Editor’s Note: This post is by J.W. Verret of the George Mason University School of Law.
In my recent paper, currently in the submission process, Treasury Inc.: How the Bailout Reshapes Corporate Theory and Practice, I explore the implications of the U.S. Treasury Department and the Federal Reserve’s controlling ownership positions in many companies through its decision to take equity in TARP bailout participants. I show how existing corporate theory is unprepared for the presence of a controlling government shareholder and I demonstrate a variety of unanticipated complications for corporate practice. I close with three recommendations, one of which has assisted Senators Corker and Warner in introducing implementing legislation.
Corporate law theory and practice considers shareholder relations with companies and the implications of ownership separated from control. Yet through the TARP bailout and the government’s resultant shareholding, ownership and control at many companies has merged, leaving corporate theory and practice for the financial and automotive sectors in chaos. The government’s $700 billion bailout is a unique historical event; not merely because of its size, but because of the resulting ripple through scholarship and practice.
To emphasize the unique nature of Treasury’s ownership through TARP, the article briefly considers the history of the United States government’s entanglement in private business. Though the federal government has frequently chartered businesses that were wholly owned by the United States, the government’s ownership in businesses through TARP is a circumstance without precedent. Before rethinking theoretical and practical elements of corporate theory, the article will consider the two threshold questions in the analysis: whether Treasury and the Federal Reserve are actually controlling shareholders, and whether there are any substantive limits to their sovereign immunity as control shareholders under corporate and securities law.
The article argues that the government is most clearly a control shareholder for the largest TARP recipients in which it holds an interest, including Citigroup, AIG, GM, Fannie Mae, Freddie Mac, and with some significant measure of certainty the nine remaining banks from among the top nineteen banks to originally receive TARP funding. The article also offers the suggestion that the government might, depending on its degree of ownership, also be considered a control shareholder for many of the other 600 banks accepting TARP funding.
The article then considers the application of sovereign immunity to the Treasury and Federal Reserve’s exercise of ownership. After considering a number of novel challenges to the government’s sovereign immunity, it concludes that the federal government’s belt-and-suspenders protection from liability, including the liability waivers of the Emergency Economic Stability Act, waivers included in the Securities Exchange Act, and challenges in using sovereign immunity exceptions like the Takings Clause, foreclose meaningful challenge to the federal government’s sovereign immunity in its exercise of ownership power over its TARP shares.
This work updates the six central theories of corporate law to reveal that none function adequately when considered with a controlling government shareholder that enjoys sovereign immunity. Corporate law theory is home to essentially six distinct and at times vigorously opposed schools of thought. First, the article looks to the foundations of corporate law in agency theory and nexus-of-contracts theory. In both, it considers the effects of a control shareholder with sovereign immunity. Then, it considers the Cain-and-Abel-like warring children of the agency and nexus-of-contracts marriage: shareholder primacy and director primacy. Shareholder primacy is a difficult fit, as it contemplates a non-conflicted shareholder electorate that minimizes the special interest director problem, a wash-board which TARP ownership obviously complicates. Director primacy seems an easy critic of TARP ownership, as it is inherently hostile to the accretion of shareholder power, and yet is difficult to understand in light of elected directors who may be beholden to government shareholders.
The team production model theory of corporate law is also considered in the article, with the result that the model’s reliance on the board of directors as a mediating hierarch, balancing the interests of varying stakeholders, is complicated by the political pressures placed on the unique government shareholder hierarch. The progressive corporate law model of corporate law is also considered, with the result that the accountability of government regulators and the disclosure rules underlying progressive corporate law are threatened by the presence of government ownership.
The article also develops an economic model of incentives facing political decision-makers in exercise of their shareholder power. It gives particular emphasis to the fact that retail shareholders and taxpayers, as more dispersed interest groups, will have substantially less influence than other rent seeking groups. It also considers the fact that rents for an official exercising government shareholder powers aren’t time discounted, but the costs of using a bank to subsidize interest groups are substantially time discounted. Indeed, given the average two year tenure of a Schedule C appointee, the government appointees may be gone long before the costs of subsidization are revealed.
The article warns that i) Treasury has free reign to engage in insider trading of its shares pursuant to unique provisions in the ’34 Act ii) Treasury is the only control shareholder that evades fiduciary duties to other shareholders under corporate law, iii) Treasury may end up serving as a lead plaintiff in private securities class action litigation against the very companies it is trying to support through TARP, iv) unregistered securities of any TARP recipient held by another TARP recipient may be considered affiliated sales by virtue of their sharing a controlling shareholder v) the ability of boards of directors to approve conflicted transactions may be endangered, and vi) the government will obtain the right to nominate candidates for the Board of publicly traded companies, and vote for other shareholder’s nominees, under the SEC’s recent shareholder proxy access rule.
The article offers hope to the concerned corporate law traditionalist in three unique reform suggestions. First, it recommends that the government eschew its voting common equity, and even its non-voting preferred shares, in favor of frozen options. Frozen options would be designed such that the government would never be permitted to exercise them, and accordingly never be permitted to exercise the voting or other rights that accompany either common or preferred shares, but the government would be permitted to sell them into the market and allow other shareholders to exercise all the rights that accompany the form of shares into which those temporarily frozen options morph. This should serve as a significant buffer to the analysis that the federal government holds a control position in TARP companies, central to the article’s analysis concerning the resultant complications in corporate theory and practice, while still permitting the taxpayer to participate in share appreciation of bailed-out companies.
Second, the article recommends that the Treasury and the Federal Reserve set up trusts to hold its ownership that create an explicit obligation of those entities to maximize long term shareholder wealth in the invested TARP companies. Toward that end, the article’s author has contributed language to implementing bi-partisan legislation introduced by Senator Corker and Senator Warner, the TARP Recipient Ownership Trust Act of 2009. This should be accompanied by a waiver of the federal government’s sovereign immunity with respect to state corporate law, as well as a waiver of its immunity under section 3(c) of the Exchange Act and attendant immunity provisions of the Emergency Economic Stability Act.
Third, in conjunction the preceding recommendations, the article suggests that the federal government as a shareholder should execute a 10b-5 trading plan similar to the type filed by executives to protect against liability for insider trading. This plan should be binding on the Treasury by law, with appropriate ranges of trade amounts, to minimize the threat of insider trading by the Department and cement a near term exit date by the government from its positions in private businesses.