Law of Set-off Makes No Sense to New York Times Business Columnist

In a column on the front page of Friday's Business Day section in the Times, provocatively titled, "Wielding Derivatives as a Tool for Deceit", Floyd Norris writes that derivatives

"are often weapons of mass deception.

"For some derivatives, a desire for deception is the only reason they exist. That deception can allow those who own derivatives to evade taxes or accounting rules. It can allow activity that might otherwise be illegal, were it not called a derivative, or that would face regulation if it were labeled what it truly is.

"Sometimes, banks use derivatives they create to help their clients deceive the public. Other times, they enable the banks to deceive those clients."

He tells an interesting story of how, during the 1990s, Italy used derivatives, in which it got upfront payments, to make its budget deficit look smaller, thereby easing its admission to the Euro Zone.  At the time, Mario Draghi, now head of the ECB, was the director general of Italy's Treasury department. Norris believes the transactions should have been treated as loans, such that the cash received by Italy at the start of the transaction would not have run through the report of receipts and disbursements for the year, and thus would not have reduced the deficit.  (To be fair, he credits the FT and La Repubblica for the story).

The anecdote leads him to his general claim that banks use derivatives to create misleading depictions of their financial condition and further that accounting rules condone the practice.  This is where the law of setoff comes up.  Norris writes (my emphasis added),

"The current accounting rules in the United States go so far as to say that banks can hide obligations that are classified as derivatives. They do that by “netting” derivative positions that are currently profitable against positions that have losses, and show only the net value. That reduces the amount of assets on their balance sheets and thus makes them appear less leveraged than they are.

They can do that even if the two positions have nothing in common — save the identity of the counterparty on the other side of the transactions. It makes no sense at all to be able to hide a bet on, say, the Canadian dollar, by offsetting it against a bet on German stock prices. But that is legal now in the United States."

Now I have no idea whether combining a bet on the Canadian dollar with a bet on German stock prices is a good trade.  But I do know that setoff between two parties who are obligated to each other is a pretty clear legal principle that has been around for centuries, and the ISDA's master agreement provides for cross-termination, mark to-market and netting, and the safe harbors in the Bankruptcy Code permit financial institutions to do all that even after one of them goes bankrupt.  So it's pretty likely that, if Bank A owes Bank B money on the "Canadian dollar bet" and Bank B owes Bank A money on the "German stock prices bet", that they can net, under the ISDA master agreement, or the law of setoff, and neither of them is mis-representing its financial condition or leverage by reflecting that prospect on their financial statements. ( I suppose I should be lawyer-like and note that I only am familiar with the US law and have no idea if the same is true if one of the banks is from a non-US jurisdiction. And, yes, I know that banks don't file under the Bankruptcy Code, but (a) the practice in bank liquidations is not meaningfully different and (b) I think Norris is using "banks" as a shorthand for all large complex financial institutions including many which could file under the Bankruptcy Code.) 

I feel for journalists who have to distill complex subjects and come up with something interesting to say under deadline pressure.  Mistakes are inevitable. Financial journalism has always seemed to be a particularly mistake-prone field.  And generally I find many of Norris's columns quite well thought out.  On the other hand, it would be nice if journalists, being in a profession that purports to be interested in fact, would actually pose questions to people with knowledge in a field before they upload their mistakes to the reading public. So:.

Dear Mr. Norris, 

Setoffs have generally been permitted for centuries, and taking setoff principles into account is not something that can be accurately labeled "deceptive"..

Sincerely,

A Reader.

Economic Development, Social Capital and Bankruptcy Processes

Michael Pettis is the blogger that many people seem to turn to for unbiased, high-quality analysis of  the economic situation in China.   He had a very long post recently entitled "How much investment is optimal?" that contained some very good observations about how a bankruptcy process can enhance an economy's functioning.  He wrote:

"the institutional framework around the writing down of overvalued assets, and the liquidation process itself, is an important part of how efficiently an economy is able to absorb the benefits of capital stock. A formalized bankruptcy process that takes assets away from inefficient users, writes them down to a fair market value, and reintroduces them into the economy, creates a much more efficient economic system than one in which bad loans are not recognized, effectively bankrupt companies are allowed to continue in value-destroying activity, and the use of assets is not systematically transferred from the less efficient to the more efficient user.

"In fact an efficient and relatively rapid bankruptcy process is, I would argue, of fundamental importance to the ability of an economy to exploit capital stock efficiently. Even very advanced countries without a formal process to transfer resources quickly can have a hard time exploiting its capital and labor factors, especially after a period in which a great deal of labor and capital were directed into unproductive uses. I think Japan’s twenty years of nearly zero growth may be explained in part by the very slow process in Japan by which resources were transferred from “losers” to “winners” after the investment orgy of the 1980s.

"In fact more generally the sophistication and flexibility of financial systems are an important component of social capital because these determine the capital allocation process. Financial system capable of taking risk and supporting new and disruptive technologies or organization structures tend to result in a greater ability by a society to absorb capital. In that light, and as an aside, I would suggest that the country that sees the most change in the list of its largest companies from decade to decade – because this list creates a simple way of determining how quickly companies can be created and destroyed as their level of efficiency changes – is probably better at absorbing capital than a country whose largest companies are the same decade after decade."

The overal thrust of his post does not have that much to do with bankruptcy, but rather is about the role of "social capital" in economic growth, which he defines as "the full range of legal, institutional, and economic relationships that can make an economy more or less productive. It is this complex mix of institutions, I would argue, and which I call social capital, that drives advanced economic growth, and not simply additional labor or capital."  His point is that pure physical capital investment is always and inherently productive, but optimizes only in the right environment, one that, in his words again:

"creates incentives and rewards for managerial or technological innovation (which probably must include clear and enforceable legal and property rights),

encourages the creation of new businesses and penalizes less efficient businesses, perhaps at least in part by institutionalizing methods by which capital can quickly be transferred from less efficient to more efficient businesses, and

"maximizes participation in economic activity by the whole population while minimizing distortions in that participation."

You can see how a good bankruptcy process falls under the second bullet.

By coincidence, along these same lines, Malcolm Gladwell had a nice essay in The New Yorker's June 24 issue that made a related point.  The essay reviews a biography of an economist/social scientist named Albert O. Hirschman who died last December (the book is entitled "Worldly Philosopher: The Odyssey of Albert O. Hirschman" by Jeremy Adelman).  Hirschman is best known for a beyond-brilliant work called "Exit, Voice  and Loyalty" which is about the three ways people tend to relate to badly managed organizations and institutions (including nations): exit (get out of it); voice (speak out and try to change it) and loyalty (conform so as to remain loyal notwithstanding its faults).  But he was also much respected for his academic work in economic development, where he held very much a "bottoms-up" as opposed to "top-down" perspective. In discussing Hirschman's work on economic development, Gladwell succinctly grasps the main point:

"Developing countries required more than capital.  They needed practice in making difficult economic decisions. Economic progress was the result of successful habits - and there is no better teacher, Hirschman felt, than a little adversity."

And this is exactly right. Tying it back to the bankruptcy process, for just one example, one can see that an economy is enhanced if it has a mechanism to deal with the difficult situation where an underachieving economic actor ceases to be able to provide a full return of capital, let alone on capital, and to do so in a way that mitigates the impact on the broader economy in both the short run (confining the depth, breadth and duration of the losses) and the long run (by operating in a way that does not deter capital from investing in future economic activity).  A mechanism that makes it possible for an economic actor to shed liabilities that are beyond its capacity to satisfy helps an economy regenerate itself, rather than be buried under the perpetual burden of insurmountable debt. claims. 

A lot of modern economies today unfortunately lack this kind of regenerating mechanism, with some tending to allow legacy liabilities to go unaddressed for years, and others tending to have highly politicized and otherwise ad hoc approaches that discriminate in favor of the interests of certain politically favored constituencies and thereby create a negative climate for capital allocation and economic growth.  The current US chapter 11 is not perfect but is probably as good as there is on the planet right now, especially when a company and its constituencies are able to go down the "prepack" or "prenegotiated" route to reorganization.

Another example of how social capital, as Pettis defines it, makes a difference in economic growth comes from a short article by Peter Hall in Harvard magazine, "Anatomy for the Euro Crisis".  Outlining some of  the differences between the northern European economies that have thrived, by comparison, under the euro, and the southern economies that haven't, Hall writes:

"Germany’s coordinated market economy exemplifies the northern model. That nation can hold down labor costs because its industrial-relations institutions encourage firms and unions to coordinate on modest wage increases. Its highly collaborative vocational training system, operated by strong employer associations and trade unions, provides firms with skilled labor that gives them comparative advantages in producing high-value-added goods and capacities for continuous innovation—enabling German enterprises to compete globally on quality as well as price. An economy organized in this way is ideally suited to mount the kind of export-led growth strategies that lead to success inside a monetary union.

By contrast, Spain, Portugal, Greece, and Italy entered EMU with political economies not well-suited to this type of growth strategy. They have fractious labor movements divided into competing confederations, and weak employer associations. As a result, they lack the capacities for collaborative skill formation and wage coordination central to northern European economic strategies. Instead, their governments have tended to rely on demand-led growth, in which governments increase spending to encourage domestic consumption and then use periodic depreciations of the exchange rate to offset the inflationary effects of this strategy on the competitiveness of their products. Depreciation lowers the price of a country’s exports in foreign markets and raises the price of imports that compete with domestically produced goods."

Germany's industrial relations model, in Hall's description, has productive social capital that leads to competitive success, while the southern economies have much less and instead historically have had to resort to the deficit-and-depreciate routine to get their economies out of first gear.  Which they can no longer repeat under the euro, hence the need for structural reforms if they want to escape their current predicament.

On a closing note, on the themes of habits, adversity and success, here is a quote in the current Sports Illustrated from James Jones, benchwarmer for the two-time NBA champion Miami Heat and evidently a nascent business school lecturer:

"James Jones, one of Miami's reserve forwards, read a book during the Finals called The Plateau Effect, in part because it pertained to the Heat. 'When you're the elite, the exception, the example, you get to a peak, and you try to maintain what got you there rather than growing it,' Jones explains. 'Complacency creeps in and by the time you realize it, you're regressing.  That's the plateau.  Getting past it requires stimuli, and oftentimes the best stimuli is failure.'"

Rethinking the (Essentially Insolvent) FHA

The AEI has put out a terrific little (12 page) paper by Joseph Gyourko, who is the Martin Bucksbaum Professor of Real Estate, Finance, and Business Economics & Public Policy at the Wharton School of the University of Pennsylvania, where he chairs the real estate department and is director of the Zell/Lurie Real Estate Center. He is also a research associate at the National Bureau of Economic Research (NBER) and served as codirector of NBER’s special project on housing markets and the financial crisis.

Entitled “Rethinking the FHA”, it calls for “replacing FHA with a new subsidized savings program that provides matches of qualified households’ savings. The goal would be to help those households achieve a 10 percent down payment on the home they wish to purchase.”

This is an approach that I have been thinking about ever since the collapse of the mortgage finance market in 2008.  Why does the federal government provide so much financial support to home ownership?  Is there a better way to do it than the Fannie/Freddie/FHA model which (a) subsidizes households to take on large quantities of debt to buy homes, which (b) drives up housing prices, requiring the next round of buyers to take on yet more debt to buy a house, and (c) leaves the government holding enormous amounts of credit risk from what tend to be among the riskiest household credits in the nation, and (d) multiplies leverage throughout the economy because, not only are the households that issue mortgages left highly leveraged but the government agencies like Fannie/Freddie/FHA that take their credit risk are also highly levered and, on top of that, the holders of the government agencies’ paper are allowed to leverage it at very high ratios because of the government backing?  As Professor Gyourko writes:

 “Recent research projects high default rates—between 15 and 30 percent—among borrowers whose mortgages FHA guaranteed since 2007. Hence,  it is quite clear that very large numbers of program beneficiaries are not successful in becoming stable, long-term owners. FHA’s most recent actuarial review for fiscal year 2012 shows that its Single-Family Mutual Mortgage Insurance Fund is underwater. My own research suggests that even this sobering conclusion by FHA’s actuarial reviewer is too optimistic by tens of billions of dollars.”

 “Both FHA and the borrowers whose mortgages it insures are leveraged by more than 30 to 1. This was always a financial accident waiting to happen: this leverage ratio is on par with those that were employed by Bear Stearns and Lehman Brothers just before their collapses. To be viable, such a highly leveraged business model requires that house values never fall. We have learned the hard way that actual market outcomes are not always so obliging.”

His paper reviews these claims in somewhat more detail, but I don't think there is any real disagreement that the FHA is insolvent, because its underwriting standards are looser and its loans thus have default rates much higher than any private sector lender could sustain.  A typical FHA mortgage has only about a 3% downpayment.  I don't see how the government is serving any public policy interest puttng households into that kind of leveraged position. 

For that reason, I have been thinking along the same lines, that if the government has to be involved in supporting home ownership (which is a political reality after decades of such involvement, regardless of what little economic sense it makes), the best channel is not through the debt but the equity, exactly as Professor Gyourko proposes: give them money to build net worth, not debt that can destroy it.  But giving people 100% of their down payment obviously isn't a sound policy, so the 100% match is a much better way to go.    Or, if someone objects that it's still too hard for poor people to save anything to be matched, I could imagine a small fixed amount like $100 a month and a 100% match of anything above that.  It's also important from an inflation-management perspective that the government subsidy is not freely available for spending generally but sits, outside the economy, in savings vehicles.

The whole paper is only 12 pages and very much worth reading.

Hat tip to Arnold Kling's "askblog" which is also always worth reading.

Mick Jagger and the Iron Lady Go Way Back

Sir Mick mentions in an interview that he had a couple of one-on-one chats with Margaret Thacher when she was PM, and in them, he reminded her that they had met when he was 10 years old. 

"But I reminded her that her first attempt at entering parliament was in Dartford, where I grew up.

I remembered her when I was ten or something and she was campaigning. She was called Margaret Roberts then.

‘She struck me as a peculiar politician. She was quite brittle. Most other politicians like to be liked."
Jagger says he was impressed by the Tory leader because she "didn’t change for anyone" and that he was "slightly surprised by all the people that were still so anti her and had all this residual resentment" after she died.

The article notes that Jagger's mother was an active member of the Conservative Party when he was young.

Supremes Grant Cert in Noel Canning

Back in late January, I wrote a post advocating that the Noel Canning case on intrasession recess appointments should go to the Supreme Court, and another one comparing Larry Tribe's changes in opinion on the Consitutionality of such appointments, from the W administration (they were unConstitutional) to the Obama administration (they have magically become Constitutional).   Yesterday, the Court took the case, on a petition from the federal government, which lost in the D.C. Circuit, where a panel laid out arguments remarkably similar to W-administration-Tribe's).

I am delighted and continue to believe, as I did in January, that the odds of Noel Canning being affirmed are the better odds.   As I explained then, Justice Kagan might have to recuse herself on account of having taken a position on the issue while Solicitor General, and, if she doesn't, she will have to decide if she will stray from that view which was much less expansive than the Government's  tactically unwise carte blanche position in the D.C. Circuit.   Moreover, for reasons I laid out back in January, I think Justice Kennedy is increasingly more likely to throw his swing vote against the Government's position, particularly if the Government maintains the extreme position it expounded at the D.C. Circuit.  It will be interesting to see if Tribe submits anything in amicus and also to see if either of this self-contradictory op-eds on the topic get quoted in any of the opinions.

Since the January posts, I came across this article in the Virginia Law Review that endorses the Noel Canning decision wholeheartedly. 

Paul Krugman Knows Nothing About Apple, But That Doesn't Stop a Pundit from Pontificating

In a typically data-deficient column and blog post, Paul Krugman tosses off a few superficial observations about the increasing returns to intellectual property in the 21st century versus the 20th, selecting Apple as his example of the 21st century company.  (Lest anyone think I am insulting Krugman when I say these two pieces are "superficial", please note that Krugman himself warns "This isn't an original insight").

Going back to "The Conscience of a Liberal", Krugman has posited a gauzy, nostalgic 1950s America in which everything about the economy was somehow better than the 21st century, because unions were stronger and marginal tax rates were higher (as opposed to the rest of the industrialized world being behind the Iron Curtain or still rebuillding from WWII).  So, naturally, the column linked to above hearkens back to the 1950s to contrast "General Motors in the 1950s" with Apple today.   GM, he tells us, had "huge visible production activities" while Apple does "hardly any manufacturing" because it outsources that function.  Apple is not valuable for its "productive capacity" but its "technology, design and a brand identity".  In fact, Krugman claims, "Apple's market position is its most valuable asset."

He gives absolutely no evidence or explanation for that assertion.  It rests on nothing more than his ipse dixit, or say-so.  He just moves on, expecting Times readers to take that for granted (hmm, corporation, market, bad, yes, very bad), and shares the implications that he sees flow from that unsupported assertion: "One is that profits are no longer anything remotely resembling a “natural” aspect of the economy; they’re very much an artifact of antitrust policy or the lack thereof, intellectual property policy, etc. Another is that a lot of what we consider output is “produced” at low or zero marginal cost."

So I thought I would look more closely at those assertions.  How, for example, does Apple's "market position" today compare to GM's in the 1950's?  Well,  per this report from June 5, (a) Samsung, not Apple, had the most smartphone sales in the US in May, while (b) going back to April, Apple was number one among OEMs with 39% of the smartphone subscribers in the US, ranking number one, but only in 2d place if measured by software platform, with Google's Android having a significantly larger market share based on platform.  Considered globally, Apple has only about 9% of the worldwide market for smartphones, whereas Samsung's is  more than twice as large, according to Gartner. Hardly sounds like a market dominator!

But how does that compare with GM in the 1950's?  Well, this website says GM had a 54% market share in 1954; and even as late as the early 1980's, GM was consistently in possession of over 40% of the US market, per "Rude Awakening" by Maryann Keller. So clearly Apple has a lot less of a "market position" today than GM did in the 1950s and 1960s.

Does Apple's "market  position" in 2013 constitute some kind of entrenched position, as the reference to antitrust policy implies, where market power is used in some unfair way?  Obviously not -- Apple had zero share in smartphones as recently as 8 years ago.. As recently as Q12010, Blackberry's operating system had over 40% market share in the US, with Apple second at 24%.  And where is RIMM today?  Down to about 5%.  This headline from 2012 captures the dynamic nature of the smartphone market: "Over the Past 7 Years, Smartphone Marketshare Leaders in the US have Changed From Palm to Microsoft to RIM and Now to Android."  The author wrote:

• smartphone marketshare leaders need to be constantly evolving to meet consumer demands as leaders have changed hands with new rivals every two or three years. Palm was leading the market in 2005, only to be out done by Microsoft in 2006, who then in turn lost to RIM in 2008, and now as of 2011 Android is the most dominant leader in the past 7 years.
• A yearly snapshot of the US smartphone marketshare by OS over the past 7 years, based on Q4 data, is shown below:
• Palm: 35% 2005, 28% 2006, 16% 2007, 12% 2008, 6% 2009, 4% 2010, less than 2% 2011
• Microsoft: 17% 2005, 34% 2006, 36% 2007, 26% 2008, 18% 2009, 8% 2010, 5% 2011
• RIM: 26% 2005, 28% 2006, 31% 2007, 40% 2008, 41% 2009, 32% 2010, 16% 2011
• Android: 0% 2005, 0% 2006, 0% 2007, less than 1% 2008, less than 6% 2009, 29% 2010, 47% 2011
• Apple: 0% 2005, 0% 2006, 9% 2007, 17% 2008, 25% 2009, 25% 2010, 30% 2011
• Nokia Symbian: 23% 2005, 10% 2006, 8% 2007, 4% 2008, 4% 2009, 3% 2010, less than 2% 2011

That is pretty far removed from the kind of market data that would suggest antitrust practices are playing much of a role.  In contrast, GM's market share was obviously very stable in the 1950s, 1960s, etc., and the auto industry as a whole was pretty cozy - and a lot more ossified than the smartphone market over the past decade - with the same three companies generating substantially all of the sales for a generation.

Krugman makes the usual outsourcing complaint, yet fails, of course, to provide any data or put it in context.  66% of Apple's revenue came from sales outside the US, according to their latest quarterly press release.  So it's hardly surprising that some of their costs are lodged outside the US as well.  In this case, it's manufacturing which has to account for less than 66% of sales because gross margin is greater than 34%, so overall, there is no real outflow going on.  Most of its sales are overseas and so is a lesser amount of its costs.  How one derives a policy implication from that is hard to divine. It's absurdly unsophisticated to expect American companies to have a high level of global sales, but all their costs to be incurred at home. 

Krugman contends that "To a large extent, the price you pay for an iWhatever is disconnected from the cost of producing the gadget."  But he gives no data to prove that.  Whereas other economists, based on actual analysis as opposed to off the cuff mutterings, have estimated the cost of materials and labor for an iPhone or iPad at $229 - 275.  Gross margins like that, in the 60-70% range, are not unheard of in the technology industry.  So the price of the iPhone or iPad is not "disconnected from the cost of producing" them.  And they are certainly not produced at "low or zero marginal cost."

Krugman, in fact, displays a complete lack of understanding of how smartphone pricing.  In the US, one rarely buys just a smartphone.  One buys a smartphone and a voice and data package from a carrier like Verizon Wireless, ATT, etc.  And the price of a contract does not vary directly with the price of the smartphone, because the carriers are trying to stimulate subscriber and usage growth.  So, it turns out, the carriers, who subsidize most of the cost of a smartphone, wind up absorb a larger chunk of the price of an iPhone compared to another brand, like Samsung.   In fact, other economists have concluded that the carriers make several times as much gross profit from a typical 2-year smartphone contract as Apple or any other headset supplier does from that contract. So neither the carriers nor the customer are terribly price-sensitive where the device is concerned.  The customers are product - focused and the carriers are close to indifferent. That doesn't mean anything as far as the application of antitrust or intellectual property law to Apple.

And as far as IP law goes, the iPhone and iPad have been out for less than a decade each.  Is there some suggestion that the degree of patent and copyright protection covering them - assuming any - is too great?   If so, what is the right amount - less than 10 years?  What would be the implication of that curtailment for technological innovation?   Krugman provides no insights, just a throwaway reference to "intellectual property law, etc."  Maybe the answer lies in the "etc."

To say Apple is not valued for its "productive capacity", as Krugman writes, is basically to denigrate human capital.  Design and innovation are, as far as I can tell, the result of human beings' "capacity" to be "productive". In fact, the whole thrust of Krugman's column and blog post, elevating the physical capital of factories over human capital and innovation, is a kind of super-reactionary, antiquated rejection of most of what has been learned about productivity in the last few decades.

Productivity stems from three sources: physical capital, human capital and total factor productivity growth.  According to a recent Economic Report of the President (Obama), at 265, "Research has not just identified changes in these three factors (physical capital, human capital, and total factor productivity) as critical determinants of productivity growth; it has also come to a fairly clear view about their relative importance."  That research shows that the least contribution is made by physical capital; whereas (at 266) "the most important determinant is not physical or human capital accumulation, but changes in how much can be produced with them—that is, total factor productivity growth.".  And "improvements in total factor productivity can be described broadly as 'innovations.'” In other words, innovation is the most important factor in producing value.   Of course, that is just the opposite of what Krugman nostalgically concludes, longing for the days when people put value on an "old-style manufacturing giant, with many factories".

Krugman observes that GM employed over 400,000 people at its height. What did that mean in terms of productivity?  He doesn't give the year that happened but let's try to approximate it.  Its market share was at its height in the mid-50s.  In 1954, when, as noted above, GM had 54% of the market, the total auto and truck sales were 6.9 million, of which 54% equals 3.726 million.  So each GM worker, in the course of a year, at the height of GM's hold on the US economy, produced about 9 cars in a year, less than one a month.  How productive was that?

I can't derive a comparable productivity number for Apple -- because of the outsourcing, it would be oranges to apples, forgive the pun.  But Apple sold 37.4 million iPhones, 19.5 million iPads and just under 4 million Macs in just the most recently reported fiscal quarter, per its press release.  A total of 61 million devices of one kind of another in just three months. To appreciate that the productivity difference is so orders-of-magnitude greater, let's look at some numbers:  the entire auto industry - not just GM but the entire industry - sold 58 million units in the US in the entire decade of the 1950s.   Alternatively, at the 9 units per employee per year of the 1950's GM, Apple would require almost 28 million employees to generate the annualized equivalent of its Q113 units.  Of course, someone might say, a 21st century smartphone is a lot different than a 1950's Chevrolet.  Right -- the smartphone embeds much more technology, by orders of magnitude. Decades of incredibly difficult science are reflected in it. That's innovation and productivity.  

Apple makes great products that people want. The iPhone was a quantum leap in functionality over what Blackberry, Motorola and Nokia had on the market at the time;  the iPad succeeded as a tablet where dozens of other companies had failed.  The hundreds of millions of people who use them are better off for Apple's innovation.

The economist William Nordhaus has analyzed from time to time in the course of his career how little profit entrepreneurs capture from their innovations and how much benefit leaks away from them to the larger society.  As one author sums up his work, "Entrepreneurs typically generate a surplus benefit above and beyond the profits they reap, finds the eminent Yale University economist William Nordhaus. Nordhaus has calculated that entrepreneurs capture only about 2 percent of this surplus, with the remainder passed on to society in the form of jobs, wages, and value." Here is a link to a more detailed explanation of Nordhaus' work in this area.

And, yes, Apple has a giant cash hoard.  But you look at the turbulence in market share in its principal market over the past decade, you look at the bankruptcies or near bankruptcies of Ericsson, Northern Telecom and many other telecom players, the ongoing financial disasters at Nokia (losing billions each year) and RIMM (barely alive), who led the industry just ten years ago, and it is hard to figure out exactly what is the right amount of cash that a responsible fiduciary can say is enough in this industry.  And the GM of the 1950's?  Well, as we all know, they were bankrupted and liquidated in 2009.   And I wonder if, deep down inside,  that isn't what Krugman's agenda really is, the destruction of capital to satisfy a progressive agenda.

But, a progressive would ask, how much should Apple's owners be rewarded for its productivity? What's a "fair amount" or a "fair return"? I couldn't independently come up with one and I don't know who could; all I know is that in the 90 days of Q113, 61 million times someone chose to enter into a transaction that rewarded them $299, or $499 or $699 or whatever for an iPhone or iPad or iMac and, as between 61 million individual consumer decisions and a guy who won a Nobel Prize in Economics for largely unrelated work thirty plus years ago, the judgment expressed in those 61 million decisions is a better guide.

Questionable Ruling in SEC Lawsuit at Odds with How Securities Offerings Are Put Together

In the civil lawsuit being pursued since 2010 by the SEC against a lone Goldman Sachs employee, Fabrice Tourre, alleging "intentional and neglectful misrepresentations" in relation to the ABACUS 2007-AC1 CDO that he worked on, District Judge Kathryn Forrest issued an odd ruling last week that warrants some attention from practitioners in securities offerings.

As part of a barrage of motions in limine, the SEC filed a motion to preclude Tourre from "offering evidence or argument at trial that he reasonably relied on advice of counsel, the legal background of his co-worker, David Gerst, or the institutional processes in place at Goldman Sachs & Co."  Tourre's counsel responded by noting the obvious:

1) Tourre was not a lawyer, but actually an engineer by training, and had no independent basis to judge what was or wasn't required to be disclosed, or in what particular form something had to be disclosed, for an offering to meet the securities laws;

2) Gerst had been trained as a lawyer, and had joined Goldman from a leading securitization firm, McKee Nelson, where he had worked on other ABACUS transactions;

3) there was a "division of labor" among the Goldman employees working on the trading desk with Gerst, taking responsibility for "documentation and execution of transactions and liaising with internal and external counsel" while Tourre worked on "the risk and economics" of the desk's business;

4) the offering documents were in fact reviewed by numerous individuals at internal and external counsel and Gerst was the person on the desk responsible, as far as Tourre knew, for that process, in which no one has been yet discovered who suggested the disclosure was inadequate; and

5) telling these facts to the jury was useful to enable them to evaluate the SEC's allegations that Tourre had "intentionally and neglectfully" made misrepresentations or omissions in the course of the offering.  In other words, the way in which the deal was put together and the roles of Tourre and others was relevant to the SEC's allegations.

Anyone who has worked on securities offerings of any complexity recognizes this paradigm.  There are always bankers or traders making high-level business decisions about the material terms of the offering and then there are different people, internal and external lawyers, and sometimes other professionals, whose job it is to prepare the offering documents and make sure they conform to applicable securities laws. That division of labor is customary and, like most divisions of labor, efficient.  It matches people's skills to required tasks; lawyers don't do auditors' work or price deals, and the business people don't write legal documents or do other legal tasks for which they are not qualified. In most cases when I worked with "a desk", there was someone on the desk who was a former lawyer who was the main contact for outside counsel on the documents and other legal subjects, and then communicated between the rest of the team on the desk and outside counsel to get major questions or issues resolved in the course of structuring and negotiating the deal.  Only occasionally would the former lawyer be joined by his or her business colleagues on calls with lawyers about the documents; the company they all worked for had hired the documentation person to fulfill that task more effectively.

In the lawsuit against Tourre, the SEC seems to disagree with that practice. It alleged that Tourre was "principally responsible" for the CDO, an allegation that is somewhere between vague and simplistic, on the one hand, and utterly absurd, given the size of Goldman Sachs, its internal processes for doing a deal, and the number of outside lawyers involved in the CDO.  The SEC goes on to argue that "a corporate executive has ‘an independent duty to ensure compliance with disclosure obligations.’”. Tourre pointed out that he was hardly a "corporate executive" at Goldman and the legal authority for that proposition was a case against a CEO and CFO concerning proxy statements they had signed  -- a very different, Sarbanes-Oxleyish level of responsibility compared to a guy working on a desk who has a lawyer next to him who he thinks is responsible for documentation.

In my view, Judge Forrest should have denied the SEC's motion to preclude Tourre from telling the jury these facts.  They are clearly relevant to the allegation that Tourre was "principally responsible" for the transaction and also the allegations about Tourre's "intent" and "neglect"; simply put Tourre thought someone else, more qualified than him, was responsible for disclosure documents, which, in my experience, is an incredibly reasonable understanding. And how reasonable what he thought was seems quite relevant to the jury evaluating his intent and neglect.

Instead, Judge Forrest seems to have become confused and mistakenly framed the issue as whether Tourre was claiming to invoke an "advice of counsel" defense: "Much of that testimony would be irrelevant, given Tourre's intention not to present a reliance on counsel defense".  He admitted he wasn't claiming that defense.  The elements of that defense are several-fold and mostly inapplicable to the ongoing, multi-day process of constructing a complex deal; they are geared to a situation in which someone expressly poses a very specific discrete question to a lawyer to get advice.  But that was not the correct way to frame the question.  It's not a "defense" that Tourre has "to present"; how a transaction gets put together and who does what on it are evidence relevant to the plaintiff's allegations about his personal role in the transaction and his intent or neglect. It bears on the case in chief, and thus should not be boxed into an affirmative defense.  The judge seemed not to get that. Instead, she expressed concern that explaining "the presence and involvement of lawyers - who are presumably paid to ensure that any disclosures comply with the relevant legal requirements" might confuse the jury into thinking that lawyers "blessed" the documents.  But that wouldn't be confusion at all, since that is exactly what the lawyers were supposed to do!

It's a surprisingly confused ruling, considering the judge was a partner at Cravath for 10 years at one point in her career ( I have no idea how often she actually went to trial, though).

I raise it not only for the injustice it does to a junior banker like Tourre in this specific lawsuit but also because it sets a terrible precedent for non-lawyers working on securities deals in the future.  If it stands, a banker "primarily responsible" for the transaction, even though not a lawyer, or CEO, director or CFO covered by Sarbox, can be sued personally for any misrepresentations or omissions in an offering, and precluded from defending himself or herself by saying the responsibility for preventing those tasks was delegated to the lawyers. That would keep a lot of bankers up at night and make for very inefficient expenditures of time and money making an explicit record that the lead banker actually had detailed conversations with outside counsel and was told the documents were OK, when everyone knows that is their job in the first place.

There is no Evidence that Unsecured Recoveries in Chapter 11 are Diminishing (Part 6: Miscellaneous Questionable Methodological Decisions)

This is the 6th and last in a series of blog posts that analyze an argument, being presented to an American Bankruptcy Institute commission on reform of the Bankruptcy Code, that the recoveries of unsecured creditors are somehow declining due to the purported imbalance in favor of secured creditors. The argument relies heavily on a law journal article published two years ago by a law student named Andrew A. Wood working under the tutelage of Professor Lynn LoPucki at UCLA. So far, I have shown how the article contains, and thus the argument is based on, incredibly unreliable and error-riddled data; that the sample sets being contrasted are not properly comparable because they cover different lengths of time and different economic conditions; that the purported increase in the use of second lien debt in capital structures cannot be shown to have had any adverse effect on unsecured recoveries; that valuation and intrinsic business merit have much more to do with any decline in any constituency's recoveries; that the author's failures, when tabulating unsecured recoveries, to comprehend structural subordination and to take into account payments outside of the chapter 11 plan, results in a misleading depiction of lower recoveries than actually occurred.  In this post, I will list three more methodological choices embedded in Wood's article that cause his tabulation of unsecured creditor recoveries to be understated.

Failure to Record Post-Petition Interest Recoveries

Neither LoPucki’s nor Wood’s study reports a recovery for unsecured creditors higher than 100%.  But occasionally creditors receive post-petition interest; depending on the length of the case, it can be significant.  Among the cases in Wood’s sample, several cases involved substantial post-petition interest.  I have already mentioned Six Flags, where the debt holders at the operating subsidiaries received payments in satisfaction of a post-petition interest claim that boosted their recovery to 110% of par by my estimation. Pilgrim’s Pride and Cooper-Standard both paid post-petition interest that increased noteholders’ recoveries, by my estimation to 108 and 106 of par.   Chemtura not only allowed unsecured noteholders’ claims for about 18 months of post-petition interest but also satisfied a make-whole claim that appears to have raised recoveries by the noteholders asserting it to over 120% of par. Recording those unsecured creditors’ recoveries correctly would, of course, boost the average recovery for senior unsecured noteholders in Wood’s table.

Calculating Averages Based on the Number of Cases

It seems odd that Wood calculates bottom-line recovery percentages by taking a simple average, assigning equal weight to every case, even though some cases are much larger than others. Here, large companies like Lear, Visteon, Idearc, Smurfit and Six Flags are mixed with much smaller ones that have one-tenth or less as much debt or enterprise value.  And full recovery cases Wood ignored, like GGP, are so large relative to the rest of the sample, that were recoveries to be weighted, they would likewise significantly increase the average recovery across the sample. In general, Wood’s approach appears to bias the average recovery downward, as larger businesses tend to do better in chapter 11 than smaller ones.  If an unbiased analyst were trying to assess real world impact of laws, he or she would be inclined to give more weight to the cases with the biggest impact on the constituency in question. 

How Much Weight Should be Accorded Valuation Estimates In Disclosure Statements? 

Many of the  recovery estimates used by LoPucki and Wood come from recovery estimate tables in disclosure statements, which in turn are frequently based on an investment banker’s valuation of a reorganized debtor’s projected equity value, a valuation that is often prepared several months before emergence.  We know those are not always perfect predictors of the actual value of that equity in the future.  For example, the equity issued in the Six Flags case has performed extremely well post-emergence and a real-world assessment of recoveries in that case ought to take that real-world performance into account.  For another example, the stock of Charter Communications traded immediately after emergence at nearly twice the price paid for it in the rights offering under the plan, resulting in substantially higher returns for those creditors who subscribed to the offering than the “13%” estimate contained in the disclosure statement – prepared 6 months earlier.[1]  For a third, the stock in Lear Corporation received by the one impaired class of unsecured creditors under its plan was also much more valuable than the disclosure statement anticipated; Lear’s February 14, 2013 press release says it has “[d]elivered superior returns to stockholders relative to both the S&P 500 and the Automotive Peer Group since November 2009 when Lear resumed trading on the New York Stock Exchange following its emergence from bankruptcy.  In addition, since November 2009 the Company's equity market valuation has more than doubled.”

At its February 21 hearing, the ABI commission heard Professor David Smith reference research that, in recent years, post-emergence equity tends to carry a higher value than estimated in the related disclosure statement, contrary to trends  in the 1980’s and 1990’s.  A recent article, “The Bankruptcy Discount: Profiting at the Expense of Others in Chapter 11 ” by Mark T. Roberts, in the Summer 2013 ABI Law Review, likewise argues, from a sample of 48 large cases in the 2005-2011 period, that disclosure statements contain enterprise valuations that are 12% - 20% lower than implied by public market valuations of comparable companies.[2]  The Wood article does not make any attempt to investigate or correct for that error. To be fair to the student-author, he was probably not aware of these views at the time he wrote his article, but one would expect any future discussion of reform to incorporate all the information available to it.

---

[1]           See Petition for Certiorari, Law Debenture Trust Co. v. Charter Communications, Inc., Dkt 12-847 (Jan 10, 2013) at 5 n.2 (citing CCI 2009 Form 10-K Annual Report F-13 (Feb. 26, 2010), CCI S-1 Registration Statement, at item 15 (Dec. 31, 2009), with CCI 2010 Form 10-K Annual Report 31).

[2]           Roberts’ article does not show the full detail of his calculations so is difficult to critique. But even without access to all his work, one can note that (1) his definition of “comparable companies” is mechanistic and even naïve; (2) a valuation prepared in accordance with accepted valuation practice inherently goes beyond a mechanistic derivation from mechanically determined comps; (3)  newly reorganized companies may systematically have higher costs of debt than those whose solvency is unquestioned, driving a DCF valuation down versus comps; (4) a newly reorganized company may have different banking relationships than the rest of its industry; and (5) he does not explore  to what extent the valuations of his control group are driven up by technical factors present in the public equity markets but not much found in chapter 11 (retail interest; issuer buybacks; index fund buying; margin-fueled demand) .  Finally, in his case study of the Chemtura settlement, which he characterizes as taking $280 million from equity, he completely overlooks the consensual reduction in claims that were part of the settlement that created solvency, and fails to consider whether those  reductions would have been smaller if the estate had been valued higher.

There is no Evidence that Unsecured Recoveries in Chapter 11 are Diminishing (Part 5: Changes in Subordination Methods and Use of First-Day Orders)

This is the 5th in a series of blog posts that analyze an argument, being presented to an American Bankruptcy Institute commission on reform of the Bankruptcy Code, that the recoveries of unsecured creditors are somehow declining due to a purported imbalance in favor of secured creditors.  The argument relies heavily on a law journal article published two years ago by a law student named Andrew A. Wood working under the tutelage of Professor Lynn LoPucki at UCLA.   So far, I have shown how the article contains, and thus the argument is based on, incredibly unreliable and error-riddled data; that the sample sets being contrasted are not properly comparable because they cover different lengths of time and different economic conditions; that the purported increase in the use of second lien debt in capital structures cannot be shown to have had any adverse effect on unsecured recoveries; and that valuation and intrinsic business merit have much more to do with low recoveries than inter-creditor balance does.   In this post, I will show that the Wood article's portrayal of declining unsecured recoveries results in large part from a sadly unsophisticated grasp of corporate finance and chapter 11 practice; more specifically, it omits from the tabulation of unsecured creditor recoveries all recoveries that occur outside a plan (for example under first-day orders), and it fails to comprehend that unsecured recoveries can vary based on structural subordination.

Likely Misclassification of “General Unsecured Creditors”

Wood has broken out “unsecured creditors” into multiple categories, as LoPucki did in his earlier article. Those categories are “Senior Unsecured”, “General Unsecured”, “Senior Subordinated” and “Junior Subordinated”.  Partly because there is no single classification regime that proponents have to follow in chapter 11, and partly because, I suspect, neither Wood nor LoPucki had much experience in negotiating chapter 11 plans, I fear that there may be significant mis-classifications in both studies, particularly between “Senior Unsecured” and “General Unsecured” which may have affected Wood’s calculations of average recoveries.   Wood states that he follows LoPucki’s earlier work in treating “all unsecured creditor classes to be general unsecureds unless words suggesting different priority, such as ‘subordinated,’, ‘junior’ etc.] were used” (Wood, p. 433).  That definition completely ignores, or obscures, the fact that, in cases involving multiple debt issuers within the same corporate family, absent substantive consolidation, unsecured creditors at different debtors may have different recoveries. In particular, where a holding company exists, debt issued there often has significantly lower recoveries than unsecured claims at one of its operating subsidiaries may have. Practitioners refer to the holding company’s debt as “structurally subordinated”.  However, Wood’s table of recoveries does not consistently distinguish and categorize the kind of unsecured claims that can be considered “general unsecured” – trade debt, senior unsecured notes and so on.  Sometimes he puts senior unsecured notes in the “general unsecured claims” bucket; sometimes he records recoveries only by one set of notes in a corporate structure with elements of structural subordination; and sometimes he ignores the notes’ recoveries altogether. 

His data for recoveries in the Lear Corporation case illustrate this inaccurate and inconsistent labeling.  His table shows a recovery of 100” for “Senior Unsecured” creditors and a recovery of “36-42%” for “General Unsecured”.  But Wood has misunderstood the classification of unsecureds in that case and as a result substantially mischaracterized the various constituencies’ recoveries, as I confirmed by examining the recovery table on page 15 of  the disclosure statement (docket 634).[1]  First, two groups of unsecured creditors recovered 100%: “Ongoing Operations Unsecured Claims” against the “Group A Debtors”, estimated to be $410 million; and “General Unsecured Claims” against the “Group B Debtors”, estimated to be $285 million. Second, “General Unsecured Claims” against the “Group A Debtors” estimated at $2.104 billion, were indeed estimated to receive 42%, but that class consisted almost entirely of (a) credit agreement deficiency claims totaling $737 million and (b) unsecured bonds totaling $1.29 billion.  Substantially all of the quintessential “general unsecured” creditors of Lear received a 100% payout.[2]  Worst, there was no class of unsecureds that received the “36%” payout included in Wood’s table; rather, that figure was erroneously copied by Wood from the liquidation analysis for general unsecured creditors of the Group B Debtors. 

An equally significant flaw with Wood’s table is its failure to recognize differences in unsecureds’ recoveries stemming from “structural subordination”.  I found numerous instances in Wood’s 42 cases where structural subordination of unsecured debt occurred but went unacknowledged, such that the structurally subordinated debt was classified as “senior unsecured” or “general unsecured”, even though there were significant disparities between recoveries of unsecured creditors at different levels of the corporate structure.  Cooper Standard, R.H. Donnelly, Simmons Bedding, Primus Telecommunications, NTK, Six Flags, and Charter Communications are all cases that I have discussed in earlier posts in which some class of structurally subordinate unsecured debt recovered less than more structurally senior unsecured creditors.  The occurrence of this phenomenon is so frequent that it ought to have been separately reported and analyzed. 

Further, notwithstanding the definition Wood recites, when I look at LoPucki’s study of 1991-1996 cases, I see a surprisingly large number of “100%” recoveries by “general unsecured creditors”, leading me to suspect that those are mostly trade and other claims that are not on account of long-term debt that happens to be unsecured.  I am skeptical that unsecured debt in those cases was consistently and accurately classified, given that it was not properly analyzed in the 2009-10 sample.  Instead, there may be substantial errors in, or inconsistencies between, the two studies in regard to how they classify unsubordinated unsecured debt when there are multiple debtors.  There is simply no way to tell if the studies are comparable, apples to apples, or even if similar claims are categorized consistently within the same study.  Thus, none of the bottom-line figures – whether they be “77%”, “53%” or 45” – are reliable.

I suspect that, were someone to have access to all the 1991-96 cases, one would see that a good bit of the purported difference in recoveries between the two eras can be explained just by this classification approach: the LoPucki study happened to cover an era with more instances of contractually subordinated unsecured debt, which, being junior, tended to have lower recoveries.  So, when his table segregated that kind of debt from the so-called “General Unsecured” category, arithmetically the latter showed a higher apparent recovery.  Whereas Wood, likely unaware that recent capital structures have comparatively little contractually subordinated debt but a meaningful amount of structurally subordinated debt,  has blindly applied the older taxonomy, unknowingly lumping a different kind of subordinated debt into the general unsecured category and thereby diluting that category’s recoveries.  But to prove that out would require one to examine all of the 1991-96 cases to see how each class of general unsecured was categorized, a task beyond the scope of this paper. 

At a minimum, the issue of failure to account for different modes of subordination consistently between the two studies illustrates how unreliable the two studies are, relative to how practitioners negotiate and understand the terms of chapter 11 plans. Further, stepping back from the errors, omissions and inconsistencies, a question is raised as to whether recoveries of unsecured creditors at a holding company that has no operating creditors and no secured debt are even relevant to the contention that secured creditors are usurping general unsecured recoveries.

Omission Of Other Payments To Unsecured Creditors. 

As practitioners know, there are numerous ways that unsecured creditors recover in chapter 11 cases that don’t show up in the recovery estimate tables in a disclosure statement.  There are payments of critical vendors; assumption of executory contracts and unexpired leases; and priorities of various priority claims for employees and retirees pursuant to first-day orders, to mention what are probably the largest ticket items.  There are many situations both under plans and in 363 sales where unsecured creditors “ride through” unimpaired economically, being assumed by the reorganized debtor or the acquirer.  Also, there are many situations in which an unsecured claim is insured, by a liability policy, for instance, or a letter of credit.  For example, in the first Journal Register case, where the debtor reported accounts payable of less than $19 million in its last 10-K before filing chapter 11, its newsprint supplier was owed approximately $2.7 million at the petition date, yet held a $3 million LC, according to the company’s critical vendor motion (docket 15).  Neither the LoPucki nor the Wood article includes any data or estimates about the recoveries unsecured creditors received through non-plan channels.

In many of the cases Wood sampled, I was struck by how small the “General Unsecured” class was under the plan.  Often it was a small fraction of the claims in the case, so small sometimes that it made no sense as a financial matter.  Most notably, in R.H. Donnelly, the General Unsecured class was only $19.5 million, according to the final disclosure statement (docket 463).  For a company with about $10 billion in funded debt, it is implausible in the extreme that they would only have $19 million in payables and other accrued liabilities. In fact, in its last 10-K before filing, RHD showed accounts payable and accrued liabilities of $216 million, 1100% greater than the Disclosure Statement figure.

Taking a case from the pool of low-recovery cases, I looked at Pliant and found it was similar. Pliant listed $93 million of accounts payable on its last 10-K balance sheet  before filing.  But the disclosure statement estimated the general unsecured pool at only $17 million. 

Something has to have happened during those cases to the rest of the accounts payable and similar liabilities.  The discrepancies are so large that further research is warranted into what happened to the rest of the general unsecured liabilities during those cases and the others of the 2009-10 vintages.  I suspect deeper research will show they were mainly taken care of through one or another of the methods I have mentioned above and likely received par or something very close to it.  For example, in Pliant, the debtor was authorized by the court’s order granting the critical vendor motion (docket 47) to pay up to $29 million in critical vendor claims --  almost double the amount of general unsecureds it identified in the disclosure statement.  If  $29 million in unsecured claims received payment in full outside of a plan, and $17 million received 17.5% under the plan, was the case in Pliant, then the unsecured recovery in the case, as opposed to the plan, was 69.5%, a radically different number than Wood’s table shows for that case.

Similarly, Building Materials was a case with recoveries estimated to fall in between Pliant and R.H. Donnelly, so I looked at payouts outside the plan there as well.  Its critical vendor motion was granted for up to $15 million in payments, while its total pool of unsecured creditors, according to the “best interests” analysis done by Peter J. Solomon and appended to the disclosure statement, shows less than $100 million in unsecured claims, so the actual recovery by unsecureds there was substantially higher than the 55% shown in the disclosure statement.

If other cases show similar facts, that would have significant repercussions for the thesis that unsecured creditors are somehow getting a bad deal in chapter 11’s.  It may be that, like drunks looking for their keys under a lamppost (because that’s where the light is), researchers have been looking for general unsecured recoveries in disclosure statements, because that’s where the recovery estimates are published, while in each case the real explanation for the apparent decline in unsecured recoveries may lie elsewhere on the docket.  It may well be the case that much of the purported difference in recoveries between the two samples in Wood’s article can be traced to the greater use of critical vendor and similar motions in the more recent sample.  And persons seeking to improve the lot of unsecured creditors in chapter 11 cases can either rest easier knowing their concerns are misplaced, or simply codify the judicially well-accepted practice of critical vendor and similar first day orders and ensure the result occurs in all districts and not just the most experienced ones.

There are many more avenues for unsecured creditors to be paid in chapter 11:  insurance, letters of credit, cure payments, statutory priority, etc.  While some of the methods for paying unsecured creditors outside a plan reflect choices made by prior bankruptcy legislation, all ought to be taken into account to assess the relative treatment of secured vs. unsecured creditors in the real world as opposed to uninformed academic studies or agenda-driven reform efforts based on statistical garbage as opposed to real fact.

---

[1]           Bizarrely, Lear is one of the cases for which the UCLA-LoPucki Bankruptcy Research Database contains a figure for unsecured creditors’ recovery (56.4%) that is reasonably accurate  if one blends all unsecured claims and recoveries into one pot.  That the database was right to begin with makes it even harder to understand Wood’s deviation from it.

[2]           In addition to those recoveries, a further $100 million was paid out to unsecured creditors under “first-day” orders as well. It should also be noted, in evaluating the “42%” recovery estimate for the one impaired class, that, according to Lear’s February 14, 2013 press release, “since November 2009 when Lear resumed trading on the New York Stock Exchange following its emergence from bankruptcy … the Company's equity market valuation has more than doubled.”

There is no Evidence that Unsecured Recoveries in Chapter 11 are Diminishing (Part 4: Valuation Differences)

This is the 4th in a series of blog posts demonstrating flaws in an argument that the Bankruptcy Code needs to be reformed to restore some purportedly lost balance between secured creditors and unsecured creditors.  In the prior posts, I demonstrated that the thesis that unsecured creditor recovery in chapter 11s has declined in recent years is based on incredibly shoddy data that is far too unreliable to support the reform agenda, and that the purported increase in second lien debt cannot be the cause of the purported decline. In this post, I lay out two valuation-related points:  1) that the two sample sets that were compared to make the argument of a decline in unsecured recoveries are not properly comparable because they cover different lengths of time and different economic environments;  and 2) any decline in recoveries is driven much more by valuation and intrinsic business merit than by the mix of secured versus unsecured debt.

Mismatched Sample Periods

Wood has chosen to analyze reorganizations that took place over a shorter period of time – 2 years – vs. the 6 years in the LoPucki study.  This makes for a highly misleading comparison. This misleading comparison is partly responsible for the purported differences in recoveries.

First, the earlier period had much more economic growth than the 2009-2010 time period. In nominal GDP terms (nominal because the debt of a chapter 11 debtors is quantified in nominal dollars, not inflation-adjusted dollars),  nominal GDP was more or less the same at the end of 2010 as it was at the end of 2008, the period Wood studies, while it rose at an average rate of more than 5% per annum over the 1991-96 period.

More significantly, the Lopucki study measures recoveries during a 6-year bull market, but Wood only studies 2 such years.  The S&P 500 index stood at 330.22 at January 1, 1991, the outset of the period covered in the “Lopucki study”, and rose to 740.74 by the end of that period, December 31, 1996  -- a 124% increase.   In contrast, from its January 1, 2009 level of 903.25 to its December 31, 2010 close at 1257.64, the same index only rose 39%, slightly less than one-third the increase in value that occurred over the period of the Lopucki study (which is understandable given that the Lopucki study period was three times as long). Both periods had roughly the same IRR – 18%.  The only difference is that the 18% IRR runs for 6 years in the sample with the higher recoveries, in contrast to only 2 years in the one with lower recoveries. Since valuations performed by investment bankers for disclosure statements reference comparable public companies explicitly (and also rely on analyses such as discounted cash flow and comparisons to acquisitions of similar companies that implicitly reflect public market valuations), the 1991-96 period is going to have higher average valuations in it than the 2009-10 period.  That’s all. There was no imbalance in the Bankruptcy Code at work.  Recovery differences were just a function of compounding over a longer period.

I can understand why a student graduating in 2011 would not be in a position to wait four more years to publish research.  But there is no excuse for his professor, or the editors of the American Bankruptcy Law Journal, or Gotbaum, to disseminate such obviously half-baked work as remotely reliable, let alone a basis for fundamental legislative changes.  It’s ridiculous to draw any inferences from comparing a six-year period of 18% IRR to a two-year period of 18% IRR.

Wood is not blameless, though. He conspicuously ignores recoveries during intervening periods, for example, the 2001-02 wave of restructurings.  But there was some data readily available to him for that period, right in the Lopucki study. In footnote 70 of that 2003 article, LoPucki wrote that a preliminary study showed unsecured creditors were experiencing substantial declines in recoveries in 2001 and 2002, compared to the 1991-96 data set.  In the 90’s, he stated, unsecured creditors received full recoveries in 59% of the cases, and only 27% of the time did they recover less than half of their claim.  But in 2001-02, he stated, the proportions were essentially reversed, with unsecured creditors recovering less than half their claim 62% of the time, and getting par only 25% of the time.  Wood does not make any use of the 2001-02 data.  Had he done so, he would have recognized that recoveries for unsecured creditors in his 2009-10 dataset were actually better than those in the 2001-02 cases, with unsecureds recovering less than half their claim only about 53% of the time (adjusting for errors Wood made in several cases).  That completely vitiates his thesis that recent recoveries are being affected by recent increases in the use of secured debt.  But the fact that both 2-year samples showed lower recoveries than the 6-year sample obviously confirms that the difference in recovery is in part attributable to the length of the sample. 

It’s Valuation,  Not the Mix of Secured Debt.

I think most practitioners familiar with the cases in Wood’s sample can tell that the recoveries would not have changed much had there been less secured debt.  Every one of the 25 companies with below-par recoveries for unsecureds, save possibly Spansion, had a debt/EBITDA ratio of over 10:1 when it filed chapter 11.   That’s going to affect recoveries.  In fact, in contrast to the typical bell-curve distribution one would typically see in a sample, the cases he cites tend to fall into a barbell pattern of two groups with extreme results:  100% recoveries and very low recoveries.  That shows the proportion of secured debt was largely irrelevant to unsecureds’ recoveries.  Only a small minority of the cases wind up with sizable but still below par recoveries to unsecureds. 

Several of the companies come from industries that bore the brunt of the “Great Recession” like auto (Hayes Lemmerz, Lear and Visteon, each of which also had large pension and OPEB liabilities that I didn’t include in the debt/EBITDA ratio), and housing (WCI, Building Materials, LandAmerica and Luminent, the last two of which were basically out of business even though they had little secured debt).  Valuations of those companies were dramatically affected by the depressed condition of their respective industries. 

Secular changes in the media industry drove ION Media, Idearc, Readers’ Digest, Young Broadcasting and Journal Register into reorganization, and pre-petition secured claims were badly haircut in all of them. Some companies in the sample had badly shrunken or even negative cash flow and, again, the secured lenders were badly haircut in each of those (VeraSun, Linens, MagnaChip, Aleris). 

A surprising number of the filings either were chapter 22s (Bally’s, Hayes Lemmerz, Pliant) or, since emergence, the debtors have filed again (Idearc, Reader’s Digest, Buffets, Journal Register), indicating that there were fundamental problems with their businesses that impaired their value even with de-levered capital structures, i.e., independent of capital structure.

Ignoring Secured Creditor Recoveries. 

Neither the LoPucki study nor the Wood article tabulates secured creditor recoveries.  By ignoring them, Wood and LoPucki deprive the reader of essential data with which to evaluate the hypotheses that secured creditors are somehow taking more value from unsecureds than in past eras. There’s no way one can determine that declines in valuation are not responsible for declines in recoveries for unsecureds and equity, without examining what happened to recoveries for the secureds in those cases.  It is clear from Wood’s data, taking it at face value, that the recoveries for every constituency that he chooses to look at have declined.  So what happened to the secured creditor recoveries that he chooses not to examine? An analyst needs to know that to figure out if the decline was valuation-driven, or if the secureds were simply capturing more of the value. The only correct way to decide which is at work is to include an analysis of  secured debt recoveries in the 1991-96 time period and then compare the results to secured debt recoveries in the more recent time period.

Still, the declines in equity recoveries are instructive if one is trying to get a handle on causation of declines in recoveries.  Even if one subscribes to the dogma that secured debt takes away from unsecureds’ recoveries and blames increases in the former for declines in the latter, one must recognize that secured debt does not take away from equity any more than unsecured debt does, so shifts in the mix of secured debt vs. unsecured debt should not change equity recoveries (yes, if you are a good soldier in the war against secured creditors, you can conjure up Rube Goldbergian sequences of causation, where being secured makes a lender act differently and that changes the case dynamics and that causes losses, but in the real world, no: it’s valuation that determines the recoveries.). Since Wood’s data show declines in equity recoveries, so it seems fairly obvious that there is another explanation for pervasive declines throughout the capital structure, i.e., valuations were different.

In sum, even if declines in unsecured recoveries have happened, and are not the result of bad data, or artifacts of methodological decisions or mistakes, one cannot explain them with confidence as the result of developments in secured debt, if one has not analyzed the recoveries of secured debt!  This seems incredibly obvious but is completely missing from the Wood analysis.  However, an understanding of the specific business dynamics of the cases in his sample informs one that the quantity of secured debt was irrelevant in many cases to unsecureds’ recoveries.