loyalty of the institution to its people, and vice versa, isn’t really there anymore — it’s a different animal from what a lot of us were used to. It’s much more of a business now and less of a true partnership. The problem is we’re supposed to all be in this together. But at some point, you stop and think: ‘Well, maybe we’re not.’”

This starts to get at the problem. Where is the glue that is supposed to hold large firms together? Turns out maybe it was simply faith that the money would keep pouring in in large enough quantities to support the current business plan. Sounds a bit like a Ponzi scheme.

The real problem is that large firms don’t really own anything but faith, which is fine for religion, but not much of a glue for a business. Here’s my analysis of the meltdown of another big firm, Wolf Block, and some deeper explanations here and in this draft paper.  I’m hard at work on a longer elaboration.

Dismantling capitalism: the Chrysler emails

The WSJ discusses and links emails from during the Chrysler/Fiat/government talks that reveal the very heavy and questionable hand of government in the negotiations.

Some highlights: 

• A March 17 email suggesting that Treasury didn’t understand Chapter 11: “what’s possible/not possible, what the impact will be beyond the actual company.”
• An email late in the negotiations (April 14) indicating that Chrysler still thought a deal with GM was the best available. Evidently this is not what the government thought.

Of course the government is providing financing, so it gets to drive a hard bargain. But unlike other lenders, the government is the government. As I've discussed, firms have to consider the risks they take when they try to treat the government as they do a private party.

So should the government be throwing its weight around to the extent revealed in these emails? Should it be participating at all, or just letting bankruptcy play its course?  (The unnamed government negotiator's ignorance of bankruptcy is scary on this point).

The Second Circuit has approved the Fiat deal, but stayed the order until Monday, giving Chrysler creditors until then to appeal to the Supreme Court.

Sotomayor on campaign finance

As Jim Copland notes, she has it dangerously wrong when she says 

We would never condone private gifts to judges about to decide a case implicating the gift-givers' interests. Yet our system of election financing permits extensive private, including corporate, financing of candidates' campaigns, raising again and again the question what the difference is between contributions and bribes and how legislators or other officials can operate objectively on behalf of the electorate. Can elected officials say with credibility that they are carrying out the mandate of a "democratic" society, representing only the general public good, when private money plays such a large role in their campaigns? If they cannot, the public must demand a change in the role of private money or find other ways, such as through strict, well-enforced regulation, to ensure that politicians are not inappropriately influenced in their legislative or executive decision-making by the interests that give them contributions. (footnotes omitted)

In fact, the "general public good" is determined by a political process in which all sides, including corporations, are free to present and support their views.  My analysis is laid out in Corporate Political Speech, 49 Wash. & Lee L. Rev. 109 (1992).  

Things we only needed one of

Here's Professor B on Wall Street 2, discussing my article on Wall Street 1.

Let's see if public opinion on capitalism can get any more messed up than it already is.

Dismantling capitalism: nationalization of GM

From Fox via Carney:

"Hey, Obama has just nationalized nothing more and nothing less than General Motors. Comrade Obama! Fidel, careful or we are going to end up to his right."

          --Hugo Chavez.

Don't believe it?  Check out Bainbridge and Lambert.

Lawyer licensing: the elephant in the Bartlett bedroom

Judge Sotomayor is facing criticisms for her decisions (sitting by designation) in Bartlett v. New York State Bd. of Law Examiners, 2001 WL 930792 (S.D.N.Y. 2001), and 970 F.Supp. 1094 (S.D.N.Y. 1997), forcing NY to let a learning-impaired applicant sit for the bar exam. Judge Sotomayor said:

There is no insinuation, and I cannot find, that Dr. Bartlett is incapable of performing the functions of a practicing lawyer. * * * Therefore, while it is undoubtedly true that not every person is physically able to be a Yankees first baseman, it is likewise true that it would be grossly unfair to impede whole classes of individuals like plaintiff, with plaintiff's automaticity and reading rate disabilities, from participating in entire classes of customary professions such as the practice of law because they can not read a professional examination like average law school (or other professional school) graduates.

So Judge Sotomayor seemingly gave short-shrift to arguments that the need to read and understand quickly and accurately was an important test of bar admission.

Now I realize that to some this will sound to some like the case of the one-legged Tarzan. But the missing issue here concerns the general usefulness of bar exam.

In my Lawyers as Lawmakers: A Theory of Lawyer Licensing, 69 Mo. L. Rev. 299 (2004) I criticized lawyer licensing in general, and bar examinations in particular, on the basis that they did not, in fact, protect the public from bad lawyers. The only function of lawyer licensing, I argued, was simply to reduce the supply of lawyers. (I then proposed a modest defense on those grounds – i.e., to encourage lawyers to assist in lawmaking by giving them property rights in their state laws.)

With respect to the bar exam, I said:

Perhaps the most important barrier to entry to law practice in a state is the requirement to take a bar exam. The bar exam usually requires months of study and the risk of embarrassing failure. That states pass a very high percentage of applicants if they take the exam enough times suggests that the bar exam is more a price of admission than an effective screen. On the other hand, the bar exam probably deters some people from attempting to obtain a license. Only four jurisdictions pass fewer than sixty percent of those taking a particular test. These include Louisiana, where the low rate may reflect the state’s idiosyncratic civil law system; the District of Columbia, which is unique in admitting lawyers on motion without prior experience elsewhere; and California, which uses its bar exam to screen graduates of unaccredited California schools. The fourth state is Delaware, whose low passage rate may be particularly significant for present purposes. Since Delaware is the most prominent example of a state where lawyers have played an important role in maintaining the state’s law, this provides some anecdotal evidence of the role of state licensing in encouraging lawyers’ participation in lawmaking.

For other criticisms of bar examinations as a licensing requirement, see Benjamin Hoorn Barton, Why Do We Regulate Lawyers?: An Economic Analysis of the Justifications for Entry and Conduct Regulation, 33 ARIZ. ST. L.J. 429, 434 n.16 (2001); Daniel R. Hansen, Note, Do We Need the Bar Examination? A Critical Evaluation of the Justifications for the Bar Examination and Proposed Alternatives, 45 CASE W. RES. L. REV. 1191 (1995); Andrea A. Curcio, A Better Bar: Why and How the Existing Bar Exam Should Change, 81 NEB. L. REV. 363 (2002); Kristin Booth Glen, When and Where We Enter: Rethinking Admission to the Legal Profession, 102 COLUM. L. REV. 1696 (2002).

I’m not an ADA expert so can’t generally critique Sotomayor’s opinions on this issue. But it’s worth noting that at least some of those criticizing her decisions in this case might be sympathetic with the implications of these decisions for lawyer licensing standards in general, and bar exams in particular, which I for one find indefensible as a means of determining fitness to practice law.

Additional point:  I am not arguing that Judge Sotomayor is taking a Friedmanian position on professional licensing.  As I said, this is only an "implication" of her decision.  Perhaps it would be more accurate to call it a possible effect of watering down the purported screening function of the bar exam.