Monday, May 11, 2009

The Ultimate Risk of Goverment Influence Over the Private Sector (Part 2)

The furor over the AIG bonuses has at least temporarily died down as many of the people were shamed into giving back their bonuses. For anyone interested in understanding the perspective of one of the chastised individuals, I recommend (if you haven’t already) reading the Op-Ed piece in the NY Times by Jake DeSantis entitled “Dear AIG, I quit.”

Unfortunately, not long after the AIG bonus scandal an even more disturbing event came to light that I believe completely overshadows it. In the AIG case, the president, Treasury, and Congress used the media and the threat of legislation to cajole people into returning their bonuses. To my knowledge no stories have surfaced of actual threats by the powers that be directed at individual employees of AIG, although many members of AIGFP apparently feared for their safety as a result of the public’s distaste for the bonuses. However, in the case of the BAC-Merrill Lynch deal, members of the Fed and Treasury allegedly decided to use more extreme tactics in the name of protecting against further global financial meltdown.

According to testimony given by BAC CEO (and former Chairman) Ken Lewis in front of New York Attorney General Cuomo, current Fed Chairman Bernanke and former Treasury Secretary Paulson applied what I see as dubiously legal pressure on him to:

A. Not disclose the billions of dollars of losses at Merrill Lynch that had emerged after the merger agreement had been signed

B. Not to attempt to invoke the material adverse change (MAC) clause in the agreement in order to get out of the deal

C. Not inform the SEC regarding either of the two above items

Furthermore, according to Lewis, Bernanke and Paulson either implicitly or explicitly said that Lewis was risking his position of Chairman/CEO and the entire Board’s position as directors if he pursued any avenues to try to extricate BAC from the Merrill deal. In other words, Lewis indicated that he was led to believe that if he did not complete the deal the government would used whatever power it had available, possibly through its TARP investment, to remove Lewis and the entire BAC Board.

Now, let me take a step back and shed some light on what these allegations mean if they are indeed accurate:

-Using the Fed and Treasury as a conduit, the US government was willing to use its position as a preferred shareholder of BAC to force the merger of two private companies who had agreed to merge in a legitimate arm’s length transaction

-The Fed and Treasury were willing to overlook the SEC rules that dictate that companies must disclose material events to shareholders as indicated by Lewis’s claim that they specifically stated they did not want a “disclosable event.”

-One government agency and one “independent” body were willing to ignore the legally binding rules of another government agency (the SEC) with no consultation, thus keeping the company’s other shareholder completely in the dark

-The government was willing to remove the Chairman/CEO and Board of a private company if the company did not proceed with a good faith transaction that the government was not a direct party to

-In the name of protecting the global financial system from a shock they did not believe it could handle, the Treasury and Fed were willing to blatantly overstep their mandates and legal authority

When you look at the above list, do these actions look like those of a banana republic or a developed nation with well-established laws? I would argue that these actions are characteristic of authoritarian governments whose countries prudent investors refuse to invest in without an appropriate premium for political risk. Now, we have to remember how fragile the US and world financial markets were in December 2008. While things had calmed down slightly since the failure of Lehman Brothers earlier in the fall, it is possible that the Merrill deal falling through could have sent the system into a very dangerous tailspin. However, my concern is that the decision to force BAC to complete the deal was made by agents without the legal authority to do so. I am not a lawyer but I do know that nothing in the Fed’s mandate says anything about forcing mergers between private parties. Last I checked the Fed’s mandate revolves around fostering price stability, full employment and economic growth.

In fact, the US does not currently have an entity whose duty it is to assess systemic risk and act appropriately to protect against financial contagion. As a result the Fed and Treasury apparently decided to assume that role, overstep their stated boundaries and act as the protector of last resort. To me, this is the equivalent of a police officer arresting someone for something that he or she thought was wrong but is not explicitly illegal. When authorities have (or believe they have) the right to make the rules up as they go, it sets a very dangerous precedent. As a result of these seemingly capricious and not particularly well-thought-out or legal actions (even taking into account the somewhat extraordinary circumstances), I believe investors have further lost faith in the power of signed contracts and the idea that the laws of the US will be consistently applied. I understand that this crisis has put the authorities in uncharted waters but I do not believe that the current circumstances give the government the right to ignore the legal foundations that have made the US the world’s business leader and the safest country in which to invest.

(Check back later this week for my analysis of what appears to be the most egregious example of undue and potentially trust-destroying influence to date: the Chrysler bankruptcy situation)