In my briefing memo, The U.S. Government as Control Shareholder of the Financial and Automotive Sector: Implications and Analysis, I offer an analysis of the implications of the U.S. Treasury holding equity control over private industry. This was also the subject for recent briefings to members and staff of the U.S. Congress and the Securities and Exchange Commission, organized through my work at the Mercatus Center Financial Markets Working Group, and a forthcoming op-ed in Forbes, Why the Bailout is Self-Defeating, which is available here. My work in this area is ongoing, with a fuller article expected this submission season, and I welcome any comments.
The Treasury Department has converted its preferred shares in Citigroup into common equity, giving it a position of up to 36% of Citi’s outstanding voting equity. This means that as defined under Delaware corporate law, the securities laws, and even the CFIUS process for reviewing foreign investments in U.S. Companies, the U.S. Treasury is a control shareholder in Citigroup. Further, the remaining unconverted preferred shares in other banks, issued to the Treasury by TARP participants, give the government substantial leverage over corporate policy decisions at those banks.
The reason for the conversion is that it will artificially increase the bank’s common equity, which will give it a good tangible common equity number when the Treasury begins its promised stress testing regime for unhealthy banks. This is however an entirely artificial construct. Tangible common equity serves as a good proxy for a banks health when it reflects the market’s interest in becoming the residual beneficiary of fees from the bank’s loan portfolio, but here it merely reflects the federal government’s willingness to bail out a bank without concern for future price appreciation in its shares. If Treasury’s bank stress tests are a final exam, the teacher has given a favorite student the answers in advance.
The consequences of a government agency holding voting equity in a private bank can also be costly. Comparisons to the different forms of government ownership in Europe, Asia and South America teach that government owned banks are unequivocally used to advance political agendas to the detriment of a bank’s financial health. Advancing a political agenda may actually be easier through controlling common equity stakes, an effective semi-nationalization, than outright nationalization. A government agency using shareholder power over private companies has two unique freedoms:
i) the ability to bypass the administrative law process, the separation of powers and judicial review that constrain regulatory discretion, and instead simply require the board to initiate corporate policy changes favored by the Treasury, and
ii) the ability to bypass the federal budget process and transparency to the voters that work to constrain transfers to political interest groups, and instead require the bank to make those transfers in the form of increased lending and artificial interest rate caps entirely off the federal budget.
Some of the issues I raise in the memo that have been lost in the rush to react to this crisis include:
How can we ensure that Treasury doesn’t use the leverage of its equity control over TARP participants to encourage those banks to lend for purposes politically useful to the government in power? If the SEC revisits proxy access, will Treasury be permitted to nominate candidates by virtue of holding unconverted TARP preferred shares? One can imagine some drastic consequences, not the least of which being pressure on a bank to refrain from lending or facilitating offerings designed to support M&A activity which threaten politically powerful organized labor at a target firm in the deal. And if Treasury is a control shareholder in the companies participating in TARP, do they then all become affiliates of one another for purposes of the securities laws?
Will the U.S. Treasury Department serve as a lead plaintiff in securities class actions against TARP participants? Will the Department of Justice serve as counsel in those matters? Will the representation be contracted out to private securities class action firms? Will the SEC play a role? Though Section 3(c) of the Exchange Act exempts the federal government from coverage, the implied private right of action under 10b-5 is a creation of judicial fiat, thus it seems likely that Treasury would be able to utilize it. Suit under other provisions of the securities laws may get a little more complicated. Treasury certainly also has the option to bring an action in Delaware to pursue its state law shareholder rights.
What are the consequences of the Treasury Department’s sovereign immunity from control person liability under state corporate law and its immunity from the securities laws under Section 3(c) of the Exchange Act? If Treasury appoints nominees to bank boards, their state corporate law immunity will depend on whether they are government officials, but the Treasury as control shareholder is certainly immune in a way that even state pension funds are not. Will this threaten the independence of those directors?
What’s to prevent the TARP administrator from trading the government’s TARP shares based on inside knowledge obtained by Treasury’s unique position? When the Resolution Trust Corporation was created to administer the governments response to the S&L crisis its litigation rights, and the rights of others to sue it, were defined by statute. But the TARP legislation was unhelpful in this regard.
My own proposal to limit these drawbacks to Treasury holding common equity, but also let the taxpayer participate in the benefits of the bailout and thereby minimize the cost of TARP, would be to issue to the Treasury something I would call frozen options. These would be options to purchase common stock that governments are not permitted to exercise, but which subsequent purchasers in the market would be permitted to exercise. Further, I argue that Treasury should establish a sales plan for its TARP frozen options, similar to the 10b-5 sales plans that executives file with the SEC.