Geoffrey Graber, who is heading up a mortgage fraud task force for DOJ, is motivated by Glengarry Glen Ross, and the results have evinced an ouch from the banking community:
The surge of settlements engineered by Graber in the past year has helped neutralize some of that criticism and rehabilitate a key piece of Holder’s legacy. Still, the settlements have been controversial. Critics such as Roy Smith, a professor at New York University’s Stern School of Business, say prosecutors were driven by “political fever” to extract massive penalties from Wall Street.
“They have to deliver something, so they come up with this,” said Smith, a former Goldman Sachs Group Inc. (GS) partner. “The fact that it’s unfair never really gets considered. The banks have no choice but to hunker down and accept it.”
A bracing corollary to those capture stories, though notice that it's the enforcement officials who win headlines for big settlements, and the bank examiners who are subject to the expose about go along get along.
Steven Davidoff Solomon and I opine on a recent opinion dismissing cases brought by Fannie and Freddie shareholders against the government in DealBook. A taste:
In one Washington court, Maurice R. Greenberg, the former chief executive and major shareholder of A.I.G., is suing the United States government, contending that the tough terms imposed in return for the insurance company’s bailout were unconstitutionally austere.
In another closely watched case in a different Washington court, the shareholders of Fannie Mae and Freddie Mac, led by hedge funds Perry Capital and the Fairholme Fund, lost a similar kind of claim.
Parsing what the United States District Court did in the Fannie and Freddie litigation offers a window into the ways in which the government’s conduct during that crisis might finally be evaluated.
There are three main points to the decision. For one, the court held that the government’s seizure of Fannie’s and Freddie’s profits did not violate the Administrative Procedure Act’s prohibition on “arbitrary and capricious” conduct. It also found that the Housing and Economic Recovery Act barred shareholders of Fannie and Freddie from bringing breach of fiduciary duty suits against the boards of the companies and that the government’s seizure of profits was not an unconstitutional “taking.”
In this post, which follows our earlier discussion of legal strategy, we’ll offer examples of companies situated within each of the five pathways. As Robert and I mentioned in our article, most companies follow the compliance pathway. Such companies insource legal compliance through their in-house legal department, or they may choose to partner with an external compliance verification service. A firm such as ISN, for example, has built a business handling compliance issues for corporations and their subcontractors. According to the Society of Compliance and Corporate Ethics, compliance is a thriving industry due to the increased legal penalties and regulations that companies face in today’s heightened legal environment.
The avoidance pathway is less frequent, given the high stakes and liability attached to this type of strategy. General Motors may have engaged in avoidance if it misled regulators about its faulty ignition switches. Avoidance issues tend to be costly to deal with, given the loss of trust and enhanced penalties that arise from this behavior.
The more interesting and rare pathways involve prevention, value, and transformation. An interesting and controversial prevention legal strategy involves trademark policing, which, in its most egregious form, devolves into the unethical and legally dubious practice of trademark bullying. For example, Chik-fil-A employs an aggressive strategy that targets large and small companies alike and uses the threat of trademark litigation to prevent anyone from encroaching upon its trademarked brands and brand equity. Setting aside the overreaching and legally dubious aspects of this approach, some companies legitimately use a preventive legal strategy that involves cease and desist letters, litigation, and U.S. Patent and Trademark Office administrative oppositions to protect the value of their brands and advertising. The Chik-fil-A case serves as a useful reminder, however, that aggressive legal strategies may push the boundaries of ethical behavior, sound legal argument, and public opinion.
Two recent examples illustrate how employing a legal strategy in the value pathway can generate positive and tangible financial returns. The first instance involves hedge funds investing in a corporate acquisition target and then filing suit in Delaware to challenge the valuation and seek an appraisal from the court. This legal strategy is referred to as appraisal arbitrage. Many of these cases either settle or result in substantially higher prices for the party seeking the appraisal.
Another value strategy that has been in the headlines recently involves tax inversions. Burger King’s recent decision to acquire Canada’s Tim Horton’s will yield business synergies, but it also exploits a legal maneuver allowed under current tax law permitting a company acquiring a foreign entity to reincorporate in the foreign jurisdiction. By reincorporating in Canada, Burger King will effectively lower its tax rate from 35% to 15%.
The last and rarest of legal strategies is transformation. This occurs when the top executives in a corporation integrate law as a core aspect of the firm’s business model to achieve sustainable competitive advantage. Few companies are able to achieve this strategic pathway, and it’s certainly not for everyone. One company that notoriously used law to achieve abnormally large market share and margins in the ticket processing industry was Ticketmaster. The ticket service provider used venue ticket licensing contracts that included several key provisions such as long term renewable exclusivity terms (up to 5 years), and more infamously, fee sharing provisions. Ticketmaster’s business model was, essentially, to take the bad rap for charging exorbitant convenience fees and sharing those fees with the venue, thus contractually locking them into a highly profitable and exclusive business system. It didn’t hurt that Ticketmaster’s pioneering CEO Fred Rosen was a Wall Street attorney turned impresario.
Another company that is showing signs of attempting to pursue a transformative legal strategy is Tesla Motors. Tesla’s recent announcement to offer open licensing terms for its battery and charging station patents illustrates a pioneering mentality that seeks to build a business ecosystem with other auto manufacturers. By doing so, Tesla has made a major legal bet that giving up patent exclusivity rights in the short term will yield long-term competitive advantage by helping to diffuse electric battery and recharging technology. The other legal strategy Tesla has pursued relates to its pioneering distribution model of direct sales to the consumer, bypassing the traditional dealership model established for conventional automobiles. To achieve this direct-to-customer model, Tesla has engaged state regulators to achieve exemptions from state dealership franchise laws. Tesla is clearly strategizing and innovating along many fronts that involve business, technology and law. It remains to be seen, however, whether these legal strategies will offer Tesla a long-term sustainable competitive advantage.
In our next and last post, we’ll discuss our experience teaching the five pathways of legal strategy to business students and how it has been a valuable resource in the classroom.
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This American Life has a banking supervision story (!) that turns on secret recordings made by a former employee of the New York Fed, Carmen Segarra, and it's pretty good, because it shows how regulators basically do a lot of their regulating of banks through meetings, with no action items after. That's weird, and it's instructive to see how intertwined banking and supervision are. There's a killer meeting after a meeting with Goldman Sachs where Fed employees talk about what happened, and - though we don't know what was left on the cutting room floor - the modesty of the regulatory options being considered is fascinating. Nothing about fines, stopping certain sorts of deals, stern letters, or anything else. The talk is self-congratulation (for having that meeting with Goldman) and "let's not get too judgmental, here, guys."
The takeaway of the story, which is blessedly not an example of the "me mad, banksters bad!" genre, is that this kind of regulation isn't very effective. It clearly hasn't prevented banks from being insanely profitable until recently, in a way that you'd think would get competed away in open markets.
But here's the case for banking regulation:
- Imagine what it would be like if Alcoa and GE had EPA officials on site, occasionally telling them to shut down a product line. That's what bank regulators do, and, more broadly, did with things like the Volcker Rule (with congressional help).
- Since the financial crisis (and that's the time that's relevant here), regulation has made banking less profitable, not more, share prices are down, so are headcounts, etc.
- Regardless of how it looks, regulators that essentially never lose on a regulatory decision - that includes bank supervisors, but also broad swaths of agencies like Justice and DoD - don't experience themselves as cowed by industry. Kind of the opposite, actually. So what you really worry about is the familiarity leading to complacency, not fear. Regulators can fine any bank any number they like. If they want someone fired, they could demand it without repercussion.
The fact that TAL pulled off this story, given that it was centered around an employee who lasted at the Fed for 7 months before being fired, who made secret recordings of her meetings with colleagues (who does that?), who mysteriously and obviously wrongly alleged during her time at the Fed that Goldman Sachs did not have a conflict of interest policy, whose subsequent litigation has gone nowhere, and whose settlement demand was for $7 million (so that's one million per month of working as a bank examiner, I guess), is impressive. But that's the former government defense lawyer in me, your mileage may vary.
Morover, even skeptical I was persuaded that maybe the Fed could do with a more ambitious no-holds-barred discussion among its regulators, at the very least.
In our last post, we discussed our framework for legal strategy called the five pathways. Today, we’d like to address how companies navigate within these pathways to attain the best results. As we mentioned in our MIT Sloan article, there is no one-size-fits-all approach to developing a legal strategy. Companies and industries are simply too diverse for such a simplistic solution. Instead, what we find is that legal strategy often is dependent on internal and external variables, such as company size, corporate culture, regulation, pace of technological change and the company’s maturity stage.
That is not to say, however, that a large and mature company in a regulated industry cannot cross the divide from risk management to a value creation pathway. One well established transportation company recently engaged in a strategic and cross functional (legal and finance) assessment of freight contracts to evaluate which ones to renew, cancel or negotiate. The company, which was operating at full capacity, changed its legal strategy to optimize its operations for the near and medium terms. This type of strategic contract assessment clearly fits within the value pathway.
To cross the divide and move from a risk management pathway (avoidance, compliance, prevention) to a value-enabling pathway (value and transformation) we suggest that C-level executives must view the law as an important and enabling resource for achieving strategic goals. This perspective requires a strong working knowledge of law, or legal astuteness, and organizational commitments such as the deployment of resources and authority to develop and test legal strategy.
Our research suggests that successful legal strategies require a champion, or what we refer to as a chief legal strategist. This is someone who is authorized by top management and recognized across the organization as the point person for driving legal strategies. Sometimes that individual is the general counsel, such as Twitter’s former chief legal officer, Alexander Macgillivray, who once stated that fighting for free speech is more than a good idea, it is a competitive advantage for the company. We find, however, that an associate general counsel is more often able to devote time to legal strategy execution. These individuals often possess strong legal and business fluency, leadership capabilities and the ability to work dynamically in teams.
For our next post, we'll offer more examples of companies operating within each pathway.
Philadelphia's own Charles Plosser, an economics professor, and Richard Fisher, an investor, have retired from their perches atop Fed regional banks, meaning that the Federal Open Market Committee has lost two of its hawks. Dan Tarullo has stayed, which means that there is a law professor on that most essential of government committees still. But it used to be that the Fed was run by lawyers, and they have disappeared. Plosser and Fisher's retirement offers the opportunity to reflect on a fascinating chart:
The transformation of the FOMC into a redoubt of the economics profession makes it just about the only such place in the federal government that has such a role.
The Basel Committee is doing a lot of Basel III capital accord implementation this week. Page 10 of this report makes it look like the largest banks hold slightly less capital than smaller banks, which is the opposite of what you would want (smaller banks hold more variable capital though). And this report suggests that the effort to have banks deal with a hypothetical effort to adopt the new capital rules was messy. Not to worry, though! As is the case with all Basel documents, bland positivity about the success of the regulatory effort is the tone of the day.
One of the reason that bank capital regulation became an international affair was to ensure a regulatory "level playing field," which would be paired with market access to the US and UK. That is, as long as the rest of the world complied with the Anglo-American vision of capital requirements, access to London and New York would be assured.
But as former law professor and current Fed Board member Daniel Tarullo will testify to Congress today, as those global (call them "BCBS") rules have become more elaborate and comprehensive, some countries have elected to depart from them - only upwards, not downwards. Switzerland is trying to use very, very heightened capital requirements to shrink its universal banks into asset managers. And now the United States is enacting global rules with its own pluses. For example, the liquidity coverage ratio, which requires banks to keep a certain percentage of their assets in cash-like instruments,
is based on a liquidity standard agreed to by the BCBS but is more stringent than the BCBS standard in several areas, including the range of assets that qualify as high-quality liquid assets and the assumed rate of outflows for certain kinds of funding. In addition, the rule's transition period is shorter than that in the BCBS standard.
The Fed is also imposing an extra capital requirement on the largest American banks:
This enhanced supplementary leverage ratio, which will be effective in January 2018, requires U.S. GSIBs [very large banks] to maintain a tier 1 capital buffer of at least 2 percent above the minimum Basel III supplementary leverage ratio of 3 percent, for a total of 5 percent, to avoid restrictions on capital distributions and discretionary bonus payments
And another such requirement based on the amount of risk-based capital,
will strengthen the BCBS framework in two important respects. First, the surcharge levels for U.S. GSIBs will be higher than the levels required by the BCBS, noticeably so for some firms. Second, the surcharge formula will directly take into account each U.S. GSIB's reliance on short-term wholesale funding.
I think of the global efforts in financial regulation as being notable precisely because they created, incredibly informally, some reasonably specific and consistently observed rules that comprise most of the policy action around big bank safety and soundness. The little new trend towards harmonization plus is a bit comparable to the trade law decision to create the WTO for global rules, but to permit regional compacts like NAFTA and the EU to create even freer trade mini-zones. Some find this multi-speed approach to be inefficient and, ultimately, costly to the effort to create a consistent global program. We'll see if the Basel plus approach rachets up bank regulation, or just disunifies it.
You'd think that the state that's home to the center of American business would take a Delaware-style light touch approach to overseeing it. But instead, the New York paradigm is to take ambitious politiicans, blend with broadly worded supervisory or anti-fraud statutes like the Martin Act, and come up with stuff that, to my ears, sounds almost every time like it is off-base, at least in the details. So:
- Eliot Spitzer pursued research analysts for the sin of sending cynical emails even though they issued buy recommendations, despite that fact that analysts never issue negative recommendations, and if cynical emails are a crime, law professors are the most guilty people in the world.
- I still don't understand what Maurice Greenberg, risk worrier par excellence, did wrong when he was running AIG. I do know that after he was forced out by Spitzer, the firm went credit default swap crazy.
- Maybe there's something to the "you didn't tell your investors that you changed the way you did risk management for your mortgage program" prosecutions, but you'll note that it is not exactly the same thing as "you misrepresented the price and/or quality of the mortgage products you sold" prosecutions, which the state has not pursued.
- Eric Schneiderman's idea that high frequency trading is "insider trading 2.0" is almost self-evidently false, as it is trading done by outsiders.
- Federal regulators wouldn't touch Ben Lawsky's mighty serious claims that HSBC or BNP Paribas were basically enabling terrorist financing.
- And now Lawsky is going after consultants for having the temerity to share a report criticizing the bank that hired them to review its own anti-money laundering practices with the bank, who pushed back on some, but not all of the conclusions.
The easiest way to understand this is to assume that AGs don't get to be governor (and bank supervisors don't get to be AGs) unless people wear handcuffs, and this is all a Rudy Giuliani approach to white collar wrongdoing by a few people who would like to have Rudy Giuliani's career arc.
But another way to look at it is through the dictum that the life of the law is experience, not logic. The details are awfully unconvincing. But these New York officials have also been arguing:
- Having analysts recommending IPO purchases working for the banks structuring the IPO is dodgy.
- HFT is front-running, and that's dodgy.
- This new vogue for bank consulting is dodgy, particularly if it's just supposed to be a way for former bank regulators to pitch current bank regulators on leniency.
- If we can't understand securitization gobbledegook, we can at least force you to employ a burdensome risk management process to have some faith that you, yourself, understand it.
- And I'm not saying I understand the obsession with terrorism financing or what the head of AIG did wrong.
Their approach is the kind of approach that would put a top banker in jail, or at least on the docket, for the fact that banks presided over a securitization bubble in the run-up to the crisis. It's the "we don't like it, it's fishy, don't overthink it, you're going to pay for it, and you'll do so publicly" approach. It's kind of reminiscent of the saints and sinners theory of Delaware corporate governance. And it's my pet theory defending, a little, what otherwise looks like a lot of posturing.
The saga of Argentina v. NML Capital, Ltd. (known by the anti-hedge fund camp as “Argentina v. Vulture Funds”) continues. And it’s getting pretty heated. Argentina published a two-page ad in the New York Times and The Wall Street Journal last Thursday, calling the judgment of the original U.S. court finding against Argentina (Judge Griesa of the federal district court of Manhattan) “erroneous and improper” and maintaining that Argentina had not defaulted on its debt obligations because the country deposited the money necessary for an interest payment due to the restructured bondholders on June 30. (Note: Every default has a 30 day grace period.) Argentina’s action is contemporaneous with its filing of a case against the U.S. in the International Court of Justice, contending that the U.S. court judgments violated its sovereignty. In response to the ad, Judge Griesa issued a summons to Argentina’s lawyers to appear in his court last Friday. Judge Griesa told Argentina to cease making “false and misleading” statements about its debt obligations (i.e., that it did not default); also, if Argentina defies his orders, he would have to consider finding Argentina in contempt of court. Perhaps Griesa is annoyed with reports that Argentina is waging a social media campaign against the court rulings:
“Argentina recently sought to vilify not just the hedge funds [holding out from Argentina’s restructuring] but also Judge Griesa, resulting in a social media campaign under the name #GrieFault. In Argentina, posters have been mounted around the capital of Buenos Aires with images of Judge Griesa’s head imposed on the body of a vulture.” [NY Times]
In a previous post (The Argentinian Sovereign Bond Litigation, Part I), I roughly described the factual background for the Argentinian bond litigation, culminating in the July 30th Argentine default of bonds. Incidentally, Joseph Cotterill (Commentator, Financial Times’ FT Alphaville) tells us that on August 7, 2014, the Argentine Republic filed a case in the International Court of Justice in the Hague, claiming that “US court decisions . . . have violated its sovereign immunity in public international law.” That story can be found here.
In this post, I would like to focus on the particular clause which has served as the basis for the judicial decisions enjoining Argentina from paying its restructured creditors unless it also paid the holdout creditors in full. That clause is the pari passu clause – the contractual provision that promises that all (pari passu-designated) bondholders will be treated on an equal footing. A common variant of the clause reads: “The Notes will rank equally (or Pari Passu) in right of payment with all other present and future unsecured and unsubordinated External Indebtedness of the issuer.” Although the pari passu clause is ubiquitous in sovereign bonds, its meaning (or application) in the sovereign debt context is highly disputed. In fact, an empirical study, based on extensive interviews of sovereign debt lawyers, reveals at least five possible explanations, ranging from “the clause was simply the product of mindless copying from corporate bonds” to “the clause was intended to prohibit sovereigns from passing laws that would have the effect of involuntarily subordinating certain creditors.”
Why the confusion/disagreement over its meaning? In a corporate liquidation, the clause helps ensure that pari passu-ranking creditors receive equal shares of the proceeds. But in the sovereign debt context, no liquidation is possible. Unlike private debtors, sovereigns cannot go bankrupt and their assets cannot be seized, pooled and distributed to a fixed group of claimants at a single moment of reckoning.
So what is the purpose of the pari passu clause in a sovereign bond? The federal district court in Manhattan and then the Second Circuit in NML Capital v. Argentina offered an interpretation of pari passu. They expressed the view that the pari passuclause required a debtor who was unable to pay all its creditors in full to pay each creditor proportionately or “ratably.” Hence, the sovereign debtor could not be permitted to stiff creditors who had refused to restructure their debts while paying the other creditors who had assented to the restructuring. To do so would violate the promise of equal treatment under the pari passu clause (according to these courts). And, by upholding an injunction against the third party financial intermediary responsible for transferring payments to the restructured creditors, the pari passu clause was given not only meaning but also teeth—a concrete remedy that could be used by the hold-out creditor to induce the sovereign debtor to pay its debt. These decisions disturbed many, because they threatened to make future sovereign debt restructurings more difficult—by encouraging, perhaps, more holdout strategies.
The July volume of the Capital Markets Law Journal (CMLJ) happens to be devoted to the pari passu clause. (Links to all the CMLJ articles can be found here (subscription required), and links to the authors’ prior SSRN drafts are provided below where available.) (Apologies in advance to authors if I’ve mischaracterized some of their arguments or omitted them. I tried to be as judicious as possible.)
The centerpiece of the CMLJ volume is a fascinating work of history. Benjamin Remy Chabot (Federal Reserve Bank of Chicago) and G. Mitu Gulati (Duke) have discovered what appears to be the first use of pari passu principle in connection with a sovereign bond issue. In their article, "Santa Anna and His Black Eagle: The Origins of Pari Passu?" , they show that the spirit of the pari passu concept can be traced back to General Santa Anna’s 1843 decree promising that foreign holders of Mexican Black Eagle bonds would be treated with a “just equality among the creditors, as much as regards the rate of interest as the order of payment.” Similar language appeared in the preamble of the Black Eagle bonds, although not as a contractual provision per se. Chabot and Gulati show that the promise of equality was drafted in response to foreign outrage expressed against a former debt restructuring. This restructuring treated holders of identical claims differently based on their nationality or country of residence. Thus, the pari passu language in respect of the Black Eagle bonds appears to have been intended to prevent discrimination in payments among nationalities of the creditors in the context of a sovereign default.
Chabot and Gulati’s findings, of course, raise the question: why is the original (first) meaning of a clause relevant? Stated another way, what is the relevance of history as a guide to contract interpretation? Chabot and Gulati offer a response:
“Even if lawyers today are copying the clause by rote, surely the earliest drafters of the clause were not doing that. Someone had to have thought of this clause first. If we could find them, and figure out what they were thinking, that we potentially have a way of cutting the Gordian knot.”
W. Mark C. Weidemaier (UNC) addresses this question (“why is the original meaning of a clause relevant?”) in “Indiana Jones, Contracts Originalist”. With wit and humor, Weidemaier reminds us that, in the absence of contemporaneous evidence of the parties’ intentions, judges would ordinarily assign the clause’s historically-accepted meaning if one exists. But in a situation (such as this) where there is no historically-accepted meaning, Weidemaier asks, “ . . . why should the judge try to uncover the intentions of the first drafters?” He then answers, “Whatever the merits of originalism as an approach to constitutional interpretation, surely the originators of a contract term have only a modest claim to authority.” (But a modest claim is arguably still better than no claim, right?) Surveying the available historical evidence, including the Black Eagle bond story, Weidemaier concludes that there is no known precedent to support the Second Circuit’s interpretation that the pari passu clause grants each bondholder a unilateral right to block payments to restructured bondholders. Therefore, the million dollar question is the normative one: whether the pari passu clause, which has not traditionally served the purpose imbued it by the Second Circuit, should be repurposed to do so.
Sovereign debt guru, Lee C. Buchheit (Clearly Gottlieb), invites us to think more generally and deeply about the effort to excavate examples of contracts or clauses from a fragmentary historical record. In “A Note on Contract Paleontology,” Buchheit notes that while the Black Eagle bond story may not much clarify the substantive meaning of the modern version of the pari passu clause, it may explain “why some people have an emotional attachment to the notion of ratable payments in a distressed situation” and why modern litigants are prepared to stretch their interpretation of this boilerplate provision to assign it a meaning that neither the text nor the history of the clause can support.
My article, “Pari Passu: The Nazi Gambit” takes us through a pre-war instance of pari passu. In the paper, I present what might be the clearest historical evidence of what the clause was understood to mean in the pre-war period. I discovered this evidence while studying the protests lodged against the German government when Germany first defaulted on two international loans entered into by it during the aftermath of the First World War. When Germany, in response to its financial crisis, selectively defaulted on the American tranches of the Dawes and Young Loans, parties defending the interest of American bondholders invoked pari passu in their protests against Germany’s discriminatory practices. In claiming that Germany violated the pari passu clause, the protesters adopted the meaning that the clause promised parity in servicing across the various tranches of the Dawes and Young Loans. In other words, bondholders of the various tranches were entitled to be repaid in proportion to their holdings of debt. What’s more, based on the evidence, Germany seems to have acquiesced in this interpretation of pari passu. Perhaps more pertinent to the Argentinian bond litigation, I find no evidence to suggest that the pari passu clause was understood as entitling the aggrieved creditor to a unilateral right to block payments to bondholders who assented to a government’s restructuring proposal. In fact, neither the investors (in the Dawes and Young loans) nor the Bank for International Settlements (trustee) seemed to have interpreted the clause as a tool by which one investor could interfere with payments to another. That said, the failure to invoke an inter-creditor remedy may simply reflect the more mundane fact that legal redress of sovereign debt defaults was highly unlikely during this period.
John V. Orth (UNC) provides useful perspective in “A Gathering of Eagles.” Orth reminds us that the pari passu clause addresses a ubiquitous problem in the borrowing context: unequal payments to creditors of equal rank. Seen in this light, the story of the Mexican Black Eagle bonds is an instantiation of this ubiquitous problem. Accordingly, the meaning of the pari passu clause is clear: it promises equal treatment for all creditors of the same priority. The only problem is the application of the clause to the sovereign debt context, where it is difficult to enforce the terms against a sovereign debtor, which is the same problem with all other clauses of a sovereign bond. The implication of Orth’s piece (I think) is that the pari passu clause is not materially different from all other sovereign promises: they are all “ultimately unenforceable” and “will continue to multiply until there is an effective resolution regime for sovereign defaults.” So, in the end, Orth emphasizes the lack of a practical mechanism of resolving these types of disputes with sovereigns.
Lachlan Burn (Linklaters) is skeptical of the value of historical spelunking for interpreting the pari passu clause in sovereign debt issues governed by English law. In “History – ‘Bunk’ or a Useful Tool for Contractual Interpretation?”, Burn argues that English courts would interpret contracts in a “commercially sensible” way, which he believes “would prevent any due weight being given to the Black Eagle bonds.” After all, Burn notes, as these Mexican bonds have been sitting in a basement until their recent discovery, “[t]hey formed no part of the background information available to the sovereign issuer of bonds or the investors during the last hundred years or so.” Moreover, Burn cautions that “historical precedent will often be a dangerous tool for interpreting contracts.” Finally, Burn argues that enforcement, rather than the meaning of the pari passu clause, is the central issue underlying the Argentinian litigation. (This last point is similar to the one made by Orth.)
Tolek Petch (Slaughter and May) in “NML v. Argentina in an English Legal Setting” notes that under English law, the legal history of a clause is relevant but not determinative. Ordinarily, the court would find an interpretation that accords with business common sense as it would have been understood by both parties at the time that the bonds were issued. Therefore, English courts can and have overturned centuries of precedent on the basis that the proposed construction was not in conformity with the intentions of the parties. Petch discounts the significance of the fact that in the pre-war period Americans protestested against German discriminatory treatment because they are basically ex post facto arguments that will be seen as inherently self-serving and, more pertinently, not contemporaneous with the drafting/negotiation of the disputed provision. (Excellent point, but would Petch or English law accord any significance to the fact that Germans themselves apparently acquiesced in the Americans’ interpretation of pari passu?) Applying the “business common sense” principle of English courts, Petch in the end rejects the “rateable” interpretation of the clause, in part because “no sovereign borrower would agree to” it. Argentina (and many sovereign debt experts) would agree with Petch’s last point!
In “Interpreting the Pari Passu Clause in Sovereign Bond Contracts: It’s All Hebrew (and Aramaic) to Me,” Mark L.J. Wright (Federal Reserve Bank of Chicago/NBER) argues that the Second Circuit “has, if not completely misinterpreted the meaning of the pari passu clause, then at least misapplied it.” He stresses the importance of interpreting the pari passu clause in the context of long-existing social norms among sovereign debt market participants. In short, it has been customary to treat holders of similar debts similarly, i.e., to repay them in proportion to their holdings of debt (measured at face value plus deferred interest). But custom also reveals a complementary “principle of differentiation,” under which certain claims (e.g., claims that had been reduced in value as a result of a prior default) were accorded preferential treatment precisely because they were meaningfully different. Applying the principle of differentiation and observing that Argentina’s restructured creditors hold bonds that have been reduced by almost 70% of their value, Wright argues that the NML decision got it all wrong and ignored the principle of differentiation.
Side-stepping the debate over the relevance of historical origins, in “NML v. Argentina: The Borrower, the Banker, and the Lawyer – Contract Reform at a Snail’s Pace,” Leland Goss (Int’l Capital Markets Ass’n) looks to the present and the future and asks: Why have most of the foreign law governed sovereign bonds issued since the Second Circuit’s ruling failed to change their pari passu clauses? After surveying a number of explanations, e.g., network effects theory, blaming the lawyers’ risk aversion, he offers his own highly entertaining theory.
In “The injunction has landed: the ‘Black Eagle’, pari passu and sovereign debt enforcement,” Joseph Cotterill (Financial Times) recounts the Black Eagle bond history and key moments in the Argentine bond litigation to remind us that “the enforcement of sovereign debt can take many forms” and that “Pari passu is one strategy among many others,” including, e.g., discovery of assets, injunctions, and courts’ powers of equity. The Black Eagle Bond story is just as much about ad hoc enforcement of sovereign debts as it is about pari passu. And that ad hoc enforcement is what we see even today – 171 years after General Santa Anna’s decree.
In “The origins and future of non-discrimination in sovereign bankruptcies: a comment,” Philip Wood (Allen & Overy) puts the pari passu clause into the context of the broader principle of non-discrimination and equality in payment between creditors. Wood speculates that the “concept of equality of payment by law was well established by the second century BC in Roman law.” This is evident from the laws against fraudulent conveyances, which developed around this time. Wood then provides a very helpful exposition of the byzantine devices used in sovereign debt contracts for restructurings in light of the non-discrimination principle.
In the same CMLJ volume, Jeffrey Golden (CMLJ, PRIME Fin. Found’n), Anna Gelpern (Georgetown, Petersen Inst. for Int’l Econ.), and Joanna Benjamin (London School of Econ.) also have very interesting contributions (but not on the topic of the pari passu clause).
What’s the long-term impact of the judicial rulings? Anna Gelpern (Georgetown, Petersen Inst. for Int’l Econ.) has some interesting thoughts in her “Sovereign Damage Control.”
Thanks to Gordon Smith for inviting me to guest blog on The Conglomerate. Having long been a big fan of Gordon’s work, I was gratified to finally meet him at the April 2014 conference/micro-symposium on Competing Theories of Corporate Governance, hosted by my friend and wonderful colleague Stephen Bainbridge and the Lowell Milken Institute for Business Law and Policy, UCLA School of Law. (The conference was a wonderful opportunity to debate and discuss the competing models of corporate governance with the leading proponents of those models. Streaming links to the conference panels can be found here.)
Although most of my work has been devoted to federal insider trading, the role of in-house counsel, and gatekeeping, what I’d like to write about this week is . . . sovereign debt. If you’ve been paying attention to the international financial news lately, you may have noticed that on Wednesday, July 30, Argentina missed its regular bond payment and defaulted for the second time in 13 years. This second default occurred after mediated talks between Argentina and a group of hedge funds broke down. The first default occurred in 2001 after which Argentina proceeded to restructure its debt by offering a take-it-or-leave-it exchange of new discounted bonds for old ones. At the end of the day, almost 93 per cent of Argentine bond investors consented to taking writedowns in two Argentine debt restructurings. But a group of hedge funds refused to participate in the restructuring and demanded full repayment, suing Argentina in NML Capital, Ltd. v. Republic of Argentina in New York. Because it’s notoriously difficult to enforce debt collection against a sovereign state, Argentina believed that it could simply exclude these defiant holdouts from the repayments.
Not so. In 2012, Argentina’s expectations were upended, when—in a highly controversial decision—Judge Thomas P. Griesa of the federal district court in Manhattan ruled that Argentina could not continue to pay the restructured bondholders without also paying the hedge fund holdouts in full. Moreover, any bank that aided the payment to holders of restructured bonds without also paying the old bonds held by the holdouts would be in violation of the court order. Judge Griesa’s ruling was affirmed by the U.S. Court of Appeals for the Second Circuit, and in June 2014 the U.S. Supreme Court declined to hear Argentina’s appeal.
Whether you side with the hedge fund holdouts or Argentina, commentators generally agree that these rulings against Argentina have at minimum a (short-term) destabilizing impact on the sovereign debt markets. For example, Floyd Norris (NY Times), notes that by rejecting Argentina’s appeal, the Supreme Court “most likely damaged the status of New York as the world’s financial capital. It made it far less likely that genuinely troubled countries will be able to restructure their debts. And it increased the power of investors — often but not solely hedge funds that buy distressed bonds at deep discounts to face value — to prevent needed restructurings.”
Professor Tim Samples (UGA) opines in a recently released article that the current state of affairs is “… a radical departure from the traditional unenforceability of sovereign debt in favor of the opposite extreme: enforcement through potent injunctive remedies applicable to third parties” and that these decisions “create major uncertainties for sovereign debt markets.”
Professor Joseph Stiglitz (Columbia, former chief economist of the World Bank) warned: “Unable to restructure, governments that default would be permanently shut out from the debt market, with consequential adverse effects on development and economic growth prospects.”
Professor Mitu Gulati (Duke): “The decision has very significant implications . . . . The world has changed.” And Professor Mark Weidemaier (UNC) warns about the expansive coverage of Griesa’s injunction: “The injunction by its terms extends to virtually the entire global financial system.”
So how did we get into this mess and what’s the long-term impact of these judicial decisions? To answer both questions, we need to focus on the particular clause in the Argentinian bonds that has been the subject of a growing body of scholarship and that has served as the legal hook for these judicial rulings: the pari passu (equal footing) clause. Now that we’re up to speed on the general factual background of the Argentinian debt litigation, in a follow-up post, I will discuss recent scholarship on the history and disputed meaning of the troublesome pari passu clause.
Two recent developments in the law and practice of business include: (1) the advent of benefit corporations (and kindred organizational forms) and (2) the application of crowdfunding practices to capital-raising for start-ups. My thesis here is that these two innovations will become disruptive legal technologies. In other words, benefit corporations and capital crowdfunding will change the landscape of business organization substantially.
A disruptive technology is one that changes the foundational context of business. Think of the internet and the rise of Amazon, Google, etc. Or consider the invention of laptops and the rise of Microsoft and the fall of the old IBM. Automobiles displace horses, and telephones make the telegraph obsolete. The Harvard economist Joseph Schumpeter coined a phrase for the phenomenon: “creative destruction.”
Technologies can be further divided into two types: physical technologies (e.g., new scientific inventions or mechanical innovations) and social technologies (such as law and accounting). See Business Persons, p. 1 (citing Richard R. Nelson, Technology, Institutions, and Economic Growth (2005), pp. 153–65, 195–209). The legal innovations of benefit corporations and capital crowdfunding count as major changes in social technologies. (Perhaps the biggest legal technological invention remains the corporation itself.)
1. Benefit corporations began as a nonprofit idea, hatched in my hometown of Philadelphia (actually Berwyn, Pennsylvania, but I’ll claim it as close enough). A nonprofit organization called B Lab began to offer an independent brand to business firms (somewhat confusingly not limited to corporations) that agree to adopt a “social purpose” as well as the usual self-seeking goal of profit-making. In addition, a “Certified B Corporation” must meet a transparency requirement of regular reporting on its “social” as well as financial progress. Other similar efforts include the advent of “low-profit” limited liability companies or L3Cs, which attempt to combine nonprofit/social and profit objectives. In my theory of business, I label these kind of firms “hybrid social enterprises.” Business Persons, pp. 206-15.
A significant change occurred in the last few years with the passage of legislation that gave teeth to the benefit corporation idea. Previously, the nonprofit label for a B Corp required a firm to declare adherence to a corporate constituency statute or to adopt a similar constituency by-law or other governing provision which signaled that a firm’s sense of its business objective extended beyond shareholders or other equity-owners alone. (One of my first academic articles addressed the topic at an earlier stage. See “Beyond Shareholders: Interpreting Corporate Constituency Statutes.” I also gave a recent video interview on the topic here.) Beginning in 2010, a number of U.S. states passed formal statutes authorizing benefit corporations. One recent count finds that twenty-seven states have now passed similar statutes. California has allowed for an option of all corporations to “opt in” to a “flexible purpose corporation” statute which combines features of benefit corporations and constituency statutes. Most notably, Delaware – the center of gravity of U.S. incorporations – adopted a benefit corporation statute in the summer of 2013. According to Alicia Plerhoples, fifty-five corporations opted in to the Delaware benefit corporation form within six months. Better known companies that have chosen to operate as benefit corporations include Method Products in Delaware and Patagonia in California.
2. Crowdfunding firms. Crowdfunding along the lines of Kickstarter and Indiegogo campaigns for the creation of new products have become commonplace. And the amounts of capital raised have sometimes been eye-popping. An article in Forbes relates the recent case of a robotics company raising $1.4 million in three weeks for a new project. Nonprofit funding for the microfinance of small business ventures in developing countries seems also to be successful. Kiva is probably the best known example. (Disclosure: my family has been an investor in various Kiva projects, and I’ve been surprised and encouraged by the fact that no loans have so far defaulted!)
However, a truly disruptive change in the capital funding of enterprises – perhaps including hybrid social enterprises – may be signaled by the Jumpstart Our Business Start-ups (JOBS) Act passed in 2012. Although it is limited at the moment in terms of the range of investors that may be tapped for crowdfunding (including a $1 million capital limit and sophisticated/wealthy investors requirement), a successful initial run may result in amendments that may begin to change the face of capital fundraising for firms. Judging from some recent books at least, crowdfunding for new ventures seems to have arrived. See Kevin Lawton and Dan Marom’s The Crowdfunding Revolution (2012) and Gary Spirer’s Crowdfunding: The Next Big Thing (2013).
What if easier capital crowdfunding combined with benefit corporation structures? Is it possible to imagine the construction of new securities markets that would raise capital for benefit corporations -- outside of traditional Wall Street markets where the norm of “shareholder value maximization” rules? There are some reasons for doubt: securities regulations change slowly (with the financial status quo more than willing to lobby against disruptive changes) and hopes for “do-good” business models may run into trouble if consumer markets don’t support them strongly. But it’s at least possible to imagine a different world of business emerging with the energy and commitment of a generation of entrepreneurs who might care about more in their lives than making themselves rich. Benefit corporations fueled by capital crowdfunding might lead a revolution: or, less provocatively, may at least challenge traditional business models that for too long have assumed a narrow economic model of profit-maximizing self-interest. James Surowiecki, in his recent column in The New Yorker, captures a more modest possibility: “The rise of B corps is a reminder that the idea that corporations should be only lean, mean, profit-maximizing machines isn’t dictated by the inherent nature of capitalism, let alone by human nature. As individuals, we try to make our work not just profitable but also meaningful. It may be time for more companies to do the same.”
So a combination of hybrid social enterprises and capital crowdfunding doesn’t need to displace all of the traditional modes of doing business to change the world. If a significant number of entrepreneurs, employees, investors, and customers lock-in to these new social technologies, then they will indeed become “disruptive.”
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Corporate disclosure, especially in securities regulation, has been a standard regulatory strategy since the New Deal. Brandeisian “sunlight” has been endorsed widely as a cure for nefarious inside dealings. An impressive apparatus of regulatory disclosure has emerged, including annual and quarterly reports enshrined in Forms 10K and 10Q. Other less comprehensive disclosures are also required: for initial public offerings and various debt issuances, as well as for unexpected events that require an update of available information in the market (Form 8K).
For the most part, corporate disclosure has focused on financial information: for the good and sufficient reason that it is designed to protect investors – especially investors who are relatively small players in large public trading markets. Some doubts have been raised about the effectiveness of this kind of disclosure and, indeed, the effectiveness of mandatory disclosure in general. A recent book by Omri Ben-Shahar and Carl Scheider, More Than You Wanted to Know: The Failure of Mandated Disclosure, advances a wide-ranging attack on all mandatory disclosure. (I think that their attack goes too far: I’ll be coming out with a short review of the book for Penn Law’s RegBlog called “Defending Disclosure”). Assuming, though, that much financial disclosure makes sense, what about expanding it to include other activities of business firms?
Consider three types of nonfinancial information that might usefully be disclosed: information about a business firm’s activities with respect to politics, the natural environment, and religion.
1. Politics. One good candidate for enhanced corporate disclosure concerns business activities in politics. Lobbying laws require various disclosures, and various campaign finance laws do too. It is possible to obscure actual political spending through the complexity of corporate organization. (For a nice graphic of the Koch brothers’ labyrinth assembled by the Center for Responsive Politics, see here.) Good reporters can ferret out this information – but they need to get access to it in the first place. My colleague Bill Laufer has been an academic leader in an effort to encourage public corporations to disclose political spending voluntarily, with Wharton’s Zicklin Center for Business Ethics Research teaming up with the nonpartisan Center for Political Accountability to rank companies with respect to their transparency about corporate political spending. The rankings have been done for three years now, and there are indications of increased business participation. Recently, even this voluntary effort has been attacked by business groups such as the U.S. Chamber of Commerce for being “anti-business.” See letter from U.S. Chamber of Commerce quoted here. Jonathan Macey of Yale Law School has also objected to the rankings in an article in the Wall Street Journal, arguing that the purpose of political disclosure is somehow part of “a continuing war against corporate America.” These objections, however, seem overblown and misplaced. What is so wrong about asking for disclosure about the political spending of business firms? One can Google individuals to see their record of supporting Presidential and Congressional candidates via the Federal Election Commission’s website, yet large businesses should be exempt? Political spending by corporations and other business should be disclosed in virtue of democratic ideals of transparency in the political process. Media, non-profit groups, political parties, and other citizens may then use the resulting information in political debates and election campaigns. Also, it seems reasonable for shareholders to expect to have access to this kind of information.
In Business Persons, I’ve gone further to argue (in chapter 7) that both majority and dissenting opinions in Citizens United appear to support mandatory disclosure as a good compromise strategy for regulation. One can still debate the merits of closer control of corporate spending in politics (and I believe that though business corporations indeed have “rights” to political speech these rights do not necessarily extend to unlimited spending directed toward political campaigns). It seems to me hard to dispute that principles of political democracy – and the transparency of the process – support a law of mandatory disclosure of corporate spending in politics.
2. Natural environment. Increasingly, many large companies are also issuing voluntary reports regarding their environmental performance (and often adding in other “social impact” elements). Annual reports issued under the International Standards Organization (the ISO 14000 series), the Global Reporting Initiative, and the Carbon Disclosure Project are examples. The Environmental Protection Agency (EPA) has also established a mandatory program for greenhouse gas emissions reporting, which is tailored to different industrial sectors. One can argue about whether these kinds of disclosures are sufficiently useful to justify their expense, but my own view is that they help to encourage business firms to take environmental concerns seriously. Many firms use this reporting to enhance their internal efficiency (often leading to financial bottom-line gains). As important, however, is the engagement of firms to consider environmental issues – and encouraging them to act as “part of the solution” rather than simply as a generating part of the problem.
One caveat that is relevant to all nonfinancial disclosure regimes: The scope of firms required to disclose should be considered. I do not believe that the case is convincing that only public reporting companies under the securities laws should be included. (For one influential argument to the contrary, see Cynthia A. Williams, “The Securities and Exchange Commission and Corporate Social Transparency,” 112 Harvard Law Review 1197 (1999)). Instead, it makes to sense for different agencies appropriate to the particular issue at hand to regulate: the Federal Election Commission for political disclosures and the EPA for environmental disclosures.
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Portugal took the kind of quick action on its second largest bank that is completely by the book. What can we learn about the current reality of bank bailouts from it?
- Even medium sized banks are global: BES was doomed not by its Portuguese operations, but by its Angolan unit. This sort of thing has driven supervisors to set up global regimes - the idea that their domestically safe and sound bank is in trouble internationally, but they don't know it - or that its foreign counterparties are, and they don't know that.
- The government created a good bank and a bad bank, meaning that BES stakeholders now have one bank with depositors and branches, and another with dodgy loans in Angola. This is a way of giving everyone - creditors, shareholders, employees - a haircut, but, since the Portuguese government is loaning BES $4.5 billion, it is hard to say this isn't also a lender of last resort bailout. Still, a textbook approach.
- This sort of ring-fencing, on a much larger scale, is one of the ways that some regulators would like to practice bank safety. A British bank would have its British assets segregated from its overseas ones, and so on. That obviously creates internal inefficiencies in the bank, but there you go.
- What Portugal did was to "resolve" BES. You can perhaps see why some think that one of the failures of the post financial crisis reforms is the failure to, so far, come up with a cross-border resolution scheme. The British couldn't do this with Barclays, or couldn't without agreement by the Americans, and who knows if, when the chips are down, that would be forthcoming?