Does the Fed Have the Legal Authority to Buy Equities?

Here is guest post I wrote on the Fed’s open-market operations authority for Confessions of a Supply-Side Liberal, a blog on financial economics (and other subjects) run by University of Michigan economist Miles Kimball:

Greg Shill: Does the Fed Have the Legal Authority to Buy Equities?

This is the second guest post by Greg Shill, a lawyer and fellow at NYU School of Law, on the legal scope of the Fed’s powers in the area of unconventional monetary policy.  His work focuses on financial regulation, corporate law, contracts, and cross-border transactions and disputes, and his most recent article, “Boilerplate Shock: Sovereign Debt Contracts as Incubators of Systemic Risk,” examines the role of financial contracts in the Eurozone sovereign debt crisis. (His first guest post was “So What Are the Federal Reserve’s Legal Constraints, Anyway?”)

As a longtime follower of Miles’ work, it’s an honor and privilege to write for his blog and to put my ideas in front of his diverse and sophisticated audience.  So, thank you, Miles, and your devoted readers.

I.

For the past several years, the Federal Reserve has used many levers to stabilize and stimulate the economy.  One of its most controversial has been the use of so-called unconventional monetary policy, chiefly three rounds ofquantitative easing (or QE, beautifully explained in this clip) from 2008 to 2014. Although the wisdom of these policies has been widely debated, the Fed’s legal range of action largely has not.  In fact, as I have notedpreviously, policymakers and observers have been remarkably quiet about the scope of the Fed’s legal authority to conduct unconventional policy, and when they do describe it they often offer timid visions of the Fed’s powers.

Economists and other observers have often urged the Fed to do more to juice a recovery that was, until recently, broadly disappointing.  These proposals have included not only calls to cut interest rates and launch quantitative easing in the first place (both of which the Fed did), but to target higher inflation, introduce electronic money, conduct direct monetary transfers to the public, extend QE beyond its wind-down in October 2014, and expand the range of assets eligible for purchase under QE.  The Fed of course did none of those more ambitious things, and today, with QE finished and policy normalizing, defining the legal limits on the Fed’s monetary policy arsenal may feel less urgent.  Yet it is a startlingly important question to leave open, given persistent overall weakness in the global economy today combined with the strong likelihood that the Fed will need to consider aggressive and creative measures in the future.

The general question is: in a future recession or crisis, does the Fed have the tools it needs to go beyond what it’s done in the past?  This is one of the most important open legal questions in public policy today…

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How Do We Know if Higher Capital Requirements Really Will Make US Banks Less Competitive?

The Federal Reserve

The Federal Reserve

Federal Reserve Governor Dan Tarullo is reportedly set to reveal to the Senate Banking Committee today that the Fed is planning to boost capital requirements for too big to fail (TBTF) banks. Wall Street objects, saying it’ll place US banks at a competitive disadvantage to their European counterparts. This is said to be causing US banks to consider moving some trading operations out of the US. I may be missing something, but to me this is an unsatisfying debate, from both an epistemic and policy standpoint.

The postcrisis drive to boost capital requirements—in the main, an effort to require TBTF banks to hold more cash relative to their riskiest liabilities, so as to reduce the chance that they will go under—has been a mixed success. Basel III (not in force till 2019) is the leading international effort in this regard, but it has been widely attacked as weak, including for imposing too-low capital requirements. And so when some agency or commentator calls for new capital requirements in the US or another jurisdiction that exceed Basel minima, banks often say the proposed rule will place US banks at a disadvantage relative to European banks and hint that it will be self-defeating (since many regulations can be dodged by financial engineering or by moving the regulated activity overseas, though the latter can actually be quite difficult).

As regulators, finance professionals, and scholars begin to think about the new proposed rule, let’s stop and define our terms. If I were working for the Senate Banking Committee, I’d be curious about the following question today:

Do we know, in fact, that if this rule is adopted, banks in the US will be required to hold more capital than their European counterparts?

On the surface, the answer appears to be “yes,” because the proposed ratios in the Fed rule are higher than those in Basel III. But by itself this is not terribly revealing. The Fed’s new rule will presumably determine capital ratios on the basis of Generally Accepted Accounting Principles, or GAAP (which is mainly used in the US). Europe and most of the rest of the world use the International Financial Reporting Standards accounting system, or IFRS. This distinction can have systemic consequences when it comes to calculating capital ratios, because apples are not always being compared to apples. As this note from Ernst & Young explains (PDF):

IFRS and US GAAP differ substantially in their treatment of what is included in the exposure measure (i.e., the denominator of the leverage ratio [of assets to liabilities]).

This is largely because of differences in GAAP and IFRS netting rules, which in turn mean the volume of liabilities that need to be backed by a given percentage of assets differs. The International Swaps and Derivatives Association further explains (PDF):

The different offsetting requirements [imposed by IFRS and GAAP] result in a significant difference between amounts . . . [calculated] in accordance with IFRS and amounts [calculated] in accordance with U.S. GAAP, particularly for entities that have large derivative activities.

According to these FDIC figures, GAAP is overstating US bank capitalization ratios relative to IFRS, sometimes by 50% or more. In other words, differences in accounting treatment may be painting an unduly rosy view of the health of US banks, and it could be that new rules like the one the Fed is proposing are a corrective, or at least are not going to make Europe as appealing as opponents contend, because of IFRS.

Public and political debates over bank capital requirements should address the role of these accounting differentials. The banks themselves and the organizations that have a role in overseeing the implementation of capital requirements, like the Bank for International Settlements, clearly appreciate the challenges of measuring assets using two different metrics (see discussion of “calibration”). The political debate over the possible flight of trading operations should likewise consider these crucial accounting differences rather than assuming that a given ratio in Europe is automatically equivalent to that ratio in the US.

Photo: Wikipedia

The Undead Norm of Unenforceability in Sovereign Debt

True story: two years ago, U.S. hedge fund NML Capital seized an Argentine navy vessel in Ghana. NML recently won an important series of rulings in US courts on defaulted sovereign bonds issued by the Latin American nation.

True story: two years ago, U.S. hedge fund NML Capital seized an Argentine navy vessel in Ghana. NML recently won an important series of rulings in US courts on defaulted sovereign bonds issued by the Latin American nation.

As the Argentina sovereign debt litigation hurtles towards its thrilling conclusion (or at least a new phase), I’ve sketched this proposal for a new paper and welcome any thoughts:

The Undead Norm of Unenforceability in Sovereign Debt

Historically, sovereigns have repaid their debts not because they feared court orders if they didn’t but to preserve their good name in global capital markets. Courts played along, tolerating transgressions of their enforcement authority even beyond what sovereign immunity would require. This dance has allowed courts to lend their expressive support to the fiction of enforceability while avoiding the downsides—for courts and markets—that aggressive attempts at enforcement against foreign sovereigns would bring. However, in NML v. Argentina, the latest round of litigation over Argentina’s 2001 default, the SDNY signaled a shift: it issued an unprecedented injunction prohibiting the world payments network from processing Argentina’s bond payments unless the sovereign also tendered payment in full to a group of holdout creditors. This ultimately pushed Argentina into default in July 2014, prompting some legal scholars and the financial press to declare that the episode would seriously impair future efforts to restructure sovereign debt.

In The Undead Norm of Unenforceability in Sovereign Debt, I intend to argue that the NML decision (which was upheld on appeal) is poised to close the gap between the rhetoric of obligation and the reality of enforcement, but only temporarily, and that the systemic effects many fear are unlikely to materialize. NML provides a clear example of some of the dangers I write about in Boilerplate Shock: Sovereign Debt Contracts as Incubators of Systemic Risk: standard terms in private, foreign-law contracts—in this case, a provision known as the pari passu clause—are driving macroeconomic events to a degree that no one anticipated.

However, the magnitude of the harm here will probably be contained. The near-term systemic impact has not been (and was unlikely to be) great in part because, unlike Greece (whose bonds I use as an example in Boilerplate Shock), Argentina is not a member of a monetary union. On a longer horizon, the effects seem even likelier to dissipate. Argentina’s contract-driven default is just the type of salient event that will prod the market to update boilerplate terms, in this case probably by restricting the reach of pari passu in future bond issues and perhaps in existing ones (by adding Collective Action Clauses, for example, which virtually eliminate the holdout problem). This should allow restructurings to continue on the flexible, ad hoc basis on which they currently occur—which is to say, without excessive judicial interference at the enforcement stage. Far from demonstrating that the norm of unenforceable sovereign debt is dead, this episode suggests it can’t be killed.

For this article, I’ll be standing on the shoulders of a rich literature on the Argentina dispute and drawing on research I’ve done at the intersection of commercial law, private international law, and financial regulation. In Boilerplate Shock, for example, I argue that currency and governing law clauses in Eurozone sovereign bonds are magnifying systemic risk in ways no one imagined when they selected those contract terms. In Ending Judgment Arbitrage: Jurisdictional Competition and the Enforcement of Foreign Money Judgments in the United States, I argue that fragmentation in the U.S. judgment enforcement regime post-Erie renders that system ripe for manipulation by savvy judgment creditors via a process I call “judgment arbitrage.”

Undead shares many commonalities with these two articles (particularly Boilerplate Shock). Perhaps most important, together they posit that private contracts—combined with choice of law rules and expansive conceptions of jurisdiction that make it possible to secure and actually enforce judgments based on them—are driving international economic events to a degree that no one anticipated. This is mainly a story of cascade effects, amplified by standardization: the interpretation of a given contract term impacts other actors (whose rights are determined by similar contracts) in the relevant market, and where that market is systemically significant, it can affect the global financial system.

As I suggest above and in the Boilerplate Shock abstract, I think the risk of contract-driven systemic failure (which I call “boilerplate shock”) is far more manageable today in the case of Argentina than in the Eurozone sovereign lending market. Let’s hope the risk does not materialize in Europe either; we already live in pretty exciting times.

Photo: Reuters/NYT

The Latest in the Bank of America “Mortgage-Settlement-Industrial Complex”

That choice phrase, which describes a $16.65 billion BofA-Justice Department settlement announced today, comes courtesy of Bloomberg’s Matt Levine.

I discussed the implications of the case with Law360 (paywall). 

From DealBook:

The landmark settlement, announced by Attorney General Eric H. Holder Jr. in Washington on Thursday morning, requires Bank of America to pay a $9.65 billion cash penalty and provide about $7 billion in relief to homeowners and blighted neighborhoods.

“The size and scope of this multibillion-dollar agreement go far beyond the ‘cost of doing business,’” Mr. Holder said in a prepared statement. “This outcome does not preclude any criminal charges against the bank of its employees. Nor was it inevitable over these last few weeks that this case would be resolved out of court.”

What Financial Regulation and the Israel-Palestine Conflict Have In Common

Gaza City (credit: NYT)

Gaza City (credit: NYT)

I wrote yesterday about the misguided boycott of SodaStream from a corporate law perspective, but today—with Hamas firing rockets at Tel Aviv and Jerusalem and the Israeli military firing missiles at targets in Gaza—brings a grim opportunity to make a more general point about the management of crises.

As financial regulation scholar Anna Gelpern details in Financial Crisis Containment, it’s essential to distinguish between containing an existing crisis on the one hand and preventing a crisis or resolving the problems that led to it on the other. She was writing about financial crises but I see no reason her argument need be limited to that circumstance, which is hardly unique in its requirement of distasteful policy decisions in service of the greater good.

The distinctions Gelpern draws are important to understanding any crisis (my emphasis):

First, containment is distinct from . . . regulation, crisis prevention and resolution. Containment is brief; it targets the immediate term. It involves claims of emergency, rule-breaking, time inconsistency and moral hazard. In contrast, regulation, prevention and resolution seek to establish sound incentives for the long term. Second, containment decisions deviate from non-crisis norms in predictable ways, and are consistent across diverse countries and crises. . . Third, containment measures are costly, but so is failure to distinguish containment from other tasks.

As this thoughtful post at 972 Mag (“They Left Us No Choice”: On Military Escalation and its Israeli Rationale) argues persuasively, it is both true that Israel had no choice to respond to the crisis of rockets but with military force and that during the run-up to the crisis it wasn’t doing enough to prevent it or to resolve the underlying issues.

Gelpern’s observation that crisis and pre-crisis are different animals and require different responses applies a fortiori here. The more recurrent the crisis and seemingly intractable the problem, like Israel-Palestine, the more careful we need to be about drawing the distinction between crisis and pre- or non-crisis. (And it’s no answer to declare the Middle East always in crisis. There are periods of relative calm.)

The degree of bipartisan support for emergency responses to the financial crisis reflected the intuition that crises require temporary, unpleasant policies.

Similar things can be said about the 2007-09 financial crisis. It was both true that the government had no choice but to respond to the prospect of the failure of the banking system by backstopping the banks and that during the run-up to the crisis the government wasn’t doing enough to prevent the crisis or resolve the underlying issues, because among other things it was under-regulating the banks. Even if the rescue had been structured to be harsher on banks, as some would have liked, any outcome that would have helped them heal would by definition have meant rewarding the institutions that brought down the economy. (That doesn’t mean the government shouldn’t have done more to help homeowners or others suffering from the crisis, of course.) It had to save the banks. The emergency underscored the need to address moral hazard, but that essential project couldn’t be addressed properly until the emergency had passed.

In sum, the legitimate responses to the financial crisis and the Gaza rockets both involve sanctioning a degree of chutzpah. With a few exceptions, the very financial institutions whose activities caused the late crisis were saved. The very Israeli administration that has seemed more eager for conflict than peace is today allowed to pursue conflict. Management of a crisis is about getting out of the crisis.

But as Gelpern’s taxonomy implies, that order of operations is time-bounded. When the crisis management stage ends, prevention of a future crisis and resolution of the underlying issues can and should resume in earnest. If it doesn’t, that’s not really an argument against vigorous containment. That issue—the failure of the political process—is a separate and important problem to focus on.

The distinction between crisis and non-crisis tracks is perhaps even more salient in practice than theory. It’s just not practical to seek lasting reform during a crisis. You don’t legislate a new fire code when the city is still in flames.

Should You Have Put Johnny’s College Money in GM Stock on April 11?

One interesting subject at the intersection of law, finance, and human behavior is the impact of looming litigation and enforcement actions on the affected company’s stock price. This post is going to be a bit of a think piece, as truly fleshing out some of the concepts here would require not just more research but industry expertise and empirical modeling.

With that caveat, a core assumption of Wall Street traders, financial economists, and the investing public holds that new information, including new information on legal risk, will generally move the market if it’s material. Materiality in this sense is basically circular; it’s something that moves the market. That’s a pretty high bar. However, securities law and accounting rules (GAAP, which applies to public and nonpublic companies alike) treat materiality in the disclosure context much more liberally. Where the chance of a litigation loss is “probable” or even “reasonably possible”—terms that mean somewhere between 10-70% chance of a loss—it usually must be disclosed.

The gap between the market sense of “materiality” and the legal and accounting sense is critical. As this Perkins Coie note discusses, the SEC “has increasingly taken the position that it is not enough that a possible loss or range of loss cannot be determined ‘with precision and confidence,’ and has indicated that it may ask companies to provide support for an assertion that an estimate cannot be made, particularly as litigation progresses.” So the possibility of a litigation loss must be disclosed even if its probability and magnitude can’t really be estimated yet and many of the underlying facts aren’t yet known.

The drafters of the legal and accounting rules may not have intended a significant gap between their definition of materiality and the economic definition, but I suspect the gap was known. One policy goal behind a rule that promotes early disclosure of relatively improbable risks is to make it hard for companies to conceal the risk of losses, and thus to promote better cost internalization and risk management. That’s a crucial objective, but it is pregnant with tradeoffs. Accuracy is probably one downside, since the disclosure obligation kicks in before much is known about the probability or magnitude of the risk. It could be that early disclosure tends to exaggerate the market response, because the risks are simply impossible to price at the early stage they are disclosed.

Share price movements of public companies following high-profile scandals provide some opportunity to measure the ability of the market to price disclosed-yet-unresolved legal risks. General Motors, for example, is currently in the throes of an unfolding legal and regulatory scandal. The company announced a major recall February 7, 2014 and has announced nearly 50 more since, involving a total of 17 million cars in the US and a few million more abroad so far (here’s a timeline of events).

GM’s problems have a lot of legally and politically salient features beyond those of most corporate legal scandals. Grim deaths of totally blameless consumers, grieving families, a simple fix that would have cost pennies per car to implement. And GM’s new CEO, Mary Barra, has admitted that the company knew about these problems for a decade. Criminal and civil investigations are ongoing, and Congress is investigating.

Of course, at at time like this, the impact on the company’s share price is not the main concern, but looking at it might provide an interesting, rough-and-ready measure of the market’s perception of this newly-disclosed legal risk. The cost of the mechanical fix is currently expected to come in around $700 million, but the legal and reputational damage is harder to gauge. Is the market doing a decent job of pricing them, or are traders overreacting to dramatic events? And what if any role are the securities laws and accounting rules playing here?

Let’s try to assess the reaction first. As depicted below, between February 7 (the announcement of the recall) and yesterday’s close, GM shares (blue) significantly underperformed those of its chief US rival, Ford (in red), as well as the broader S&P 500 index (green). GM is essentially flat (+0.5%), whereas Ford is up 12.5% and the S&P is up 8.9%. This could be a recall effect.

GM v. Ford v. S&P 2/7/-6/18/14 But did the market go too far in punishing GM? In March, some financial journalists suggested that GM’s recalls might be unjustifiably depressing share prices and this week TheStreet rated GM stock a buy. Does this lend support to that view?

It’s not entirely clear (and the reasons why underscore how hard it is to get market predictions right). However, if current trends continue, the market may have seriously overestimated GM’s legal risk in April relative to the facts known at that time.

The case of GM involves a watershed event in the form of a series of damaging disclosures made in a short, discrete window of time, followed by a rapid and massive drop in share prices, followed in turn by a strong rally.

Adding more competitors makes for a richer comparison. In this second chart, GM (blue) is underperforming rival Daimler, but outperforming both Honda and Toyota, with Honda down over 4% in the same window: GM v. HMC, TM, DAINAll these stocks are performing poorly in this period, except Daimler. It could be that GM’s weak share price is attributable to the weakness of the auto sector in general relative to the S&P. Even so, I think this window may be somewhat obscuring the share-price impact of the unfolding recall. At the risk of stumbling into empirical territory, I think it’s clear here that selecting the right time window is important.

I have three observations in that connection:

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3 Thoughts on the Alibaba IPO

Chinese tech-company giant Alibaba filed papers this week to go public in New York. Since this news is at the intersection of three sexy topics – tech companies, large amounts of money, and the general sense that anything big and China-related must be a unique threat/opportunity  there has been a lot of reporting on the company’s planned initial public offering (see, e.g., herehere, here).

Alibaba is an enormous company. Estimates of its value range from $100 billion to $235 billion, in the ballpark of American Express to AmEx plus Amazon. The company is arguably even “bigger” if you consider it in terms of reach rather than economic value. As Zach Karabell put it in Slate, Alibaba is “a behemoth in China that acts as an Amazon, PayPal, and UPS all rolled into one, plus a dollop of Facebook and other social network sites.”

I have three observations about what the Alibaba IPO might mean for U.S. equity markets, Alibaba’s plans, and Yahoo, which owns a 24% stake in Alibaba:

1. Despite various headwinds, U.S. equity markets continue to dominate. Specifically, U.S. markets continue to be the destination of choice for many global companies – which now includes China’s most ambitious tech company as well as many European tech companies – looking to raise capital. As the chart below indicates, it’s not even close; Alibaba is just the latest data point.  This observation cuts against two common memes: one about the putative burden of U.S. regulations, the other a generally overstated point about the declining relevance of the U.S.

    • Every time U.S. securities regulation expands, there’s an immediate objection that the costs of regulation will drive companies overseas – either they’ll reduce their U.S. presence or they’ll choose to list on an exchange in a jurisdiction with more lax securities laws. Most recently we have seen this argument during the debates over Dodd-Frank, but it comes up a lot. It was prominent during debates over Sarbanes-Oxley, and it colors discussions of America’s accounting and anti-corruption regimes (GAAP and the FCPA, respectively), which are among the most stringent in the world.
    • I don’t think anyone disputes that these forms of regulation have the potential to chill capital formation in the U.S. to the point of sending it abroad. A serious effort to measure the tradeoffs would require a data-intensive study in itself (not a blog post), but it’s worth emphasizing just how competitive U.S. capital markets continue to be. To date companies, including foreign companies, have continued to come to market in the U.S., opting into those onerous U.S. regulations. Although it would be nice to find more longitudinal data (this only covers two years), you can see from the table below that U.S. equity markets continue to dominate (PDF) the world – in 2013, they accounted for about one half of the total value of the planet’s top ten stock markets and are at least holding their own from 2012-13:

World Federation of Exchanges - 2013 WFE Market Highlights

    • This is probably because American equity markets offer network effects and other competitive advantages that no other market can match. As Karabell argues, U.S. markets are better positioned “in terms of complexity, liquidity, and transparency. . . [If] you are almost any company of size doing business anywhere in the world, the United States remains a safe and potent place to raise capital.” (This has been true for as long as anyone reading this post has been alive.) Our sophisticated regulatory framework is integral to that competitive advantage.
    • One caveat to this point is that right now U.S. equity markets are likely benefiting from the perception that they are safe and stable relatively speaking, and offer shares denominated in the world’s reserve currency. Modest growth in the U.S. paired with elevated economic and political risks abroad would appear to favor issuing in the U.S. at the moment. It will be interesting to see what happens to the U.S. share of the global public equity market if/when economic conditions normalize and some of those political tensions ease. But it’s also not clear the U.S. will lose this advantage anytime soon, since there are always economic and political tensions.
    • In Alibaba’s case, it has also been reported that the company’s unique ownership structure means it could not list in Hong Kong. If that’s true, the U.S. may have an additional competitive advantage on that point, though it seems likely that other factors also drew them to New York.

2. Alibaba’s F-1 registration statement tells us very little about the company’s plans. There’s been Talmudic scrutiny of this filing, as if the true intentions of the company are now hiding in plain sight, just waiting to be divined by someone with expertise in legal and financial jargon. This places far too much weight on the F-1, which is a basic disclosure document that must be filed by any foreign company issuing securities in the U.S.

    • Quartz ran an article yesterday headlined, “Alibaba isn’t going global – at least not yet,” that exemplifies this practice. Analyzing the F-1, the author emphasized that in that document “Alibaba framed its growth prospects in terms of only the Chinese market. . . In fact, Alibaba doesn’t list eBay or Amazon in its list of competitors, naming only Chinese firms,” and regarding the proceeds of the offering it only states they will be used for “‘general corporate purposes’ and short-term debt instruments or bank deposits.”  From this the author concluded that “it’s not apparent that funds from the listing will go toward international expansion.” Elsewhere we see bald assertions that Alibaba really has its eye on the Chinese market.
    • To the extent these comments are based on the registration statement, they are overblown. These disclosures are designed to satisfy the relatively limited requirements of the Securities Act of 1933, not tip the company’s hand.
    • So why else are they raising money? Beyond the usual reasons – raising more capital than is feasible as a private company, allowing early investors to cash out – I have no idea. However, it’s worth noting that being a U.S.-listed company may make it a little easier for Alibaba to do a few things. One is acquire other American-listed companies that offer services in the U.S. that Alibaba offers in China, on the basic principle that deals among firms that share regulators and an investor base tend to implicate fewer regulatory and other concerns than pure cross-border M&A. Given the enormous size and diversity of Alibaba businesses, that is potentially a lot of U.S. companies – eBay, maybe, but a lot of smaller ones too. It would be idle speculation on my part if I said I thought they were going to do some big acquisitions in the U.S., but the limited “use of proceeds” they declared in their registration statement certainly does not mean they are not going to. There is nothing nefarious or Trojan Horse-like going on here; it’s an issue of reading too much into registration statements.
    • Bottom line: to understand Alibaba’s F-1 statement to the point of drawing conclusions about the company’s growth strategy, you’d have to have a lot of knowledge about Alibaba, its current competitors, and the industries it could plausibly enter. I suspect few journalists poring over the statement can clear that bar (I certainly can’t).

3. What will happen to Yahoo stock and Yahoo CEO Marissa Mayer’s reform efforts once Alibaba goes public?

    • Currently, Yahoo owns 24% of Alibaba, and the value of Yahoo excluding Alibaba is probably less than zero – about negative $3.45 billion by one calculation. For years now, Yahoo stock has partly served as a vehicle for owning an indirect piece of Alibaba’s explosive growth in China. Soon, anyone interested in buying into Alibaba will be able to do so directly, and it’s been reported that Yahoo will sell around half its stake in Alibaba after the IPO anyway.
    • It’ll be interesting to see what impact all this has on Marissa Mayer’s efforts to overhaul Yahoo. Those efforts have generally been well received by Wall Street to date. With Alibaba contributing much less to Yahoo’s top line in the future, will she have less freedom of action (because revenues are down) or more (because revenues are down)? Even more intriguing, maybe she’ll find some really neat way to put the proceeds of the sale to use (one-up Tesla CEO Elon Musk’s hyperloop idea?). But based on what she’s been doing, we’ll probably see a boost in dividends and buybacks instead, and maybe an acquisition or two.

My thanks to Chris Gaskill, who has advised companies on IPOs as outside counsel and has worked in house at two public companies, for his thoughts on these subjects. As always, all opinions are my own.

Destructive Coordination in Securities Contracts

[cross-posted from The Conglomerate] [image: Flickr]
Destructive Coordination in Securities Contracts
Posted by Greg Shill

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In my last post—also a shameless plug for my recent article, “Boilerplate Shock”—I argued that boilerplate terms governing securities could serve as a trigger that transforms an isolated credit event into the risk of a broader systemic failure. I’ll now briefly explain why I see this danger—which I call “boilerplate shock”—as a general problem in securities regulation, not just some quirky feature of Eurozone sovereign debt (the focus of the paper and post). Any market where securities are governed by uniform boilerplate terms is vulnerable to boilerplate shock.

The nature of this phenomenon—systemic risk—is of course familiar, but its source in contract language is a little unintuitive. How could private contracts unravel an entire securities market or the world economy?

Through coordination around uniform standards. 

In the back of our mind most of us probably still conceive of contracting as an activity that occurs among two, or perhaps a few, individuals or firms. But when standard terms are used by virtually all actors within a given market, it’s worth considering the collective impact of those terms as a distinct phenomenon.

Coordination’s benefits are well known. Consider uniform traffic signals. But coordination can also compound the effects of bad individual decisions.

As Charles Whitehead has argued, widespread “destructive coordination” among banks during the precrisis days helped generate systemic risks. When the credit markets froze, for example, firms using the same risk management formulas reacted in the same way at the same time. This helped transform isolated events into systemic ones—e.g., Lehman, the canonical example of a failure that triggered a de facto coordinated panic.

A similar risk, I argue, is present where participants in a securities market rely on the same standardized contract terms. Whether they were intended to or not, these terms will often control what happens in the event of certain legal emergencies, like a country departing the euro orLehman declaring bankruptcy.

For example, if an effort by Greece to pay its bonds in “new drachmas” is rejected because of Boilerplate Contract Terms A and B, the market will surely be concerned that Terms A and B also govern the bonds of similarly situated borrowers, like Spain, Italy, etc. You’ll see that the borrowing premium the “peripheral” euro countries (the uppermost five lines: Ireland, Italy, Greece (biggest spike), Portugal, Spain) paid versus richer euro countries (Germany, France, the Netherlands, the three lowest lines) zoomed higher as worry over a Greece exit gripped markets in late 2011/early 2012, and again (to a lesser extent) because of Cyprus exit talk in early 2013:

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Bloomberg. Click to enlarge.

Moreover, this panic occurred against a backdrop of unduly rosy assumptions (namely, that a departing euro country could convert its bonds into a new currency and thereby avoid default, a likely contagion trigger). I argue that the uniformity of boilerplate across these bonds would intensify these problems significantly since it’s likely to result in a declaration of default.

To my mind, this demonstrates that boilerplate securities contracts, in the aggregate, can be systemically significant. “Boilerplate Shock” introduces this concept and offers a modest proposal to mitigate its dangers in the Eurozone.

Beyond the euro, what about the risks of boilerplate shock in general?

Boilerplate shock is probably an inherent and permanent risk in any securities market.

Securities contracts are quintessential candidates for boilerplate. They are used by sophisticated parties for repeat or similar transactions and are drafted quickly—sometimes in three and a half minutes. The (correct) assumption is that they are more efficient for the parties that use them.

I’d like to begin thinking about how contracts can be drafted with a view to systemic risk mitigation, or at least to avoid exacerbating existing risks. But I think this is a hard problem that lacks an off-the-shelf solution:

  • The risk is also an externality: it is severe because of its collective impact. The parties do not bear the primary risk that uniform contracts will result in a meltdown, and in the unlikely event a crash happens (1) no individual party will be to blame and (2) at least one party to the initial transaction (the initial purchaser of a bond, for example) will probably no longer hold the asset, because most systemically significant securities are actively traded on the secondary market.

But banning or discouraging boilerplate is not the answer:

  • The risk that a bunch of assets governed by the same terms will plummet in value is not only an externality. Risk allocation among parties might improve if scrutiny of existing securities boilerplate improves. The terms can evolve.
  • A requirement to craft unique, artisanal terms—disclosures, subordination provisions (“flip clauses“), choice of governing law—for each individual securities transaction would be criminally inefficient.
  • A requirement to craft unique contract terms might even be unjustified on risk-management terms alone, because it would increase drafting errors.

It’s tricky to mitigate the risks of securities boilerplate.

Some options for places to start:

  1. Validation by third parties: perhaps issuers could use risk-rated contract templates. For example, see credit ratings…but see credit ratings.
  2. Culture: inculcate systemic risk mitigation as a professional norm among private sector lawyers? In principle, this could work. The number of lawyers who draft these contracts is pretty small. In practice, one could envision many complications.
  3. Insurance: encourage the development of derivatives to account for the possibility of boilerplate shock? Like some of the other solutions, this one presumes some agreement on what terms create the risk of boilerplate shock. It could also encourage new forms of moral hazard.
  4. Mandatory regulation: some public entity could be tasked with the mission of proactively identifying and combating the risk of boilerplate shock in contract practices. Arguably a natural choice given that the risk is an externality. Nevertheless, I’m a little skeptical. First of all, who would do it? A domestic regulator, like the SEC or CFTC, that might be dodged on jurisdictional grounds? An international institution, which is arguably more subject to capture? More generally, regulation seems like a heavy-handed first choice.

In sum, when standardized and aggregated, choices that determine legal risks—e.g., contract terms designating governing law, payment priority—can create the same hazards as choices about business risks. This suggests that contract terms should be taken seriously as possible sources of systemic risk alongside more familiar sources, like leverage and credit quality.

Securities contracts as a source of systemic risk—what do you think?

More Monies, More Problems

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More Monies, More Problems
Posted by Greg Shill
[cross posted from The Conglomerate]

I expressed concern in my last post that uniform contract terms could destabilize securities markets in unexpected ways. In a recent paper, I dub this risk “Boilerplate Shock.” The paper uses boilerplate terms in Eurozone sovereign bonds as a case study, but I argue that any market in which a lot of securities are governed by uniform contract terms is vulnerable to boilerplate shock. In this post, I will focus on the Eurozone and my proposed solution to the risk of boilerplate shock there.

One major problem is that no one really knows how to deal with sovereign debt obligations denominated in a currency that still exists but is no longer used by the debtor. A partial breakup of the European Monetary Union would trigger some question marks in commercial law and private international law (among other things).

In the Eurozone sovereign lending market, bond contracts typically contain standardized language specifying:

(a)  choice of governing law (often foreign), and
(b)  currency of payment (euros).

The combined effect of these clauses, I argue, is to render any country that departs the euro more likely to default on its debt. Whatever the impact of the departure itself, a forced default would make things much worse for Europe and the world economy.

Leading scholars have concluded or strongly suggested that a sovereign that changes currencies can redenominate (convert) its bonds to its new currency even where the contract is governed by foreign law (e.g., Philip Wood (p. 177), Michael Gruson (p. 456), Arthur Nussbaum (pp. 353-59), Robert Hockett (passim)). As a descriptive matter, I believe this to be a mistaken interpretation of New York (and probably English) private international law and commercial law (see “Boilerplate Shock” pp. 47-67). But normatively, I agree: a sovereign should be able to redenominate its bonds under certain circumstances. Among other things, the alternative would make currency union breakups far more dangerous than they already are.

In brief:

  • The prevailing consensus underestimates the risk that a departing Eurozone member’s attempt to redenominate its sovereign bonds into a new currency will be ruled a default.
  • Since the bonds of other struggling euro countries are largely governed by the same boilerplate terms ((a) and (b) above), this misapprehension has the potential to be particularly damaging. In addition to surprising the market (which appears to incorporate this consensus), it is likely to spread beyond the immediate debtor to the bonds of similarly situated countries that have issued under the same terms.
  • Same for CDSs (which are likewise often governed by foreign law, usually New York).
  • Thus, given the widespread use of terms (a) and (b), a ruling that a departing country cannot pay its euro-denominated contracts in a new currency could cause the market to demand unsustainable premiums from other weak debtors.
  • This could cause Eurozone countries to lose market access. Greece is not TBTF in any sense, but some of its neighbors are—and are also too big for the EU (including the ECB) and IMF to bail out. Italy (the world’s 9th largest economy) and Spain (13th) come to mind.

Thus, if my commercial law/private international law analysis is right, these boilerplate contracts could end up playing quite a big role in the event of any euro breakup.

To mitigate this risk of boilerplate shock, I suggest a new rule of contract interpretation. The proposal is detailed at pp. 67-71 of the article. I suggest commercially significant jurisdictions adopt it by statute. Here is a quick summary.

Any sovereign that:

  1. Belongs to an international monetary union, and
  2. Issues bonds in the currency of that monetary union subsequent to the adoption of this rule, and
  3. Leaves the monetary union and introduces its own currency,

shall retain the right to redenominate its bond obligations into its new currency, UNLESS the sovereign has affirmatively waived the right to redenominate its bonds.

You’ll notice this is a default rule—merely a presumption of the right to redenominate—not a mandatory rule. It is also prospective-only: it does not apply to existing issuances. It also does not protect sovereigns that issue in foreign currency (e.g., Argentina), only those that are monetary union members and issue in the common currency (e.g., France).

The reason for these limitations is to minimize unintended consequences and near-term disruption to the market, but also to embody the relatively modest objectives of the rule. It is an information-forcing default rule that is intended to facilitate better risk management by parties. It is not a “save the world” rule.

The challenge, as I’ll discuss in my next post on the paper, is not that redenomination would be ruled impermissible when it ought to be available (otherwise, that might suggest a mandatory “pro-redenomination” rule). It is that the likely effect of these boilerplate terms—to prohibit redenomination—was almost certainly not bargained for and is largely unknown to parties. This market failure has, in turn, created latent risks to the broader financial system and the existing legal tools are poorly suited to address them.

Image: © Disney, “Duck Tales”

The Risks of “Boilerplate Shock” in the Eurozone and Beyond

[Cross-posted from The Conglomerate]

The Risks of “Boilerplate Shock” in the Eurozone and Beyond
Posted by Greg Shill

By now, the risk that a distressed European nation such as Greece might leave the Eurozone and thereby spark global economic calamity is well known. Regular readers of this blog may even privately relish the prominence of the issue. Not since the days of the gold standard has international monetary policy come so close to being a socially acceptable topic of dinner conversation.

As I noted in my first post, observers rightly perceive the Eurozone sovereign debt crisis to be driven by political and economic forces. But many consequences of a euro breakup would be determined by law, including sources of American (specifically New York) private law.

This is a complex issue. I try to address it more fully in a new article, “Boilerplate Shock,” which I’ve just posted on SSRN.

In brief, and to continue picking on Greece, one key question in the event of a euro breakup would be: would a court recognize an attempt by Greece to convert its euro-denominated debt into its new currency, or would it instead insist that Greece pay in euros, the currency of contract? The answer is important because, as a practical matter, requiring payment in euro would be tantamount to forcing a default.

That’s the familiar narrative, anyway. And I agree. But I believe that the ubiquity of boilerplate terms in these bonds—specifically, clauses selecting governing law (usually foreign) and currency of payment (euro)—is likely to make any dispute over redenomination even more damaging than this suggests.

In the article, I argue that the sparse literature on the question of redenominating sovereign bonds overlooks some sources—especially cases interpreting New York contract law and private international law—that, if extended to Eurozone sovereign bonds, could surprise the market and cause serious global repercussions. I argue that the reason for this is not only that the dominant view overlooks what are likely controlling sources of law. It is that standardization of contract terms across the Eurozone sovereign lending market makes the stakes of surprise that much higher.

If Greece’s attempt to redenominate its bonds is declared a default, then the fact that the operative terms in Italian, Spanish, Irish, etc. sovereign bonds are the same or similar makes markets likely to demand unsustainable premiums from those countries. Capital and investor flight could be very rapid. We have seen several previews of this movie over the past few years in the Eurozone, and each time official-sector bailout institutions have saved the day. But the European Union/European Central Bank and IMF probably do not have the resources to stop a broad-based bank run of this nature, to say nothing of the political support necessary to attempt it.

Maybe none of that will happen. Nevertheless, the potential for uniform contract terms to create risk not just to individual third parties but to securities markets seems likely to grow at least as fast as those markets. Using Eurozone sovereign bonds as a case study, I introduce the term “boilerplate shock” to describe the potential for standardized contract terms—when they come to govern the entire market for a given security—to transform an isolated default on a single contract into a threat to the market of which it is a part, and, possibly, to the economy in general. My larger objective here is to foster a discussion of the potential for securities law and private-sector securities lawyers to manage (or alternatively, to contribute to) systemic risk.

I’ve posted an abstract below and will be returning to the subject. I look forward your comments.

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