Thanks again to Eugene and the rest of the folks in the Volokh community for the opportunity to discuss Treasury Inc.: How the Bailout Reshapes Corporate Theory and Practice. I have had a lot of fun this week. If you enjoyed these topics, look for the rest of the Treasury Inc. series next year, and please feel free to drop by my new home, Truth on the Market, where I will start blogging this week.
It has been a rare opportunity to share with this forum my new paper, Treasury Inc.: How the Bailout Reshapes Corporate Theory and Practice, forthcoming with the Yale Journal on Regulation and available here. This week we have enjoyed a rigorous discussion about the implications of the government as a shareholder in the financial services and automotive industries.
As I expected from the Volokh community, the comments have offered a rigorous intellectual contribution to my work, and for many of the commentators I recommend reading the full paper for answers to their insightful questions. For this post, I will shift to the implications of Treasury Inc. for the federal budget, the subject of an in-process paper forthcoming with the Louisiana Law Review that will also be the focus of my comments at this years Federalist Society National Lawyer’s Convention.
Government deficits and debt have captured national attention in the last few months owing to their role in the venomous debate over health care reform. Our nation’s debt is officially $11 trillion. Yet the government’s accounting practices for its ownership in the automotive and financial sectors omit a big slice of the real national debt and annual budget deficit.
When Peter Orszag ran the Congressional Budget Office, he fought the Bush administration over consolidating Fannie and Freddie’s debt into the national budget. His position was that two principles of government accounting require consolidation. Principle one, we control these companies; principle two, we guarantee their debt. For more, take a look at, after I testified on this issue here, this press release from the Congressional House Oversight Committee about how I discovered the problem described in this post.
The Treasury disputes its control of TARP companies. Yet the government tells GM what kind of cars to build and GM and Citigroup which directors to elect. It tells Fannie and Freddie which mortgages to subsidize. Secretary Geithner affirms that we stand behind the banks, which means we stand behind their debt as well. Budget consolidation principle one, check. Principle two, check.
This doesn’t mean we should consolidate debt of all companies taking TARP money, and government accounting principles aren’t fully prepared for this unique situation. Since the government is acting like a private investor by purchasing common stock, private financial accounting principles also provide useful guidance.
The first useful rule in financial accounting is that consolidation of debt is appropriate where a parent company controls another company by owning a majority of its stock. This covers GM at 60% Treasury ownership, AIG at 85%, and Fannie Mae and Freddie Mac at 100%. The second rule is that even if a shareholder has less than 50% ownership, if the equity and non-equity position of the parent combined make it the beneficiary of most of the company’s future profits, consolidation will also be appropriate. This should clearly cover Citigroup, with 34% government ownership (purchased with $40 billion of TARP money) and an additional $301 billion in outstanding guarantees from Treasury.
Look only at the outstanding debt of these five TARP companies (out of over 600 of them). Citigroup has $1.8 trillion in debt; AIG, $807 billion; Fannie and Freddie, $5.2 trillion; and GM, $10 billion. This means that $7.8 trillion is missing from the national debt.
The government predicts annual budget deficits of $1.75 trillion this year, $1.1 trillion next year and similar amounts going forward. Now, let’s consider adding $7.8 trillion to the national debt. Amounts added to the national debt should be added over time (in accounting jargon, amortized) into the annual budget deficit. Over 10 years, that’s an extra $780 billion each year. This means the annual budget deficit would increase by roughly 80%.
Sure, one day we may be able to sell off our government’s equity interests in TARP companies, and eventually remove them from our nation’s balance sheets. That would be great, and fiscal hawks would be happy to buy the champagne for such a celebration.
Until then, let’s remember that accounting statements for governmental bodies and private companies alike are intended to portray accurate pictures of those organizations at a certain point in time, reflecting the uncertainty of the future and the likelihood that significant owners (or residual credit holders) of most of a firms assets are likely to stand behind that firms debts, for no other reason that it is in their self interest. Particularly when a shareholder stands as both a creditor AND an unchecked regulator of the company in which they hold shares.
When the U.K. recently recognized in its budget the debt from its two bank bailouts, its national debt doubled overnight. Warnings later emerged that the U.K.’s Triple-A bond rating may be in jeopardy, unprecedented for a modern Western nation.
If we properly accounted for our debt and deficit, we might be in the same situation. A downgrade of U.S. debt may even be beneficial, a sign that we’ve hit rock bottom and need to recover from this deficit addiction. Credit warnings would result in a diminished appetite for Treasury bonds, force the Treasury Department to borrow at higher interest rates and curb its habit for runaway spending.
Administrations are short-lived. But the debt remains, and it is a legacy by which our children will rightly judge us.
The full faith and credit of the U.S. is not a depthless well, and our nation’s current budget policies risk turning Treasury bonds into the ultimate subprime loan. Future generations could be saddled with inflation, increased taxes and interest payments on Treasury bonds that take up an ever-increasing share of the federal budget.
We have been discussing my new paper, Treasury Inc.: How the Bailout Reshapes Corporate Theory and Practice, which you can download here. In my last post I made the case that the government is a control shareholder in many of the banks and automotive companies that accepted TARP bailout cash. So why does that matter? In corporate law shareholders determined to be in control of the corporation have the same duties to other shareholders as executives or members of the board of directors. Control shareholders cannot use their power to force the corporation into business decisions that will harm the value of the company for the other shareholders. In securities law, control shareholders are even jointly liable with the company for violations of the securities laws.
The government’s sovereign immunity throws a wrench into this dynamic. I won’t bore you with all the sovereign immunity analysis in the paper, but let me just say that the government takes a belt-and-suspenders approach to sovereign immunity protection for the bailout. The Tucker Act, which waives sovereign immunity for some torts by the government, doesn’t seem to fit, because fiduciary duty violations aren’t traditionally understood to be torts. Takings clause litigation, generally a difficult test to pass, would seem especially difficult here in light of the many objectives articulated by the government in the bailout legislation. Section 3 of the Securities Exchange Act, passed in 1934, includes a specific exemption for the federal government from, among other things, insider trading laws.
Does this matter? What could the government do that would be so pernicious to the value of Citigroup’s shares? Let me list a few examples. Citigroup funds Mergers and Acquisitions activity, which often results in layoffs of excess employees or factory closings at target companies to make them run more efficiently. We can expect a number of interest groups would have the government pressure Citigroup not to underwrite M&A deals that would bring value to Citigroup as a result. Citigroup has already agreed to limit its visa program to hire foreign workers. Citigroup loans money so that people can buy houses, the government subsidizes loans so that people who cannot otherwise afford to buy houses can do so. We can expect that the government will pressure Citigroup to subsidize loans to select groups at an interest rate lower than the risk of the loan would suggest, thus losing money for Citigroup and causing it to violate its fiduciary duty to its shareholders.
Government ownership in banks is prevalent around the globe, and the evidence is that this happens with reckless abandon. In Italy, for instance, banks with substantial state ownership lend at lower rates, for loans of similar terms and risk, in regions important to the ruling coalition in Parliament. Based on this evidence, we should expect to see Citigroup, and other TARP recipients, subsidize lending in battleground states as a result of the government’s controlling interest in TARP recipients combined with the sovereign immunity it enjoys.
In my last post I opened a discussion about my new paper, Treasury Inc.: How the Bailout Reshapes Corporate Theory and Practice, which you can download here. My thesis is that corporate law and theory goes haywire when the government, while enjoying sovereign immunity protection from corporate and securities law, takes control of a company by owning shares. But does the government really control TARP companies?
When Treasury initially sold Congress on the bailout, the plan was to create all sorts of nifty market-oriented structures to reinvigorate the market for troubled assets. But once the government got the money, it used most of the first $300 Billion to buy stock in over 600 troubled banks (from Citigroup and Bank of America to your local First State bank). Eric Posner warned us about this sort of surprise. Some of the stock is non-voting preferred stock that gives Treasury the ability to appoint directors in certain circumstances, for other companies like Citigroup the stock is voting common equity. The share purchase program was later extended to the automotive sector by Tim Geithner. The question is whether the government is a controlling shareholder based on its percentage of share ownership, the fact that the government regulates banks, and the fact that it loans them a lot of money.
Control is an elusive concept. What does it mean to control something? Is it the power to dictate demands, to encourage, to threaten, or maybe the power to destroy something if you wanted? Some forms of control require force. Then again, sometimes control can be exhibited more powerfully through a sublime and unspoken understanding, the Godfather-esque “I give him an offer, he don’t refuse.” It is a question not lent to easy answers, and yet corporate and securities law is riddled with special provisions assigning liability, prohibiting transactions, or requiring additional disclosure based on whether a shareholder controls a company.
Analysis of control in business law is unfortunately muddled. For an entirely novel method of determining control, keep an eye out for an article I’m doing with Terry Chorvat sometime next year. For now, here are some basic rules: i) control is exclusive, a corporation may only have one control shareholder, ii) control is usually present for majority shareholders, unless the board has staggered terms (like the U.S. Senate) iii) holding a majority of shares is not required for control, owing to the collective action problems, rational apathy, and regulatory restrictions limiting dispersed shareholder exercise of their votes, and iv) factors indicating control for sub-majority shareholders could include percentage of holdings, special contractual rights, concurrent status as a powerful creditor, or actual exercise of control such as holding corporate office.
With that, let’s turn to the question of whether the federal government is a control shareholder for any of the 600+ companies accepting TARP bailout money. We start with the obvious point that the government stands as both a powerful creditor and shareholder for most of these companies. It also has a power that no other shareholder has, it regulates the companies. For banking, Treasury and the Fed are regulators, for the automotive industry the DOTD, DOE, and other entities do the job. At GM and AIG, Treasury and the Fed are majority shareholders (GM is not currently publicly traded, but soon will be). Fannie and Freddie are not technically TARP bailout owing to their pre-bailout conservatorship (in much the same way that Marcia, Jan, and Cindy are not technically Brady) but in light of their starring roles in the financial crisis, let’s throw them in anyway as former Fortune 500 companies that are presently 100% government owned.
At AIG, the Federal Reserve placed its shares with a trust that it created, the AIG Trust, managed by three trustees selected by the Federal Reserve. The Fed’s position is that this helps to create a buffer between the Fed and AIG. I don’t buy that argument. I had an opportunity to testify about the AIG Trust, along with then AIG CEO Ed Liddy and the three trustees, at a hearing before House Oversight this summer where I urged that the AIG Trust Document actually requires the Trustees to manage the trust in the best interest of the Treasury Department. To read the testimony, see here. I’ve consulted for the Special Inspector General for TARP and the GAO TARP team on this issue for a Corporate Governance Audit requested by Senator Baucus, a very engaged and informed group of folks by the way, hopefully that report will bring this issue to light.
At Citigroup the government holds a 34% interest. For any other shareholder 34% ownership, by itself, is a close call for determining control. When we add the fact that banking is a deeply regulated industry, regulated by same two government entities that control the shares in question, and we also consider the fact that the government is also a substantial creditor of Citi through a number of guarantees it has also offered to Citi’s outstanding liabilities, I feel confident in asserting that the federal government is a control shareholder in Citi. For real world indicia of control, consider that the government has chosen most of Citi’s current directors, and that Citi has been the first to accede to congressional demands on mortgage re-modifications, support for cramdown legislation, and worker visa limitations.
I won’t analyze every one of the 600 companies, but I think you get the point. Treasury and the Federal Reserve are control shareholders of many TARP companies, the only real question is how many.
As a longtime fan of The Volokh Conspiracy, it’s a particular honor to join you today. I admit spending much class time in law school surfing Volokh rather than taking notes, and it was often a wiser investment (not true for my students of course). The financial crisis has made it an exciting time to teach corporate law and financial regulation inside the beltway. My recent focus has been Treasury Inc.: How the Bailout Reshapes Corporate Theory and Practice, a paper coming out next semester in the Yale Journal on Regulation about how the government’s new role as a shareholder requires a paradigm shift for corporate law. The plan is for this to be the first in a Treasury Inc. series looking into strange consequences of government shareholdings for administrative law, federal budget accounting, theory of the firm, and public choice theory.
Most of the debate over the bailout has been whether we should have bailed out the finance and automotive sectors in the first place, done something else, or done nothing at all. Fascinating question, and it is fun watching the economists fight that one out, but that’s not the question that interests me. My focus is the tectonic shifts in corporate theory and practice that result as companies have given the Treasury and the Federal Reserve equity stakes in exchange for TARP bailout money. To sum up my position: the theory and practice of corporate and securities law are unprepared for the presence of a control shareholder, like the government, that also enjoys sovereign immunity from the federal securities laws and state corporation law.
The six central theories of corporate law, which at times stand in mutual and vigorous opposition, all break down in the presence of an immune control shareholder. Debates about whether we should give more power to shareholders to maximize shareholder wealth, give more power to directors to do the same, or abandon wealth maximization as our paradigm and take a progressive view toward stakeholders, all lose their usefulness in the chaotic presence of a controlling immune shareholder.
The corporate practitioner’s view is equally problematic. We will need to rethink everything we know about insider trading, securities class actions (for which Treasury may end up serving as a lead plaintiff), and state law fiduciary duties for control shareholders. A Board’s ability to approve transactions may be endangered. Finally, the government may obtain the right to nominate candidates for the Board of Directors of public companies under the SEC’s new proxy access rule at TARP recipients in which the government owns a mere 1% stake.
To defend this idea, over the next week I will need to answer a few questions first. Is the government really a control shareholder, and in which firms? Do Treasury and the Federal Reserve enjoy complete sovereign immunity in their exercise of shareholder power? And is there any way to limit the fallout going forward? We will also take a look at a bi-partisan bill from Senator Warner and Senator Corker to which I have contributed language that may limit some of the damage, the TARP Recipient Ownership Trust Act of 2009.
We will also close with an observation on a related issue. If I can establish that the government controls merely the five bailed-out companies in which it has the largest stake (Fannie, Freddie, AIG, Citigroup, Bank of America) then under private sector accounting principles and under government accounting rules (and in these strange times, who knows which is which?) we are currently failing to recognize roughly HALF of the real national debt and HALF of the real budget deficit due to failure by the President and Congress to consolidate the debt of those firms into the national debt and deficit (particularly interesting in light of how the health care debate seems to center around the deficit).