One, of several, regulatory responses to the financial crisis has been to consider the extent to which bank failure can be explained by flaws in banks’ corporate governance arrangements.

In many jurisdictions this diagnosis has generated calls upon shareholders to act as effective owners and hold boards of banks to account, as well as calls to empower shareholders to enable them to do so. But what do we know about the relationship between shareholder power and bank failure? To date scholarly attention has been paid to the relationship between board independence and bank failure, but limited attention has been given to the relationship between bank failure and the core corporate governance rules that determine the ease with which shareholders can remove and replace management. In our paper, Shareholder Empowerment and Bank Bailouts, we examine the relationship between shareholder power — and, thus, managerial accountability — and the probability of bank bailouts.

…continue reading: Shareholder Empowerment and Bank Bailouts

In the first presidential debate, Mitt Romney identified the Dodd-Frank Act as the “biggest kiss” to Wall Street, opening a topic that has received too little attention in this election season. Supporters of the act argue that it ends bailouts, but this is true only if bailouts are defined narrowly as the use of taxpayer funds to rescue a failing financial institution. However, the source of funds for a bailout is not the real issue. The possibility of a creditor bailout creates moral hazard, no matter where the bailout funds originate, and it is moral hazard that provides the largest banks or other large financial firms with competitive advantages. The same is true of the special “stringent” regulation required by the act for banks and other firms deemed systemically important. These provisions create moral hazard by reassuring creditors that there is less risk in lending to these large firms than to small ones, and thus provide the biggest firms with a continuing competitive advantage in the form of lower funding costs. Romney is correct to see this as a subsidy to big banks and other large financial institutions. Title I invokes stringent regulation for systemically important firms, Title II provides a mechanism for bailing out creditors if a systemically important firm should fail, and Title VIII authorizes Federal Reserve funding for an unlimited number of additional financial institutions. If President Obama is re-elected, Dodd-Frank is likely to continue in its current form, adding materially to the problem of moral hazard and TBTF in the US financial system.

At its enactment, the Dodd-Frank Act (DFA) was advertised as legislation that would end financial bailouts. When signing the legislation on July 21, 2010, President Obama said, “There will be no more tax-funded bailouts—period.” But this is an accurate depiction of the act only because the president and the act’s other proponents define bailouts as the use of public funds for rescuing failing financial institutions.

…continue reading: The Future of Bailouts and Dodd-Frank

From the election of a French president who has openly expressed his opposition to austerity without a greater focus on stimulating economic growth to the struggles to form a new Greek government that may or may not agree to abide by the conditions set out in the existing bailout plan, recent elections have enveloped the Eurozone in yet more uncertainty. With the desire for an alternative to a programme of strict austerity gathering increasing popular support, balancing the challenges of the Eurozone’s rapidly escalating political crisis alongside the fiscal imperatives that need to be tackled has rarely been so difficult, or the path ahead for Europe’s leaders so unclear.

In these circumstances few would dare to predict the future. But the ability to assess and anticipate potential market risks – from the impact of sovereign debt issues on an already weakened banking sector to the prospect of a country, or even countries, leaving the Eurozone – is crucial. Also crucial is the need to prepare for a variety of eventualities, whether through more stringent credit assessment, tighter documentation, careful counterparty choice or other tactics.

…continue reading: The Eurozone Crisis and Its Impact on the International Financial Markets

American corporations today are like the great European monarchies of yore: They have the power to control the rules under which they function and to direct the allocation of public resources. This is not a prediction of what’s to come; this is a simple statement of the present state of affairs. Corporations have effectively captured the United States: its judiciary, its political system, and its national wealth, without assuming any of the responsibilities of dominion. Evidence is everywhere.

The “smoking gun” is CEO pay. Compensation is an expression of concentrated power — of enterprise power concentrated in the chief executive officer and of national power concentrated in corporations. Median US CEO pay for 2010 was up 35 percent in the midst of a lingering recession, while CEO pay over the last decade has doubled as a percentage of pre-tax corporate income. Yet there has been no justification for current levels of CEO pay based on economic value added.

When Lee Raymond retired as CEO of ExxonMobil at the end of 2005, after six years at the helm of the merged firm and another six as head of Exxon before that, he walked away with more than a quarter billion dollars in realizable equity. In his final year alone, Raymond received in excess of $70 million in total compensation — an hourly wage of about $34,500 calculated at 40 hours a week for 50 weeks. No metric can justify such a raid on the corporate treasury and shareholder equity, but Raymond is only a particularly egregious and early example of what has since become common practice. Little wonder that the driving concern of banks receiving TARP “bailout” money was to pay it back so as to escape any restriction on executive pay.

…continue reading: The Corporate Capture of the United States

In the paper, Safer Ratios, Riskier Portfolios: Banks’ Response to Government Aid, which was recently made publicly available on SSRN, we investigate the effect of TARP on bank risk taking. One of the key features of the past decade has been an increased role of government regulation, which culminated in the bailout of over 700 firms under the Emergency Economic Stabilization Act (EESA) of 2008. At the forefront of an ongoing regulatory debate is the potential effect of the bailout on the risk-taking behavior of financial institutions, since imprudent risk-taking is often blamed for leading to the crisis in the first place. On the one hand, recent regulatory reforms, including the EESA, the Dodd-Frank Act of 2010, and Basel III, were tasked with promoting financial stability and preventing excessive risk-taking by financial institutions. On the other hand, the bailout sent a signal of implicit protection of certain financial institutions, which could encourage risk-taking as a response to a perceived safety net for institutions that encounter financial distress.

We study three channels of bank operations – retail lending, corporate lending, and financial investments. We use hand-collected data on bank applications for government capital to control for the selection of fund recipients and investigate the effect of both application approvals and denials. To distinguish banks’ risk taking behavior from changes in economic conditions, we also control for the volume and quality of credit demand based on micro-level data on home mortgages and corporate loans.

…continue reading: Did the Bailout Encourage Risk-Taking?

As used in this post, “clawback” means a repayment of previously received compensation required to be made by an executive to his or her employer. Three federal statutes that provide for clawbacks are discussed in this post. They are:

• 1. Sarbanes-Oxley Act of 2002 (SOA) §304; 15 U.S.C. §7243(a);
• 2. Emergency Economic Stabilization Act of 2008 (EESA) §111(b)(3)(B), as added by Section 7001 of the American Recovery and Reinvestment Act of 2009 (ARRA); 12 U.S.C. §5221(b)(3)(B) (applicable only to recipients of assistance under the Troubled Asset Relief Program (TARP) that have not repaid the Treasury); and
• 3. Dodd-Frank Wall Street Reform and Consumer Protection Act (DFA) §954, 15 U.S.C. §78j-4(b).

A summary comparison of the three statutory clawback rules is provided in the chart below.

…continue reading: Clawbacks Under Dodd-Frank and Other Federal Statutes

(Editor’s Note: This post is Lucian Bebchuk’s most recent column in his series of monthly commentaries titled “The Rules of the Game” for the international association of newspapers Project Syndicate, which are available here.)

A year after the United States government allowed the investment bank Lehman Brothers to fail but then bailed out AIG, and after governments around the world bailed out many other banks, key question remains: when and how should authorities rescue financial institutions?

It is now widely expected that, when a financial institution is deemed “too big to fail,” governments will intervene if it gets into trouble. But how far should such interventions go? In contrast to the recent rash of bailouts, future government bailouts should protect only some creditors of a bailed-out institution. In particular, the government’s safety net should never be extended to include the bondholders of such institutions.

In the past, government bailouts have typically protected all contributors of capital of a rescued bank other than shareholders. Shareholders were often required to suffer losses or were even wiped out, but bondholders were generally saved by the government’s infusion of cash.

…continue reading: Should Bondholders be Bailed Out?

(Editor’s Note: This post comes to us from Tracy A. Thomas of the University of Akron, and is based on a comment in the Washington University Law Review.)

In March 2009, ailing insurance giant American International Group (AIG) triggered a national outcry when it paid out $165 million in government bailout funds for employee bonus incentives. [1] President Obama called the bonus payments an “outrage” and promised that his administration would “pursue every single legal avenue to block these bonuses and make the taxpayers whole.” [2] He chastised the firm for its audacity of using borrowed taxpayer monies to reward financial recklessness and greed. This was the same company, of course, who within days of receiving its first infusion of government cash in September 2008, sent its executives on a half-million dollar boondoggle retreat at a fancy desert spa. [3] And just several months after the initial fiasco, AIG tried to award $265 million in further bonuses, [4] adding to performance bonuses of $454 million paid to employees and executives in 2008. [5] It was just over a year ago when AIG turned to the government for its survival. The government stepped in to assist AIG when the company faced imminent death from its risky financial derivative products that were backed by precarious mortgages. [6] Fearful that the toppling giant would trigger a cataclysmic domino effect, the government authorized the bailout funds to keep AIG, and the entire U.S. financial sector, afloat. [7] The government agreed to loan AIG the money, now totaling over $173 billion, collateralized with AIG’s assets and an 80% equity ownership of the company. [8] The first infusion of cash to AIG was authorized by the Federal Reserve in September 2008, supplemented with funds authorized in October by Congress in the $700 billion bailout bill, the Emergency Economic Stabilization Act (EESA), which established the Troubled Assets Relief Program (TARP).

As a result of the AIG bonus debacle, the President and Congress took several steps to try and avoid these problems in the future. In the EESA, Congress gave the Treasury Secretary the power to require these troubled financial institutions to meet appropriate standards for executive compensation, but did not directly prohibit the type of employee bonuses at AIG. [9] The subsequent American Recovery and Reinvestment Act (Recovery Act), passed in February 2009 after the transition to the Obama administration, added significant new restrictions for highly-paid executives of financial institutions that receive TARP assistance, including prohibitions against paying bonuses, retention awards, or incentive compensation, except as payments of long-term restricted stock. [10] President Obama also installed Kenneth Feinberg, former special master of the 9/11 Fund, as the pay czar to oversee all employee bonuses and payments for companies receiving large amounts of bailout funds, including AIG. [11]

…continue reading: Bailouts, Bonuses, And The Return Of Unjust Gains

(Editor’s Note: This post comes to us from Professor Emma Coleman Jordan of the Georgetown University Law Center, and relates to Professor Jordan’s report “A Fair Deal for Taxpayer Investments: Public Directors Are Necessary to Restore Trust and Accountability at Companies Rescued by the U.S. Government“, released by the Center for American Progress. The report was released at an event featuring Chairman Towns of the House Committee on Oversight and Government Reform, details and video of the event are available here.)

During the financial markets crash of 2008, the Treasury Department and the Federal Reserve—of necessity—improvised dramatic and aggressive solutions to rescue the financial sector from imminent collapse. A welter of creative regulatory and monetary solutions provided massive amounts of government assistance to rescue private firms from probable failure. However, the benefits of government intervention have so far largely flowed one way only—from the taxpayers to the financial sector—and there has been a marked absence of accountability or transparency associated with these government-provided benefits.

Taxpayer bailouts have become a central policy tool since the onset of the current economic crisis—with approximately $12 trillion dollars to date deployed to support or rescue private companies in total.2 The de facto policy of providing taxpayer support to struggling “systemically important” companies has produced an ill-defined terrain of shared governance between financial executives on the one hand and federal regulators who hold both the power of government and the power of ownership on the other.

This unusual mix of private and public power requires a more visible implementation of financial accountability to regain the trust of the American public. The American people must know that their interests as taxpayers are being safeguarded, and that as investors they can have confidence that federal intervention into the private markets is following a consistent, well-defined, and transparent process—one which follows well-established guidelines for ensuring accountability, rather than a series of ad hoc approaches. This paper argues that the best vehicle to accomplish this goal is the establishment of public directors—positions of direct representation in the boardrooms of companies that have received significant amounts of government funds and which will provide federal agencies that are the new owners and regulators with a visible structure of accountability.

The prospects for a robust prudently guided financial sector have been substantially clouded by the fact that the both the corporate governance structure and the executive leadership of the financial sector remain largely unchanged—92 percent of the management and directors of the top 17 recipients of TARP funds are still in office. The Obama administration has outlined an ambitious and sweeping plan to reform the regulatory system governing financial institutions and markets. This regulatory reform is certainly indispensable, but perhaps insufficient. The recent market crashes exposed severe deficiencies in the fiduciary obligations and public-regarding culture of financial firms. In order to prevent future crashes, we must not only seek to change how these firms are regulated, we must also seek to change the structures by which they are run. One major issue in this regard is the passivity, insularity, and narrow band of values represented by those who oversee these firms—the directors who make up the boards of the country’s largest financial institutions.

A driving force of the 2008 market collapse was the imprudent risk taking by financial sector leaders The CEO and board of directors of each company have the legal responsibility to make decisions that advance shareholder interest. In the period leading up to the crisis, the conventional wisdom among financial sector CEOs was that the high returns available from mortgage-backed securities, and the highly leveraged balance sheets and off-balance sheet transactions concentrated in exotic financial instruments were the way to maximize short-term profitability and thus advance shareholder interests. This industry-wide consensus proved to be fatally flawed.

Public directors will provide a corrective to the boards of the financial institutions that helped cause the crisis. Public directors can offer increased independence of thought and diverse perspectives among board members. Public directors should be chosen for a strong public service history, financial and corporate literacy, as well as independence from links to the financial sector. The primary aim of the public director appointments should be to diversify traditional board member profiles and to avoid replicating the disastrous pool of narrowly self-reinforcing financial sector conventional wisdom and experience that led to the crisis. As the economy heals, there are troubling signs that banks have not increased lending, and have instead resumed planning risky strategic acquisitions, and excessive compensation practices. Proportional representation by public directors can ensure that systemically-important firms that have any measure of government ownership do not relapse into the homogenous, CEO-dominated boards that were in place before the crisis.

Regulators should determine most of the details of the public directorships—after all, they have the most direct experience in trying to regulate private companies that have received public funds. But the decisions should be made with two critical principles in mind. First, the principle of proportionality should be applied to government investments in private firms. Public directors should be appointed to the boards of directors on a roughly proportional level to the amount of funding received by the rescued firm—and this should include not just purchases of company stock, but other investments and subsidies provided to help support the firm. For example, if a company receives government funding equivalent to 25 percent of its market capitalization, public directors should make up roughly 25 percent of that company’s board.

Second, because public directors should represent taxpayer interests, they should have a history of public service, and they should be chosen to provide both intellectual diversity and diversity of perspective gained from individual experience. They should also have experience and expertise from outside of the economic sector in which they serve. Diversity is necessary for good governance, as it breaks up the “groupthink” that too often characterizes corporate boards, which are typically filled by allies of management. And experiential diversity is also important for the appropriate representation of taxpayer interests. When other stakeholders—such as pension funds, unions, or hedge funds—invest major sums in corporations, they demand board representation, and their directors are picked to represent the interests and worldview of these stakeholders. Taxpayers should not be treated any differently.

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.