The latest edition of The Economist has a fascinating article on “Chilecon Valley” that discusses the emergence of a startup community in Chile. The article focuses on a unique program of Startup Chile (a new Chilean governmental body) that gives grants to entrepreneurs in the United States and elsewhere to move to Chile for several months as they work on building their company and developing their technology. The grant recipients are then expected to network with, speak to, and mentor Chilean entrepreneurs.
The article touches on how law can foster or hinder the growth of a startup community, including by liberalizing immigration laws and allowing failed ventures to get a fresh start in bankruptcy.
Chile is making considerable efforts to diversify its economy beyond extractive industries like mining and agriculture. My spouse is co-organizing a fantastic three-day conference in Santiago from November 28 to December 1st that will focus on social entrepreneurship, sustainability, and innovation. The conference includes a fantastic line-up of speakers, including a keynote address by Al Gore, a pitch competition for social entrepreneurship startup companies, and some awesome music, including Devendra Banhart and Denver’s own Devotchka. Several panels will analyze the contribution of law to developing a entrepreneurial ecosystem in Chile.
You can check out my wife’s newly launched blog and website on the Chilean startup community here.
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As in a bad horror movie (or a great Rolling Stones song), observers of the current crisis may have been disquieted that one of the central characters in this disaster also played a central role in the Enron era. Is it coincidence that special purpose entities (SPEs) were at the core of both the Enron transactions and many of the structured finance deals that fell part in the Panic of 2007-2008?
Bill Bratton (Penn) and Adam Levitin (Georgetown) think not. Bratton and Levin have a really fine new paper out, A Transactional Genealogy of Scandal, that not only draws deep connections between these two episodes, but also traces back the lineage of collateralized debt obligations (CDOs) back to Michael Millken. The paper provides a masterful guided tour of the history of CDOs from the S&L/junk bond era to the innovations of J.P. Morgan through to the Goldman ABACUS deals and the freeze of the asset-backed commercial paper market .
Their account argues that the development of the SPE is the apotheosis of the firm as “nexus of contracts.” These shell companies, after all, are nothing but contracts. This feature, according to Bratton & Levin, allows SPEs to become ideal tools either for deceiving investors or arbitraging financial regulations.
Here is their abstract:
Three scandals have fundamentally reshaped business regulation over the past thirty years: the securities fraud prosecution of Michael Milken in 1988, the Enron implosion of 2001, and the Goldman Sachs “Abacus” enforcement action of 2010. The scandals have always been seen as unrelated. This Article highlights a previously unnoticed transactional affinity tying these scandals together — a deal structure known as the synthetic collateralized debt obligation (“CDO”) involving the use of a special purpose entity (“SPE”). The SPE is a new and widely used form of corporate alter ego designed to undertake transactions for its creator’s accounting and regulatory benefit.
The SPE remains mysterious and poorly understood, despite its use in framing transactions involving trillions of dollars and its prominence in foundational scandals. The traditional corporate alter ego was a subsidiary or affiliate with equity control. The SPE eschews equity control in favor of control through pre-set instructions emanating from transactional documents. In theory, these instructions are complete or very close thereto, making SPEs a real world manifestation of the “nexus of contracts” firm of economic and legal theory. In practice, however, formal designations of separateness do not always stand up under the strain of economic reality.
When coupled with financial disaster, the use of an SPE alter ego can turn even a minor compliance problem into scandal because of the mismatch between the traditional legal model of the firm and the SPE’s economic reality. The standard legal model looks to equity ownership to determine the boundaries of the firm: equity is inside the firm, while contract is outside. Regulatory regimes make inter-firm connections by tracking equity ownership. SPEs escape regulation by funneling inter-firm connections through contracts, rather than equity ownership.
The integration of SPEs into regulatory systems requires a ground-up rethinking of traditional legal models of the firm. A theory is emerging, not from corporate law or financial economics but from accounting principles. Accounting has responded to these scandals by abandoning the equity touchstone in favor of an analysis in which contractual allocations of risk, reward, and control operate as functional equivalents of equity ownership, and approach that redraws the boundaries of the firm. Transaction engineers need to come to terms with this new functional model as it could herald unexpected liability, as Goldman Sachs learned with its Abacus CDO.
The paper should be on the reading list of scholars in securities and financial institution regulation. The historical account also provides a rich source of material for corporate law scholars engaged in the Theory of the Firm literature.
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In the Crocker Fellows class today, we talked about teams. I have blogged about entrepreneurial teams and teams in the classroom, but the Crocker Fellows Program is built on a particular notion of teams, captured by the famous definition of teams in Katzenbach and Smith (1994): "a small number of people with complementary skills who are committed to a common purpose, performance goals, and approach for which they hold themselves mutually accountable." In our class, the teams of five people comprise a mix of majors, including engineering, computer science, business, life science, graphic design, etc.
Chris Mattson led the discussion, using the Nightline episode on IDEO as an illustration. Here it is:
Does anyone use the IDEO shopping cart? I haven't seen any in the US, but there are reports of similar carts in France. And Chris has seen similar carts in China ... so has this guy. If you are interested in more on IDEO, you might also check out Tom Kelly on Stanford's ecorner.
As for the Crocker Fellows, the teams are still in the "forming" stage (see Tuckman's stages of group development), but they are transitioning quickly into the "storming" phase. While I am eager to see what emerges from these teams, I was asking myself some questions today in my observer status:
- What is the role of law and lawyers, if any, at this stage in the innovation process?
- Lawyers work in teams to develop briefs or documents ... is the IDEO process essentially the same as writing an innovative brief or constructing a new deal structure?
- Could we use teams in this way to teach law? (My classroom teams have a more modest function than the teams we are using in the fellows program.)
No answers, yet, but maybe by the end of the semester I will have some more ideas.
On Sunday, January 8th, the AALS Section on Financial Institutions and Consumer Financial Services will be holding a panel discussing featuring an impressive list of papers selected from an annual Call for Papers. The panel will take place from 9 am to 10:45 am in the Marriott Wardman Park in Maryland Suite B. It is part of a full weekend of programs by the section, including a Saturday lunch speech by Federal Reserve Governor Sarah Bloom Raskin.
In advance of that panel, let me showcase the papers one by one. (The Conglomerate is all about emphasizing the scholarly aspects of the AALS Annual Meeting.) Each of the four papers deals with a different set of foundational challenges to the regulation of financial institutions. The first paper I will preview looks at three interrelated problems:
- Which regulator should be responsible for consumer/investor protection; and
- How to allocate regulatory responsibility generally, when innovative financial services do not fit neatly within traditional regulatory silos.
In many ways, the first challenge – disintermediation -- is an echo (an extremely loud one) of an old problem. Starting over 30 years ago the cozy world of depository banking was rocked first by the rise of rival intermediaries – money market mutual funds, deeper bond markets and more sophisticated structured finance, as well as other elements of shadow banking.
Now scholars are looking at another competitive wave coming from radical disintermediation, in which the web facilitates direct connections between lenders and borrowers. This is the subject of the first paper, Regulating On-line Peer-to-Peer Lending in the Aftermath of Dodd-Frank, by Eric Chaffee (Univ. of Dayton School of Law) and Geoffrey C. Rapp (Univ. of Toledo College of Law). Eric will be presenting the paper, which is forthcoming in the Washington & Lee Law Review. Andrew Verstein (Yale Law School) will serve as discussant. Andrew has also written a fantastic paper on the same topic, The Misregulation of Person-to-Person Lending, which is forthcoming in the U.C. Davis Law Review.
Chaffee and Rapp outline the business model and current regulatory treatment of peer-to-peer lending, which includes platforms like Prosper Marketplace and Lending Club. They examine how securities laws govern the investment by lenders and banking law regulates the borrower end. The Dodd-Frank Act required the GAO to look at the regulation of p2p lending, and the GAO responded by formulating two alternatives. The first was continued regulation of investors on p2p sites by the SEC and regulation of borrowers by agencies responsible for consumer financial regulation (i.e. the CFPB). The second is assigning regulation to a unified consumer regulator.
In the end, Chaffee and Rapp argue that regulatory heterogeneity is not bad, but actually the way to go. They argue for an “organic” approach to regulating P2P lending, allowing different regulators to govern different aspects of the business. Here is their abstract:
The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act called for a government study of the regulatory options for on-line Peer-to-Peer lending. On-line P2P sites, most notably for-profit sites Prosper.com and LendingClub.com, offer individual “investors” the chance to lend funds to individual “borrowers.” The sites promise lower interest rates for borrowers and high rates of return for investors. In addition to the media attention such sites have generated, they also raise significant regulatory concerns on both the state and federal level. The Government Accountability Office report produced in response to the Dodd-Frank Act failed to make a strong recommendation between two primary regulatory options – a multi-faceted regulatory approach in which different federal and state agencies would exercise authority over different aspects of on-line P2P lending, or a single-regulator approach, in which a single agency (most likely the new Consumer Financial Protection Bureau) would be given total regulatory control over on-line P2P lending. After discussing the origins of on-line P2P lending, its particular risks, and its place in the broader context of non-commercial lending, this paper argues in favor of a multi-agency regulatory approach for on-line P2P that mirrors the approach used to regulate traditional lending.
Verstein comes out the other way and argues against SEC regulation of P2P lending and for unified regulation of p2p lending by the CFPB. Here is his abstract:
Amid a financial crisis and credit crunch, retail investors are lending a billion dollars over the Internet, on an unsecured basis, to total strangers. Technological and financial innovation allows person-to-person (“P2P”) lending to connect lenders and borrowers in ways never before imagined. However, all is not well with P2P lending. The SEC threatens the entire industry by asserting jurisdiction with a fundamental misunderstanding of P2P lending. This Article illustrates how the SEC has transformed this industry, making P2P lending less safe and more costly than ever, threatening its very existence. The SEC’s misregulation of P2P lending provides an opportunity to theorize about regulation in a rapidly disintermediating world. The Article then proposes a preferable regulatory scheme designed to preserve and discipline P2P lending’s innovative mix of social finance, microlending, and disintermediation. This proposal consists of regulation by the new Consumer Financial Protection Bureau.
This should be a lively discussion and of interest to our securities law junkies. Disintermediation is of course a topic a challenge for securities regulation generally, as other platforms are linking equity investors and companies seeking capital. Usha has been blogging about Sharespost and friend of the Glom Joan Heminway is working away on disintermediation too, looking at “crowdfunding” from the securities regulation angle (See her working paper here, see also, among others, Pope )
Law schools are under attack. Depending upon the source, between 20-50% of corporate counsel won’t pay for junior associate work at big firms. Practicing lawyers, academics, law students and members of the general public have weighed in publicly and vehemently about the perceived failure of America’s law schools to prepare students for the real world.
Admittedly, before I joined academia a few months ago, I held some of the same views about lack of preparedness. Having worked with law students and new graduates as outside and in house counsel, I was often unimpressed with the level of skills of these well-meaning, very bright new graduates. I didn’t expect them to know the details of every law, but I did want them to know how to research effectively, write clearly, and be able to influence the clients and me. The first two requirements aren’t too much to expect, and schools have greatly improved here. But many young attorneys still leave school without the ability to balance different points of view, articulate a position in plain English, and influence others.
To be fair, unlike MBAs, most law students don’t have a lot of work experience, and generally, very little experience in a legal environment before they graduate. Assuming they know the substantive area of the law, they don’t have any context as to what may be relevant to their clients.
How can law schools help?
First, regardless of the area in which a student believes s/he wants to specialize, schools should require them to take business associations, tax, and a basic finance or accounting course. No lawyer can be effective without understanding business, whether s/he wants to focus on mom and pop clients, estate planning, family law, nonprofit, government or corporate law. More important, students have no idea where they will end up after graduation or ten years later. Trying to learn finance when they already have a job wastes the graduate’s and the employer’s time.
Of course, many law schools already require tax and business organizations courses, but how many of those schools also show students an actual proxy statement or simulate a shareholder’s meeting to provide some real world flavor? Do students really understand what it means to be a fiducuiary?
Second and on a related point, in the core courses, students may not need to draft interrogatories in a basic civil procedure course, but they should at least read a complaint and a motion for summary judgment, and perhaps spend some time making the arguments to their brethren in the classroom on a current case on a docket. No one can learn effectively by simply reading appellate cases. Why not have students redraft contract clauses? When I co-taught professional responsibility this semester, students simulated client conversations, examined do-it-yourself legal service websites for violations of state law, and wrote client letters so that the work came alive.
When possible, schools should also re-evaluate their core requirements to see if they can add more clinicals (which are admittedly expensive) or labs for negotiation, client consultation or transactional drafting (like my employer UMKC offers). I’m not convinced that law school needs to last for three years, but I am convinced that more of the time needs to be spent marrying the doctrinal and theoretical work to practical skills into the current curriculum.
Third, schools can look to their communities. In addition to using adjuncts to bring practical experience to the classroom, schools, the public and private sector should develop partnerships where students can intern more frequently and easily for school credit in the area of their choice, including nonprofit work, local government, criminal law, in house work and of course, firm work of all sizes. Current Department of Labor rules unnecessarily complicate internship processes and those rules should change.
This broader range of opportunities will provide students with practical experience, a more realistic idea of the market, and will also help address access to justice issues affecting underserved communities, for example by allowing supervised students to draft by-laws for a 501(c)(3). I’ll leave the discussion of high student loans, misleading career statistics from law schools and the oversupply of lawyers to others who have spoken on these hot topics issues recently.
Fourth, law schools should integrate the cataclysmic changes that the legal profession is undergoing into as many classes as they can. Law professors actually need to learn this as well. How are we preparing students for the commoditization of legal services through the rise of technology, the calls for de-regulation, outsourcing, and the emerging competition from global firms who can integrate legal and other professional services in ways that the US won’t currently allow?
Finally and most important, what are we teaching students about managing and appreciating risk? While this may not be relevant in every class, it can certainly be part of the discussions in many. Perhaps students will learn more from using a combination of reading law school cases and using the business school case method.
If students don’t understand how to recognize, measure, monitor and mitigate risk, how will they advise their clients? If they plan to work in house, as I did, they serve an additional gatekeeper role and increasingly face SEC investigations and jail terms. As more general counsels start hiring people directly from law schools, junior lawyers will face these complexities even earlier in their careers. Even if they counsel external clients, understanding risk appetite is essential in an increasingly complex, litigious and regulated world.
When I teach my course on corporate governance, compliance and social responsibility next spring, my students will look at SEC comment letters, critically scrutinize corporate social responsibility reports, read blogs, draft board minutes, dissect legislation, compare international developments and role play as regulators, legislators, board members, labor organizations, NGOs and executives to understand all perspectives and practice influencing each other. Learning what Sarbanes-Oxley or Dodd-Frank says without understanding what it means in practice is useless.
The good news is that more schools are starting to look at those kinds of issues. The Carnegie Model of legal education “supports courses and curricula that integrate three sets of values or ‘apprenticeships’: knowledge, practice and professionalism.” Educating Tomorrow’s Lawyers is a growing consortium of law schools which recommends “an integrated, three-part curriculum: (1) the teaching of legal doctrine and analysis, which provides the basis for professional growth; (2) introduction to the several facets of practice included under the rubric of lawyering, leading to acting with responsibility for clients; and (3) exploration and assumption of the identity, values and dispositions consonant with the fundamental purposes of the legal profession.” The University of Miami’s innovative LawWithoutWalls program brings students, academics, entrepreneurs and practitioners from around the world together to examine the fundamental shifts in legal practice and education and develop viable solutions.
The problems facing the legal profession are huge, but not insurmountable. The question is whether more law schools and professors are able to leave their comfort zones, law students are able to think more globally and long term, and the popular press and public are willing to credit those who are already moving in the right direction. I’m no expert, but as a former consumer of these legal services, I’m ready to do my part.
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The NY Times added another story this week to the chronicles of changing market for lawyers. The story detailed how a number of larger firms have created a second tier of associates, one with reduced hours and reduced salary, and removed from the partnership track. Some firms move this new tier of associates to offices in smaller legal markets where overhead for the firm (and housing for the lawyers) is cheaper.
The article compared it to outsourcing jobs, but within the country. The article also quoted Bill Henderson, who has been studying trends in the legal employment market for years. In many ways, this latest law firm innovation means that the bi-modal distribution of lawyers salaries, which Henderson has studied, now occurs not only between firms but within firms as well.
Towards the end, the article discusses what the reduced salary and career advancement means when students carry significant debt loads from attending law school. This article should serve as yet another warning sign for legal education. (One should note the Times content appetite has created a propensity to string interesting factual developments into ready-made trends.)
But if this trend does have staying power, it means that the shake-up of the legal services market is not just short-term and cyclical, but lasting and structural. A number of the bloggers on this site and elsewhere have worried that if any law school's tuition, and the debt load of their students, continually outraces the earning prospects of the students, there will be dire consequences for school and graduates.
The tiering of associates has clear parallels in the tiering of law schools. This hierarchy -- reinforced and made more cutthroat by rankings -- would become more pronounced if the tectonic shifts in compensating legal graduates continue. If students realize they cannot pay a school's higher tuition, they will stop coming. Journalists help applicants connect the dots. And the crisis in the legal profession and in legal education is very good for business for journalists.
Law firms have been innovative in adapting to changed economic circumstances, but law schools less so. Tighter budgets, more fund-raising, more use of adjuncts, more investment in placement might help law schools. As might more relevant and creative legal training to prepare students.
But perhaps legal education should make even deeper changes. If there are tiers in the legal market, would it make sense to have more tiers in the types of legal degrees? We have the beginnings of tiers now, but LLMs are largely limited to tax and foreign students and SJDs to aspiring academics. The real issue is that the JD may be too long, too much of an investment, and too risky given potential job prospects. But the next step down -- paralegals -- might be too big a step down.
Developing an intermediate category seems like a natural fit for the changing legal market. My co-blogger Christine has already floated the idea of an intermediate master's degree, which would allow students to exit law school after a year or two of training.
Another idea, would be to revive the LLB degree, but more in line with the model of England and other countries, which offer law as an undergraduate degree. This would lower the cost of a legal education. But it would also come with some downsides. Family experience tells me that forcing high schoolers to make a professional choice -- particularly to be a lawyer -- at a young age can entail high personal costs. There is something truly wonderful, albeit luxurious, about an undergraduate liberal arts education.
But the English model has more flexibility than that of continental countries. I have one English friend who took (or "read for"or whatever the anglo jargon is) a bachelor's degree in literature, then took a "conversion course" to enable him to then join an inn of court and become a barrister.
Indeed, there is much U.S. legal education might learn from England, which I think offers the best preparation for being a young lawyer in the world - largely by virtue of the apprenticeship (or pupillage) systems.
But England's lessons come not only in the quality of legal training. The tiering may represent, instead of a fusty medieval vestige, a way to offer American legal students different paths to legal practice, at different costs, with different rewards, but also with different risks. One size does not fit all - whether you are dealing with a financial investment or an educational one.
Update (5/28): Here is a partial reading list of recent scholarship on changes in the legal market, including how these changes are or should be affecting legal education:
Ribstein, Practicing Theory;
Henderson & Bierman, An Empirical Analysis of Lateral Lawyer Trends;
podcasts from the Iowa Law Review symposium on the future of legal education;
My efforts to prepay my summer rent in Berlin have been a fascinating tour of modern payment systems and foreign currency risk. Here’s the scoop: my rent is due in full June 1st. My landlord would like the money early and agreed to pay the transfer fees if I could prepay. One additional complication, I need to use my University’s credit card.
Xoom is just one of a bevy of new payment systems that have emerged in the last several years. Glompetitor Tim Zinnecker has already pointed out the great article in Wired magazine two months ago on the future of payment systems. When I agreed to prepay, I thought the fees I saved would more than offset the time value of money. What I didn’t anticipate was that little ‘ole me would also be subject to foreign currency risk; I guess I need to read Kim Krawiec’s posts over at the Glompetition on the Greek debt crisis on a more regular basis. In all seriousness, I do feel blessed though that my personal stakes in the foreign currency swings are so trivial (so far) compared to what many in Europe are going through.
Disputes about the substance of marriage have obscured questions about the statutes governing marriage procedure. The states license marriages under statutes that assumed fairly standard forms during the twentieth century.
Banns developed in England to prevent clandestine marriages which undercut parents' and communities' ability to stop objectionable marriages. Licensing emerged in the U.S. as an improvised replacement, given the lack of a state church to supervise a regime of banns. Couples have, nonetheless, for generations defeated efforts to stop them from using state law to formalize their relationship.
In his memoir of growing up in Wharton, Texas, the late playwright Horton Foote recounts the story of his parents' marriage against firm parental disapproval by his mother’s parents. Albert Horton Foote and Harriet Gautier Brooks sneaked over to a nearby Texas town called El Campo, got a license, and came back to Wharton, where a minister married them in a house six blocks from Harriet’s parents' house. They set up housekeeping in Wharton and were snubbed by her parents until the day her mother called and said, "I thought I'd come over to see you this afternoon if you're going to be home." Her mother had yielded to the hardy practice of couple autonomy.
Horton Foote's parents were tame compared with the couples who went to "Gretna Greens," or to Las Vegas, to marry despite reasons (often, the age of a girl) for someone to intervene and stop them. The record of marriage is clear about one point. Marriage licensing simply does not support goals of marriage regulation and preservation of tradition. It never has, not in Las Vegas in the 1960s, not in Horton Foote's Texas, and not today.
What does licensing do? Very little. It asserts no control over the decision-making by couples. It generally does not impose health checks on the parties. It doesn't force disclosure by one person to the other. Waiting periods are almost all gone. Historically, licensing has served as a means to support anti-miscegenation laws and forms of religious discrimination. It's hard to view marriage licensing as useful, except insofar as it serves the purpose of formality, open consent to marriage, ceremonial affirmations celebrated by a community, and clear records.
At its best, licensing is about the state's serving as a facilitator of the creation and recognition of a legal status. In that way, the state is doing something similar to what it does when it facilitates the formation of other legal relationships, such as the corporation or binding agreements, all subject to autonomous party choices for their creation. Indeed, the Massachusetts marriage statute avoids the term, "license." Massachusetts’s statutory usage recognizes the parties’ control over the marriage and the role of the state as a facilitator, recorder, and source of publicity.
Despite the similarity of the state role in marriage formation to its role in facilitating other legal relations, the states have been timid and unimaginative about creating innovations in marriage procedure. Marriage statutes contain odd rigidities, little regulatory clout, and a continuing insistence that couples use the marriage license within the state that issues it. Licensing sounds like something that protects a tradition, even as its main use has been to exclude some pairings, create needless complications for couples who are physically separated, and defeat couples' occasional preferences about ceremonial details.
Adam Candeub and I have posted a paper exploring the possibility of bringing a new energy to the states' facilitative role in marriage solemnization. For shorthand, we've labeled the idea e-marriage. We suggest that, with careful study and deliberation, states could enhance their facilitative and record-keeping role by modernizing the statutes governing marriage ceremonies. For marriages of same-sex couples, states that authorize the marriages could take the next step in the logic of federalism by allowing couples in distant states to use their marriage-authorization laws.
For controversial marriages, states that do not recognize them would still be able to refuse recognition. But the couples could engage in an expressive activity, with legal meaning in many jurisdictions, in their own community. Couples already travel to marry in places like Massachusetts, returning to reside in states that refuse their marriage recognition, so such couples clearly value an official legal blessing provided by another jurisdiction.
We have tentatively planned a conference on November 12, 2010, in East Lansing, to explore the many ramifications of our idea. We will have legal scholars, legislators, economists, and English professors gather for a stimulating discussion of the possibilities for innovation in the regime governing marriage formation. We'd welcome suggestions for types of relevant commentary and for specific names of persons from business schools with expertise in evaluating proposed business models, experts in e-government and government record-keeping and statistics generation, and any other source of insight about the notion of improving current marriage formation procedure.
Yesterday I introduced the CoCo Bond concept generally; today I’ll dive in to the new use and form that has elicited some very strong market reactions. I’ll begin by discussing the Lloyds issue (the only new CoCo in progress thus far). Tomorrow I’ll explain why many regulators believe CoCos modeled after the Lloyds issue can transform institutions deemed too big to fail.
On November 3, Lloyds Banking Group, plc offered to exchange up to £7.5 billion of its outstanding subordinate bonds for a new form of contingent convertible debt—CoCo Bonds (sadly, Lloyds chose to christen them with a much less interesting title: Enhanced Capital Notes, or ECNs). Lloyds’s CoCos work differently from the CoCos issued earlier this decade. The old CoCos tied conversion triggers to asset price, and generally provided bondholders the opportunity to participate in share price appreciations (because conversion was based on a conversion premium multiplied by a conversion trigger in excess of 100%) while receiving a fixed coupon. Lloyds’s conversion trigger is not based on asset price, however, but on a determination of Lloyds’s safety and soundness, as measured by its core Tier 1 capital ratio.
Though it may initially sound complicated, the Lloyds CoCo operates in a fairly straightforward way: bondholders receive a coupon for a certain period of time, just like they would if they held a traditional bond. If Lloyds’s core Tier 1 capital ratio drops below 5%, however, the Lloyds CoCo would automatically convert to a predetermined number of ordinary equity shares, and the bondholder would become a shareholder, losing all attributes of the bond. Conversion is mandatory upon the triggering event.
Lloyds offered to exchange CoCos for its outstanding subordinated bonds as one element of a two-pronged recapitalization program designed to allow Lloyds to escape the UK’s Government Asset Protection Scheme (GAPS) (the other element is a rights issue). Lloyds believes that exchanging ECNs for its subordinated debt will provide the bank capital without diluting shareholders at the time of issue, and in the event Lloyds falls on hard times, the conversion will trigger and Lloyds will benefit from a large Tier 1 capital boost.
Though the exchange provides Lloyds this contingent cushion, it comes at a cost. ECNs pay a coupon anywhere from 150 to 250 basis points higher than the subordinated debt they replace. In simple terms, Lloyds is paying a premium for the exchange, and £500 million in fees associated with the offering. The question, then, is why issue CoCo Bonds now?
Lloyds prefers to pay the coupon premium over its other option: participation in GAPS. For Lloyds, GAPS participation would have meant issuing preferred shares to Her Majesty’s (HM) Treasury at a cost to HM Treasury of £15.6 billion. These shares would have converted into 13.6 billion ordinary shares (a) at HM Treasury’s option or (b) automatically if Lloyds’s shares appreciated to a certain level. This would have been a substantial dilution to ordinary shareholders. In addition, GAPS participation placed Lloyds in a less favorable position before the European Commission, which is in the process of restructuring large financial institutions that heavily rely on state aid. Finally, the European Commission signaled its intent to prevent Lloyds from paying any coupon on its subordinated debt for two years—part of the EC’s plan to make bondholders feel some pain.
So we know why Lloyds is issuing CoCos, but this raises more questions. Why would a U.S. bank issue CoCos? (spoiler alert: Chris Dodd wants to force them to) And why would the EC prevent Lloyds from paying coupons on its subordinated debt, but approve an exchange that ultimately results in Lloyds paying a 1.5% to 2.5% higher coupon? And, finally, why would an investor purchase CoCos outside an exchange situation? I hope to shed some light on these issues (and more) as I progress throughout my guest blogging tenure.In short, the Lloyds offer has thus far been a surprising success: investors sought to exchange £12.51 billion worth of bonds (on a £7.5 million offer), encouraging Lloyds to expand the offer (it has so far accepted £8.5 billion). Given its unique nature, Lloyds's issue may seem like a one hit wonder. Regulators appear to see things differently. Tomorrow I’ll turn to the part regulators are playing thus far in the CoCo story, and what they expect CoCos can do for them.
Some of my previous posts explored the implications of the Open Source movement for financial regulation. Other legal scholars in the corporate field are taking similar ideas on peer production and collaboration in provocative directions.
George Triantis (Harvard) has set up a "Contracts Wiki" to allow transactional attorneys to collaborate and design better agreements. The theory is if peer production works in software (like Linux), it should work for transactional documents too. They are just different kinds of code. This project is not only an interesting scholarly endeavor, it may also provide real value for both lawyers, particularly in smaller firms, and their clients.
The wiki will only pay dividends though if a sufficient number of practitioners participate.
If you are interested here is an old link to the wiki. I understand from Professor Triantis that the wiki is being bbeta tested with a small group of practitioners, but will go live and be open to a broader public sometime in the Spring. I'll ask one of the regular bloggers at the Conglomerate to post a notice and a new link then.
Now that the kids are asleep, I finished the Sunday Times. A few questions based on the profile of Bloomberg's expansion:
1. When will Google take on Bloomberg?
2. When will either take on Lexis and Westlaw?
There was a one sentence hint in the article that Bloomberg is beta testing some web-based product for law firms. Anybody know what that product looks like?
Lafley: First of all, we would get a look at a lot more early stage innovation and early stage product prototypes. When we started in '99, 2000, maybe 10 to 15% of the products we brought to market that were new every year, had an external partner. Last year, for the first time, half of all the new products innovations we brought to market had one or more external partners. So we've almost doubled our "at bats." O.K. And in the innovation game, which is a risky game, more "at bats" leads to more "hits". It's sort of the Pete Rose approach to innovation. You get up more times, you get to swing the bat a few more times, you get a few more hits. That's point number one, and that's the biggest motivator. The second biggest motivator was, when we stepped back and thought about it, what we're really good at is connecting new products and new product ideas to consumer needs and then developing those products and qualifying and commercializing them for the market. We're probably not all that much better at inventing or creating the ideas, so this opened us up to all kinds of idea sources. And we said, "O.K. Let's bring in the ideas from anywhere and everywhere and then we'll do what we do best. We'll play the game we play best."
Ryssdal: Let me continue the baseball analogy here, right. What you're doing in essence by outsourcing all this innovation, is your buying innovation. Sort of like the New York Yankees buy hits, right?
Lafley: I don't know. I'll have to think about that analogy. I think what we're doing is we're running a continual tryout camp and they can be veteran ball players or they could be young ball players. But what we're trying to do is, I don't know how many we look at a day, we can double check this and get back to you, but I'm sure we look at several new product prototypes literally every day. And from those our innovation leaders and our businesses choose some that they then try to co-develop. And that's what we're really trying to do. We're trying to get a lot of players in the game. We're trying to get these players a lot of "at bats" and we think we'll get more hits with more players in the game.
Ryssdal: You write actually, in your book that about half of your product innovations fail.
Lafley: That's right.
Ryssdal: That's not so good.
Lafley: That's the game. That's the game and in fact, in our industry, about 80 to 85% of new products fail in the sense that they're no longer on store shelves, you know, 3 to 5 years after they're introduced. There is a museum in up-state New York that is full of failed consumer products, and we have our fair share there. So, I think we know we're in a game where you fail a lot. Innovation is that kind of a game, and what we are trying to do is improve our success rate. And what we are also trying to do is fail earlier, fail faster and reallocate the resources from the failures . . . the humans, the human capital and the financial capital, so we can put the money against innovations that have a chance to make consumers lives better and become a commercial success.
Ryssdal: You've said that you want innovation at Proctor and Gamble to be a routine and methodical thing that everybody does every day, not just you as the C.E.O. making pronouncements. How does it follow then, that what is routine and methodical continues to be innovation, right? I mean, it's sort of a ...
Lafley: Yeah, it sounds like an oxymoron. The first step or the front end of the innovation process is all about ideation and creativity. That's the idea stage. That's when a new technology is invented or created. But once you have even the crudest of prototypes, once you have a hypothesis of who the consumer target might be for that new brand or product prototype, then we believe you're in a process that you can manage for consistency and reliability, and frankly for higher levels of output. And that's what we try to do. Once we have the innovation and what we call the development stage and the qualification stage, we try to be very disciplined and manage that innovation in a way in that we know whether it really connects with the intended consumer and we determine whether it's feasible, whether it's affordable and whether we can turn it into a commercially viable new brand or product line.
So what do you think of Lafley's "Pete Rose approach to innovation"? By the way, would anyone outside of Cincinnati use Pete Rose in a metaphor like this? Don't you immediately think, "Are they gambling?"
Anyway, while the Pete Rose approach has some intuitive appeal, it reminded me of my experience choosing a casebook publisher. When I was talking to Aspen about publishing Business Organizations (with Cindy Williams), one of my mentors presented me with a fairly stark contrast between Aspen and one of it's competitors. The competitor, he said, publishes a large number of first edition casebooks without much editorial investment, going to a second edition only with those that find an audience. Aspen, by contrast, invests heavily in the first edition, and has a higher success rate, in terms of producing books with multiple editions.
From the standpoint of an author, the difference is very meaningful. And I think the resulting products are different, too. If you are a professor, you may be too knowledgeable of particular books to take this test, but ask a law student sometime to look at a bookshelf with law school casebooks and explain which ones they associate with high quality: the reds, the blue-reds, the blue-golds, the browns, or the maroons. At the time I was negotiating with Aspen, the test was a bit simpler (reds, blues, and browns), but I was surprised by the lopsided results in favor of the reds.
Maybe P&G isn't enough of a brand on its own that it cares about this. After all, I suspect that most of us don't go into a store and think, "Oh, there's a new product from P&G." We think, "Hmm, that Metamucil is now offered in a family size." Or whatever. Still, the Pete Rose strategy seems to contemplate less investment in particular products, so "fail earlier, fail faster" becomes self-fulfilling, doesn't it?