Tuesday, June 16, 2015
The decision issued yesterday by Judge Thomas Wheeler of the Court of Federal Claims concerning the lawsuit by Starr International, a large shareholder of AIG, will have significant implications for the similar claims brought by various shareholders of Fannie Mae and Freddie Mac (hereinafter, the "GSEs"). I've previously put up a post critical of the trial judge's Fifth Amendment reasoning in certain of those lawsuits.
There are definitely some similarities between the two and they should be worrisome to the government and heartening to the GSE shareholders. For example, Judge Wheeler refers to the Federal Reserve taking a 79.9% stake in AIG equity (in the form of convertible preferred) as "draconian", writes that the government "usurped control of AIG without ever allowing a vote of AIG's shareholders" and notes that, even after the loan was repaid, the government retained its stake. Of course those facts are all identical to the government takeover of the GSEs.
But I see some significant differences as well. Judge Wheeler makes a very significant ruling under the Fifth Amendment, using a theory that, frankly, I was heretofore unaware of, that of "illegal exaction". In short, he concludes that, while the Fed was authorized by law to provide credit to AIG, it did not have the authority to exact, as a price for such credit, a 79.9% equity stake in AIG. "An illegal exaction occurs when the Government requires a citizen to surrender property the Government is not authorized to demand as consideration for action the Government is authorized to take." It is fascinating that there is language directly on point from an 1884 Supreme Court opinion, Swift & Courtney & Beecher Co. v. United States, 111 U.S. 22, 28-29 (1884) (“The parties were not on equal terms. . . . The only alternative was to submit to an illegal exaction or discontinue its business.”). Judge Wheeler also rejects the argument that the emergency context augmented the government's legal power or diminished the citizens' Fifth Amendment rights:
"The Government’s inability to require forfeiture of rights and property in exchange for discretionary benefits is unchanged during times of crisis, when the rule of law is maintained by requiring that government acts be authorized by statute and the Constitution. Home Bldg. & Loan Ass’n v. Blaisdell, 290 U.S. 398, 425-26 (1934) (“Emergency does not create power. Emergency does not increase granted power or remove or diminish the restrictions imposed upon power granted or reserved. . . . ‘Although an emergency may not call into life a power which has never lived, nevertheless emergency may afford a reason for the exertion of a living power already enjoyed.’”) (quoting Wilson v. New, 243 U.S. 332, 348 (1917)); Youngstown Sheet & Tube Co. v. Sawyer, 343 U.S. 579, 653 (1952) (Jackson, J., concurring) (“In view of the ease, expedition and safety with which Congress can grant and has granted large emergency powers, certainly ample to embrace this crisis, I am quite unimpressed with the argument that we should affirm possession of them without statute. Such power either has no beginning or it has no end.”)"
Of course, that makes sense - the government can always take property to address an emergency or otherwise; it just has to pay just compensation when it does so.
Somewhat counter-intuitively, Judge Wheeler proceeds to quash Starr's takings claim, because, he says, a "taking" only occurs if the government's action is authorized; here, he says, since the exaction was "illegal", it was unauthorized. This is purely a matter of semantics: either label says the government took property from private persons in violation of the Fifth Amendment. But, as I show in my discussion below of the GSE takeover, the statutory foundation for the government to take a controlling equity stake in them is better than the Fed had in the AIG context. Still, as I argued last year, a statutory foundation cannot, given the Supremacy Clause, relieve the government of its Fifth Amendment constraints. It still has to pay just compensation for taking, even if the taking is authorized and a true emergency exists.
However, the specter of imminent bankruptcy causes the judge to determine that AIG shareholders sustained no economic loss from the illegal government action and therefore are due no further amount of "just compensation". He writes:
"Common sense suggests that the Government should return to AIG’s shareholders the $22.7 billion in revenue it received from selling the AIG common stock it illegally exacted from the shareholders for virtually nothing. However, case law construing “just compensation” under the Fifth Amendment holds that the Court must look to the property owner’s loss, not to the Government’s gain. Brown v. Legal Found. of Wash., 538 U.S. 216, 235-36 (2003) (The “‘just compensation’ required by the Fifth Amendment is measured by the property owner’s loss rather than the [G]overnment’s gain.”); Kimball Laundry Co. v. United States, 338 U.S. 1, 5 (1949) (“Because gain to the taker . . . may be wholly unrelated to the deprivation imposed upon the owner, it must also be rejected as a measure of public obligation to requite for that deprivation.”); United States v. Miller, 317 U.S. 369, 375 (1943) (“Since the owner is to receive no more than indemnity for his loss, his award cannot be enhanced by any gain to the taker.”); Boston Chamber of Commerce v. Boston, 217 U.S. 189, 195 (1910) (Holmes, J.) (“And the question is, What has the owner lost? not, What has the taker gained?”)"
And then he finds that the shareholders, had the government not intervened, would have lost everything. So there is no further compensation required. In doing so, he draws close parallels to the Takings cases brought by various auto dealers whose franchises were terminated as part of the restructurings of GM and Chrysler, in which the Federal Circuit opined: " Absent an allegation that GM and Chrysler would have avoided bankruptcy but for the Government’s intervention and that the franchises would have had value in that scenario, or that such bankruptcies would have preserved some value for the plaintiffs’ franchises, the terminations actually had no net negative economic impact on the plaintiffs because their franchises would have lost all value regardless of the government action."
It's an interesting question whether a judge should opine on a liability issue when damages under the plaintiff's theory are going to be zero. Recently, in her Marblegate opinion, Judge Failla, SDNY, did the same thing, opining that an insolvent company's proposed out-of-court restructuring violated the Trust Indenture Act of 1939, even when she found, as a fact, that the complaining bondholders would receive no value if the restructuring failed and the company entered bankruptcy. So Judge Wheeler is not alone. I still am not sure it is the best practice under Article III, but I gather that appellate courts want the trial court to cover everything to avoid piecemeal litigation, so it may be just a fact of life in our legal system.
Comparison to the GSE Takings Lawsuits
There are a few distinctions between the AIG opinion and the litigation challenging the government's takeover of publicly-traded Fannie Mae and Freddie Mac. First, the government's financial support of the GSEs came from the Treasury Department, not the Federal Reserve system; so a different statute was involved. The statute (the Housing and Economic Recovery Act of 2008) established the Federal Housing Financing Agency (FHFA) as an "Independent agency" and authorized it to become conservator or receiver of the GSEs and in such role, to “immediately succeed to—(i) all rights, titles, powers, and privileges of the [GSE], and of any stockholder, officer, or director of such [GSE] with respect to the [GSE] and the assets of the [GSE].”
Second, the equity stake Treasury took in the GSEs was a combination of preferred stock and warrants to buy 79.9% of the common stock; the stock itself was not convertible. as in AIG. This may or may not be a matter of form; one legal consequence was that the Treasury Department did not vote a formal 79.9% equity stake in the GSEs. Of course, with its sister bureaucrats at FHFA, rather than a private board of directors of private citizens, running the company, it didn't need to.
As to whether or not the Treasury's equity stake was properly authorized, "HERA amended the GSEs’ charters to temporarily authorize Treasury to “purchase any obligations and other securities issued by the [GSEs].” 12 U.S.C. § 1455(l)(1)(A) (Freddie Mac); 12 U.S.C. § 1719(g)(1)(A) (Fannie Mae). This provision also provided that the “Secretary of the Treasury may, at any time, exercise any rights received in connection with such purchases.” 12 U.S.C. § 1719(g)(2)(A). Treasury’s authority to invest in the GSEs expired on December 31, 2009." So arguably, the "illegal exaction" theory is not available in the GSE context if you read the statutory language broadly and literally. That is not disabling because, as Judge Wheeler describes it, the "illegal exaction" analysis is just the label that is applied to a taking that is unauthorized; proving authorization does not necessarily equate to the absence of a taking. Further, an "illegal exaction" argument still might be made, if one concludes that the statutory authorization to succeed to the rights of "any shareholder, officer or director" does not authorize a right to engage in self-dealing and thus breach the fiduciary duty of loyalty, because none of them would be understood to have the "right" to do that. In that view, any value extracted via self-dealing would be unauthorized and thus an illegal exaction. Apparently, from another blog I looked at, although no one has yet succeeded in getting a federal court to review FHFA's actions as conservator, in Sweeney Estate Marital Trust v United States (D.D.C. 2014), District Judge Amy Jackson noted that under FIRREA, which she characterizes as HERA's predecessor statute, judicial review was provided consistently where the federal agency was alleged to have taken actions as conservator tainted by conflict of interest. So, that line of attack appears to be the crucial determinant of the GSE plaintiffs' ability to challenge the Third Amendment.
Third, a lesser-known, but extremely salient fact about the shareholder lawsuits in the GSE context is that they do not challenge the September 2008 terms. Rather they challenge a much later self-dealing transaction, described by Judge Lamberth as follows:
"On August 17, 2012, Treasury and the GSEs, through FHFA, agreed to the Third Amendment to the PSPA, which is the focus of this litigation. The Third Amendment replaced the previous dividend formula with a requirement that the GSEs pay, as a dividend, the amount by which their net worth for the quarter exceeds a capital buffer of $3 billion. The capital buffer gradually declines over time by $600 million per year, and is entirely eliminated in 2018. In simpler terms, the amendment requires Fannie Mae and Freddie Mac to pay a quarterly dividend to Treasury equal to the entire net worth of each Enterprise, minus a small reserve that shrinks to zero over time. These dividend payments do not reduce Treasury’s outstanding liquidation preferences." (Citations and internal quotations omitted).
The key point to see here is that, by August 17, 2012, the GSEs were not "on the verge of bankruptcy"; indeed, they were already profitable as Judge Lamberth himself acknowledges elsewhere in the opinion. So, the damages analysis Judge Wheeler uses -- correctly, in my view -- that AIG's shares would have had no value in the absence of government action, is not going to help the government in the GSE context. Rather, everything will come down to whether or not the self-dealing cash sweep agreed to between FHFA and Treasury was a cognizable taking or not. If it is, the just compensation claim will be very large.
I suppose I should disclose that my firm was one of the firms advising AIG at this time and further that I spent Sunday the 14th of September in their headquarters with an M&A partner and three top-bracket private equity firms that were studying whether or not a structure could be found to invest rescue funds. Discussions never got off the ground because AIG's team of financial advisors determined its hole was too large for them to fund and AIG really spent no time at all with them. In fact, I spent the evening chatting on the phone with friends at Lehman and also with advisors to the Obama campaign, in both cases about the implications of the impending Lehman bankruptcy. A memorable day and night in my career.
Monday, June 15, 2015
Gretchen Morgenson wrote a column in yesterday's New YorkTimes regarding differences in the fees that outside professionals charge private equity funds and their portfolio investments and the fees they charge the fund sponsors. As with all Morgenson columns, she would have the reader perceive that she is bringing to light a secret, nefarious and unethical practice. Never mind that she acknowledges that she learned of these differences from disclosures in regulatory filings, and that it is axiomatic that conflicts of interest are not inexorably disabling, they can be consented to. And also never mind that the scale of the purported conflict is probably microscopic, given that external professional fees rarely make a material impact on an asset manager's profitability (and, by definition, any discount is itself a small portion of that small impact). But, this being a topic I actually know something about, I thought I could shed some light on the practice.
There are at least four reasons why it happens that a fund sponsor may pay less per hour for legal fees than its funds or their portfolio companies do.
First is the simple matter of "mix" of legal work. Regardless of whether a private equity firm is involved or a public company, not every hour of legal work by a given person is billed at the same hourly rate. Routine or compliance work tends to be discounted significantly. Brief, isolated inquiries may not get recorded or billed, because the lawyer or firm does not want to risk annoying the client with nickel-and-dime bills. Some routine work never gets billed, because the monthly amounts are too small, and by the time they rise to a level worthy of troubling the client, the oldest items are too stale; you just write them off as a goodwill gesture.
Conversely, large capital raises, financings and M&A often are billed at a premium to what a simple multiplication of hours worked times hourly rates would yield. Again, these disparities exist throughout the world of providing legal services to businesses, and are not unique to what Morgenson writes about. Since private equity funds and their portfolio companies interact with the fund sponsor's law firm predominantly on matters of financing and M&A, the legal bills they get from that firm will be higher than the ones the law firm may render to the sponsor on the sponsor's compliance matters. Should this be a concern? No, because even if the fund and the sponsor used separate counsel, the nature of the services each one receives is such that the same disparities would probably persist, as they do at public companies. Also - and this is important - because the portfolio company usually retains its pre-existing legal counsel for its routine day-to-day work, it gets similar discounts, just from other firms.
In large measure, this reminds me of the "equal pay for equal work" debate. If one merely takes the 50,000 foot view, and just sums all male compensation and all female compensation and divides them by the respective hours worked, one will get the often-cited statistic that women only earn 77% of what men earn. If one looks more closely at the "mix" of the work, and compares the amount paid for the exact same job, the disparity narrows considerably, to something more like 91%,if memory serves. You can spin it either way, but in intellectual matters generally, more respect is given to the more sophisticated and detailed understanding of datasets.
Ironically, Morgenson's own income probably reflects a similar variation based on "mix". She puts out a story / column every week for the Times, for which she is likely paid a fixed salary, or a flat amount for each one, regardless of page views, or citations, or retweets etc. But she also publishes books, and for those she is likely paid a royalty based on numbers of copies sold, which amount can vary considerably from the amount she collects for her newspaper work. Even though it's the same person doing the same task, and regardless of hours worked at either one, the conventions of payment in the two contexts lead to disparities in pay for "equal work".
Second, and somewhat related, is the fact that generally accepted accounting principles treat professional fees tied to financings and acquisitions differently from day-to-day legal fees. The latter are considered operating expenses that must be recognized currently, and thus reduce EBITDA and net income. In contrast, fees for work on completed financings and acquisitions are treated more like a capital expenditure and amortized over the life of the financing (or, in the case of many acquisitions, simply added to goodwill and never amortized a bit). Obviously these have different effects upon the client's enterprise value -- often expressed as a multiple of EBITDA -- and its stock price -- often expressed as a multiple of earnings per share. Thus, while a company's legal department often bargains hard for discounts on day-to-day legal work, when they do a large, one-time transaction, they are often much more accommodating of the fees of the firms involved, knowing that the market won't penalize them for any lack of discipline in that non-recurring context. So, to tie back to private equity deals, the funds and portfolio companies are, again, predominantly interacting with the fund sponsor's law firm on financings, capital raises and acquisitions so it stands to reason that they would pay that firm undiscounted amounts. Again, one shouldn't feel they are being screwed in some way -- they just get their discounts on routine legal services from different firms.
Third, there is the busted deal / completed deal disparity, which is another type of "mix" issue. It is a convention throughout investment banking, encompassing as well those who advise alongside investment bankers, that advisors on large deals eat some, or even all, of their fees if the deal doesn't close; but, conversely, when a deal does close, advisors will generally charge a premium above their hourly rates. The premium may or may not offset the discounts up to that point, because the premium may reflect other considerations such as the degree of extraordinary effort required to close the deal, or the relative contribution of a particular professional. A lawyer can do the exact same legal work in two instances, in exactly the same amount of time, using the exact same materials, and yet the revenue realized in respect of that work can vary by more than 100% depending on whether the deal closes or not. Since, by definition, portfolio companies held by a private equity fund are all closed deals, that fact will tend to bias their legal costs higher.
In point of fact, it was a common practice of the larger funds I did work with, and those I am invested in, that there was an end-of-year negotiation on how much would be paid in respect of unbilled time for work done during the year on the fund's behalf, and the sponsor would draw down on the LPs to fund the resulting payments. I don't recall a systematic practice of recovering par or implementing a particular discount. It was more ad hoc, driven, obviously, by how well the fund's investments were performing, just like any other business.
Last, there are the traditional billing factors of complexity, efficiency and certainty of revenue. A large PE deal necessarily the simultaneous coordination of at least half a dozen legal specialties and presents a host of complicated issues, some of which arise due to the laws regulating the tax-exempt investors in the acquiring fund. Closing one of those deals is not the same as the routine legal work on which discounts are customarily given. It's not unfair to charge more for harder work.
As well, as in any industry, clients who provide recurring revenue over multiple years are likely to be awarded discounts, while shorter-term relationships, such as a portfolio company whose work may move elsewhere in two or three years, do not build up such goodwill.
It's the nature of disclosure to err on the side of making things look as bad as they possibly could, as the issuer and its counsel know that they are only working on the disclosure because the market is likely to buy the security being issued, so there is no reason to downplay anything and risk getting sued later. By simply quoting those disclosures, some of which I assume my firm prepared, Morgenson thus is able to make this practice sound more nefarious than it really is. The underlying reasons are really quite generic to legal services, and unspecific to the private equity world. The only reason it comes up in the PE context is that the fund and the fund sponsor are different entities with different owners and everyone working for the fund wants to protect themselves against being accused of hiding something from the fund investors, so they disclose it in as unvarnished a way as possible.