Ideoblog

Freedom of contract in uncorporations vs. corporations

I have often pointed out on this blog, recently in the Harvard blog, and in several articles (e.g.) that uncorporation (i.e., LLC and limited partnership) fiduciary duty opt-outs are more broadly enforced than corporate contracts.

A recent case provides direct confirmation by explicitly comparing corporations and uncorporations. In Sutherland v. Sutherland, 2009 WL 750287 (Del. CH. March 23, 2009), a closely held family corporation had the following charter provision:

Any director individually ... may be a party to or may be pecuniarily or otherwise interested in any contract or transaction of the corporation, provided that the fact that he ... is so interested shall be disclosed or shall have been known to the board of directors, or a majority thereof; and any director of the corporation, who is ... so interested, may be counted in determining the existence of a quorum at any meeting of the board of directors of the corporation which shall authorize such contract or transaction, and may vote thereat to authorize any such contract or transaction, with like force and effect, as if he were not ... so interested.

The court refused to apply the provision to treat interested directors as disinterested for purposes of immunizing interested transactions from Delaware’s entire fairness analysis. The court said (emphasis added):

The question * * * is whether such a far-reaching provision would be enforceable under Delaware law. It would not. If the meaning of the above provision were as the defendants suggest, it would effectively eviscerate the duty of loyalty for corporate directors as it is generally understood under Delaware law.

While such a provision is permissible under the Delaware Limited Liability Company Act and the Delaware Revised Uniform Limited Partnership Act, where freedom of contract is the guiding and overriding principle, it is expressly forbidden by the DGCL. Section 102(b)(7) of the DGCL provides that a corporate charter may contain a provision eliminating or limiting personal liability of a director for money damages in a suit for breach of fiduciary duty, so long as such provision does not affect director liability for “any breach of the director's duty of loyalty to the corporation or its stockholders....”

In other words, if you want to completely opt out, you have to use an uncorporation. In corporations, freedom of contract is not, by negative implication, the "guiding and overriding principle."

This is not form over substance because there are meaningful differences between uncorporations and corporations. Here's more on that. 

U.S. president now handles auto warranties

Really (HT MR). You would think that the leader of the free world would have other things on his mind.  But that's the way it is when you have to run the whole economy along with everything else. 

I've got a call in to ask him to finally do something about that leaking gasket.

More evidence on short-selling

I've argued, most recently here, that government's periodic war against short-selling amounts to killing the messenger, in view of mounting evidence of the shorts' contribution to market efficiency.  The latest evidence on the informational benefits of short-selling is Drake, Rees & Swanson, Trading Against the Prophets: Using Short Interest to Profit from Analyst Recommendations:

We find that positions taken by short sellers that conflict with consensus analyst recommendations are highly informative about future returns, and investors can profit by trading with the shorts. A six-month, abnormal return of 9.6% can be earned from a zero-investment strategy that 1) shorts firms with highly favorable analyst recommendations (buy signal) but high short interest (sell signal), and 2) buys firms with highly unfavorable analyst recommendations (sell signal) but low short interest (buy signal). To understand why this strategy is so profitable, we investigate whether shorts and analysts differ in their use of information that prior research shows to be predictive of future returns. We find that analysts tend to over-recommend stocks with high growth and high accruals - despite a negative association with future returns. In contrast, short sellers correctly use this and other fundamental analysis information to identify situations when analysts' recommendations are misleading.

Licensing history

You need a license to talk about history for money in Philly (also NYC and Washington).  The WSJ has the story.  The Institute for Justice is suing to free the Philly tour guides from having to get a license, which requires them to take a test on Philadelphia's version of history.

Not too surprisingly, the law was a tour guide's idea.  No doubt he is sincere, but it's worth noting that this is one way to reduce the competition. Philadelphia agreed because it wants to preserve its "branding, messaging and identity." Sounds like a business talking, but with a government stick. 

This would seem to be an easy case of pure speech rather than protecting citizens from economic harm.  But as the IJ points out:

The United States is in the midst of an explosion of occupational licensing. * * * Roughly 20 percent of American workers are now forced to meet government-imposed licensing requirements to work in their chosen field, up from only 4.5 percent in the early 1950s. * * * [I]n occupation after occupation—from floristry to interior design—the meteoric growth of arbitrary and unreasonable barriers to entry is making it more difficult for entrepreneurs to break into the career of their choice.* * *

The plight of Philadelphia’s tour guides is not unique. It is easy to single out this new regulation as unjust because the government’s goal—protecting people from hearing things that the government does not want them to hear—is patently illegitimate. But individuals have a right to be free from unreasonable restrictions on their choice of occupation no matter what that occupation is—be it braiding hair, arranging furniture or giving tours.

So, now let's talk about legal services.  What kind of talking about law should the government regulate?  Glad you asked.  See Lawyers as Lawmakers:  A Theory of Lawyer Licensing, 69 Mo. L. Rev. 299 (2004), online version.   

Wall Street's flight back to partnership

As I’ve been saying, the uncorporation (partnerships, LLCs, limited partnerships) is set to rise out of the ashes of Wall Street’s moribund corporate model. Wall Street investment firms, incorporated in the 1990s, lost control of risk and ended up as banks. The nail in their coffin is government money, with its baggage of heavy scrutiny, even if the firms manage to avoid confiscatory taxes on compensation.

Yesterday brought this Bloomberg story (HT Carney) about the emergence of Wall Street trading boutiques snapping up refugees from the big firms:

Broadpoint, whose shares have outperformed Citigroup Inc.’s by almost 51 percentage points this year, has added more than 240 people since September 2007. They include traders from Bear Stearns Cos., Lehman Brothers Holdings Inc. and Merrill Lynch & Co., which either collapsed or were absorbed by bigger banks * * * Cantor Fitzgerald LP, the closely held securities firm, has hired 100 people in the past six months from banks, including UBS and Bear Stearns.

* * *“The talent is streaming out of the doors of the big firms,” Bruce Foerster, a former Lehman Brothers managing director and now president of South Beach Capital Markets in Miami said. “As the best and the brightest leave, they will tip their hat to Senator Christopher Dodd. Bright people won’t want to be at places where the government is.”

Carney adds:

We need to tread carefully with any new regulations to make sure we don't stomp these innovations while they are still in their cribs. For more on this trend, check out Larry Ribstein.

Geithner's shell game

Here’s how I understand this will work (see Carney and Salmon for details).

The government wants the banks to start lending, which they can’t do until they get their capital up, which they can’t do with all those toxic loans on their balance sheet.

The government could just give the banks the money, but that would be a “bailout,” and not too popular right now. The government also could buy the assets for the inflated values they’re currently booked at. But that would be a bailout and not too popular right now.

So we have an elaborate shell game. The government subsidizes private equity companies to buy the assets at inflated values.  Instead of just giving them wheelbarrows of money, they get non-recourse loans for most of the purchase price. Although most people don't understand this right now, they will come to understand that "non-recourse" means that the buyers are exposed only for the minimal payments they’re making on these hugely leveraged deals.

When we find out that the assets are actually worth what the banks really think they’re worth (as opposed to how they’re currently booked) the taxpayers, who provided most of the money, will bear most of the loss. Remember: the loans were non-recourse. If the assets are actually worth their currently fictional values, then the private equity companies will make money, possibly a lot.

Here are the problems:

• It may not work, because the banks will have to write down the assets to the sale price (albeit still more than actual value) and they still won’t have enough capital to lend.
• If the assets don’t go up, and the taxpayers find out they’ve been hosed, there will be hell to pay.
• If the scheme works and the private equity companies make money, the spotlight’s on them. They’ve been sucked into the maw of government assisted enterprises. The uncorporations have become corporations and will be regulated as such.
• The whole thing rides on a mountain of debt and phony asset values. The hope is that people will think the economy is worth more than it is, the stock market will go up, and the economy really will be worth more.  This is what is happening so far. But I thought that kind of Ponzi scheme was how we got into this mess in the first place.

How should we fix this? Here's how: Let the banks sell the assets for what they’re worth but don’t make them reduce their capital for regulatory purposes. This would be honest, and wouldn’t require any taxpayer money.

AIG in a nutshell

Ok, so let me get this straight.

As I've said:

AIG was supposedly insuring risky paper for both banks and money funds. AIG got fees, the banks and the money funds got to look better. The problem is that AIG's plan for covering the risk was to assume, along with everybody else . . . that real estate prices would only go up. In other words, everybody was living in a Pee Wee Herman-like fantasy world.

Joe Nocera described this as a huge “scam” that "helped create the illusion of regulatory capital with its swaps, and now the government has to actually back up those contracts with taxpayer money to keep the banks from collapsing."

(By the way, the credit rating agencies let this happen because they stupidly didn’t see through Pee Wee’s stage set. Guess who’s getting $400 million - $1.2 billion in TALF fees? No peeking.)

As I commented, "[t]he government is bailing out AIG because AIG undermined a system that the government was supposed to be, but wasn't, protecting. And now who's in charge? The government, of course."

But that bailout was necessary, wasn't it?  Nope. According to Stanford economist John Taylor, the failure to rescue Lehman did not cause a market reaction, suggesting that an AIG failure wouldn't have either. (James Suroweicki disagrees, but John Carney notes that the reaction Surowiecki points to is really to the discovery of the huge hole in Lehman's balance sheet, not to Lehman's failure.)

Of course I could be wrong.  Maybe an AIG failure would have been a disaster.  Hey, maybe the market would drop to 6 or 7000.  We couldn't handle that, could we?

I've pointed out that the horrendous problem here is that we now have the government running this huge company. Now that it's in charge of the company, the government has authorized hundreds of millions of dollars of bonuses. To whom? Well, the guys who authorized the brilliant derivatives scheme that triggered the bailout.

Tim Geithner, our Treasury chief, says they had to do it. (Remember that he was the guy we had to hire although he was a tax cheat because he would provide continuity with our previous brilliant Treasury chief Hank Paulson. All this from a President who promised Change.) Geithner says there's nothing he can do about this.  Wrong.

Anyway, the House voted to put a 90% tax on bonuses at Wall Street firms getting more than $5 billion in bailout money. So now firms are trying to get out of the bailouts. And the government has to decide whether the bailouts are so necessary that we should force firms to get bailed out so the government can run them and do stuff like approve bonuses that the government can then confiscate.

Got it?

The Skadden departures and the coming failure of Big Law

ATL reports that two Skadden litigators are leaving that monument to law firm profitability to form a new firm with a DC boutique. One of the lawyers also “will become the CEO of Corporate Risk Advisors, a multi-disciplinary consulting firm providing services to the financial services industry.”

ATL says “Time will tell, but it doesn't look like Skadden associates should read too much into these departures.”

I don’t know about Skadden in particular, but this move has significant implications for Big Law. As I’ve been saying, here, the model of law firm as worker coop highly leveraged by the inverted pyramid of associate leverage is doomed. The associates no longer can pay the stars enough to make them stay.

When it starts happening even at a firm like Skadden, you know, notwithstanding comforting noises by law firm managers, and deep in your heart, that I’m right.

Why we shouldn't bail AIG/Goldman

Harvard’s Lucian Bebchuk writes in today’s WSJ why AIG can fail:

• Insurance policy holders are protected by their insurance subs (though ironically I recall AIG advertisements from just a couple of years ago selling insurance based on the supposed strength of the overall company).
• Losses to derivative counterparties would be “best addressed by the U.S. government (or foreign governments in the case of their banks) infusing capital directly -- in return for shares -- into the banks that need it.” (Could it be that this whole thing is about avoiding a direct payment to Goldman Sachs?).  
• Depositors in financial institutions, including money market funds, are now protected, as they were not when Lehman failed.

Bebchuk explains why we can let AIG fail. This is why we should:

• We cannot continue to both encourage risk-taking and to bail out failed bets. Moral hazard is not just a theoretical concern here. I wonder how Lehman and AIG would have been managed in the months preceding September 15, 2008 if Bear Stearns had not been bailed. Let's not compound that horrendous mistake.
• Bailing out AIG would contribute to a building assumption, which may become official if we get a “systemic risk regulator,” that a huge swath of our investment industry is backed by the government. If you like Fannie and Freddie you’ll love this.
• Our market-based economy demands accepting the market’s judgment on which firms should fail.
• We cannot tolerate additional US government control of financial institutions. Even if Treasury’s investment would be nominally debt, surely it would have actual or implied powers comparable to equity. AIG – and all the firms that would have to be bailed after AIG – would effectively become government institutions.

We should not accept these very serious consequences policy implications based on the ad hoc judgment of any Treasury Secretary, least of all this one.

Update:  The original version of this post erroneously stated that Geithner worked for Goldman.  Sorry, but it is an understandable mistake.

Geithner, revisited

Remember when we were all in a sweat to get Geithner confirmed as Treasury Secretary despite the fact that he couldn’t seem to handle his own taxes? Here’s what I said at the time:

Of course the confirmation's going to happen. But I thought I would post this so I can pull it out again when the ultimate irony emerges -- we learn that Geithner’s no more indispensable than his predecessor turned out to be.

Well, maybe it's not too early to say I told you so.

Update:  Apparently there's some question about whether Geithner lied to Congress about the AIG bonuses.  Geithner lie?  Could that be possible?