Describing the problems with shadow bankruptcy is easier than developing fair and efficient solutions. Already, the credit crisis has produced scores of proposals for regulatory reform. While many are laudable, and some will doubtless become law, few focus on the specific challenges of shadow bankruptcy.7This part briefly considers certain basic approaches available to regulators: forced disclosure and substantive control. Each has strengths and weaknesses in this context.
Positional Disclosure
To call the problem shadow bankruptcy is to imply that disclosure is the solution.
Certainly, to the extent that trading distressed debt really creates a securities mar- ket, regulating it as such might make sense. Thus, gaps in current securities and
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bankruptcy laws that permit stealth acquisition of control through debt should be filled by amending, for example, Rule 13d-1 of the federal securities laws, or the bankruptcy code, or both.
The problem is that this is easier said than done. First, there are mechanical and logistical issues: Where would this disclosure occur, and who would pay for it? There are already web sites that track some distressed debt (Markit,8Creditex9).
Those who use these sites—for example, shadow bankruptcy players—pay to receive the information they sell. These may be prototypes for broader disclosure systems that address problems created by shadow bankruptcy.
Second, and more difficult: when would disclosure obligations be triggered?
It cannot simply be at the commencement of a bankruptcy case because, as noted, shadow bankruptcy problems can arise well before bankruptcy. While disclosure should be part of bankruptcy, in appropriate cases, it should begin before a case is commenced.
Third, what should be disclosed? Some features of current bankruptcy law require disclosure of the price paid for securities. It is not clear that this has much value to anyone, although it is easy to see why private investors may want to keep such information confidential. Moreover, while some direct holdings—
debt or equity—may have to be disclosed under certain limited circumstances, nothing requires disclosure of derivative positions, for example, equity or debt shorts.
One solution would involvepositional disclosure.This would require private in- vestors to disclose all material rights against or affecting a distressed firm, whether held directly or derivatively, singly or in concert with others, in real time through online market portals.
Such a proposal embeds too many complex issues to discuss fully here. Some questions (and answers) would include the following:
What are material rights?Material rights would be any claims against or affecting a firm that enable the holder to affect control of the company or its restructuring.
While this may be a difficult determination to make in some cases, in many cases it will be easy: any holding of equity or debt sufficient to replace management, foreclose major assets, or the like would be material. Similarly, holding an amount sufficient to block a vote to restructure any important loan agreements or a reor- ganization plan would be material for this purpose.
What is a distressed company? Shadow bankruptcy occurs before formal bankruptcy, so merely requiring disclosure during bankruptcy is inadequate. But definingdistresscan be difficult;insolvencyis a notoriously slippery concept. One bright line test would require disclosure following any default under a material lending or similar financial agreement. There is evidence that tripping covenants of this sort tends to lead to secondary market trading in distressed debt. So, con- necting disclosure to such events would help to shed light on who obtains control of the company through that market.
Disclose what?In addition to debt and equity, private investors who hold ma- terial positions against distressed firms should disclose derivative rights, such as short-sale rights. As discussed further on, disclosure alone may not be enough to correct for all problems with such holdings. But requiring disclosure of the full panoply of rights held by an investor would reveal complex incentives, reduce bluffing, and generally level the informational playing field.
How would this be enforced?A disclosure rule is only as effective as its enforce- ment mechanism. In the securities context, private investors often act as private attorneys general, suing directors, officers, and insiders for violations of securi- ties laws. The value of these lawsuits is, however, open to question. Perhaps the penalty for failing to make appropriate disclosure in the distress context should be the disallowance of claims held by the nondisclosing private investor.
To be sure, there are many other issues to consider in developing such a regime. But positional disclosure could help to promote informational and mar- ket efficiency, which should, in turn, result in more transparent and (one hopes) welfare-maximizing decision making.
Substantive Control
Disclosure is not a perfect solution for many reasons, in particular because it will not solve what may be the most corrosive abuses of shadow bankruptcy, holding multiple positions that include certain types of short sales. As discussed earlier, when a firm is distressed, certain combinations of holdings create incentives to destroy value. Disclosure alone would not prevent the destruction. Indeed, it might have the opposite effect, accelerating the debtor’s failure, because the combination would lead other stakeholders to lose faith in the debtor’s ability to reorganize.
Thus, substantive limits on certain combinations of holdings may also be ap- propriate. In particular, senior secured claims and short positions affecting a dis- tressed firm should not be enforceable when held in combination.
As with disclosure, substantive control is a tricky proposition, especially as to timing. While it may be easy enough to define distress (e.g., tripping a covenant under a major lending facility), what do we do about legacy holders? What if, for example, an investor acquired multiple positions while a firm was solvent only to see the firm slide into insolvency? Should that investor face the same penalties as the investor who acquires the same positions when a firm is distressed?
These and many other details would have to be worked out. The important point is to begin to think about concrete solutions to a problem that appears to undermine the reorganization process Congress believed it created when it enacted Chapter 11.
CONCLUSION
The problems presented by shadow bankruptcy are, in many respects, like those presented by shadow banking, only more so: Private actors arbitrage regulatory and market gaps for private gain. Within certain limits, there is nothing wrong with this. It is how people make money.
But, as we have recognized in the larger financial system, transaction technologies—the distressed debt market and hedge funds, for example—have now outrun the regulatory system. Some reregulation will be necessary.
It is difficult at this point to say exactly how to address the unique problems of shadow bankruptcy. This chapter has considered some solutions, and these may well be the best available.
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At this point, it is enough to note that almost all proposals contemplating a new financial order fail to recognize the abuses of shadow bankruptcy. If nothing else, this needs to change.
NOTES
1. As Steven Rattner, President Obama’s “car czar” said of auto manufacturers: “We were all afraid of bankruptcy.” See Micheline Maynard and Michael J. de la Merced, “A Cliffhanger to See if a G.M. Turnaround Succeeds,”New York Times,July 26, 2009, available at www.nytimes.com/2009/07/26/business/26gm.html?sq=gmbankruptcy&st=cse&
scp=12&pagewanted=print, (quoting Steven Rattner, U.S. Department of the Treasury).
2. The current version of the bankruptcy code was originally enacted in 1978 (Bankruptcy Reform Act of 1978, Pub. L. No. 95-598, 92 Stat. 2549) and has been amended several times, including most recently in 2005, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), Pub. L. No. 109-8, 119 Stat. 23 (to be codified as amended in scattered sections of 11, 18, 28 U.S.C.). Chapter 11 of the Bankruptcy Code appears in 11 U.S.C.§§1101–1174 (2006).
3. In re Lionel Corp., 722 F.2d 1063, 1070 (2d Cir. 1983) (citing “Report of the Committee on the Judiciary, House of Representatives, to accompany H.R. 8200,” H. R. Rep. No.
95-595, 95th Cong. 1st Sess. (1977) at 226, U.S. Code Cong. and Admin. News, 1978, 5787, reprinted inCollier on Bankruptcy2 (appendix) (15th ed., 1983)).
4. See 17 C.F.R.§240. 13d-1 (2008). The rule provides as follows: “(a) Any person who, after acquiring directly or indirectly the beneficial ownership of any equity security of a class which is specified in paragraph (i) of this section, is directly or indirectly the beneficial owner of more than five percent of the class shall, within 10 days after the acquisition, file with the Commission, a statement containing the information required by Schedule 13D (§240.13d-101); (b)(1) A person who would otherwise be obligated under paragraph (a) of this section to file a statement on Schedule 13D (§240.13d-101) may, in lieu thereof, file with the Commission, a short-form statement on Schedule 13G (§240.13d-102).”
5. Federal Rule of Bankruptcy Procedure 3001 provides that “[i]f a claim other than one based on a publicly traded note, bond, or debenture has been transferred . . . after the proof of claim has been filed, evidence of the transfer shall be filed by the transferee.”
Fed. R. Bankr., 3001(e). This rule is of little use in addressing shadow bankruptcy. It applies only if a bar date has been set for the filing of proofs of claim, which may not occur until late in a case. It is designed mainly to aid the process of making distributions on claims.
It thus has little to do with disclosing changes of control through claims trading.
6. Fed. R. Bankr, 2019. The rule requires any entity that represents “more than one creditor or equity security holder” to file a statement setting forth, among other things, “the name and address of the creditor or equity security holder . . . the nature and amount of the claim or interest and the time of acquisition . . . the name or names of the entity or entities at whose instances, directly or indirectly, the employment was arranged . . . [and]
the amounts of the claims or interests . . . the times when acquired, the amounts paid therefor, and any sales or other dispositions thereof.”
7. One of the reports of the Congressional Oversight Panel appointed in connection with the Emergency Economic Stabilization Act (H.R. 1424, 110th Cong. (October 3, 2008) (as signed by the president)) has discussed certain aspects of the shadow bankruptcy system.
See Congressional Oversight Panel, “Special Report on Regulatory Reform: Modernizing the American Financial Regulatory System” (2009), 29 (discussing bankruptcy procedures for nonbank financial institutions), available at http://cop.senate.gov/documents/cop- 012909-report-regulatoryreform.pdf.
8. www.markit.com/en/products/products.page (accessed October 1, 2009).
9. www.creditex.com/ (accessed October 1, 2009).
ABOUT THE AUTHOR
Jonathan C. Lipson is the Peter J. Liacouras professor of law at Temple University–James E. Beasley School of Law. He teaches contracts, corporations, and commercial law courses, as well as a deal-based simulation. In 2007, he was a visiting professor of law at the University of Pennsylvania. Before that, he was an assistant (1999 to 2002) and associate (2002 to 2004) professor of law at the Univer- sity of Baltimore. He is a graduate of the University of Wisconsin, where he earned his B.A., with honors (1986) & J.D. (1990) He was a note editor of the law review.
Lipson writes, speaks, and blogs frequently on business law subjects, including corporate reorganization and the credit crisis. His work has appeared in, among others, theUCLA Law Review,theNotre Dame Law Review,theBusiness Lawyer,the University of Southern California Law Review,theWashington University Law Review, theMinnesota Law Review,and theWisconsin Law Review.
CHAPTER 76
Reregulating Fannie Mae and Freddie Mac
DWIGHT M. JAFFEE
Willis Booth Professor of Finance and Real Estate at the Haas School of Business, University of California, Berkeley∗
In September 2008, the U.S. Treasury and the Federal Housing Finance Agency used their regulatory power to place Fannie Mae and Freddie Mac, the two government-sponsored enterprises (GSEs), into a government-controlled con- servatorship. The action was required because the GSEs faced a serious liquidity and solvency crisis as a result of losses on subprime mortgages. The goal of the conservatorship is to return the GSEs to a safe and sound condition, while allowing the firms to continue their mission in support of the U.S. mortgage market. At the same time, the Treasury initiated programs to infuse new capital into the GSEs and to purchase GSE debt and mortgage-backed securities (MBS), which in effect created government guarantees for these GSE obligations. The Federal Reserve also soon contributed additional resources to backstop GSE bonds and MBS.
From year-end 2007, a point at which the GSE subprime losses began to ac- cumulate significantly, through the end of March 2009, the most recent data now available, the two GSEs have lost approximately $156 billion. Given that their combined year-end 2007 capital was about $71 billion, it is clear that without the government’s capital infusion of $85 billion, the two GSEs would have been in- solvent. It is equally clear that the GSEs will need significantly more government capital support before the subprime crisis ends. In addition, the Treasury and the Federal Reserve have invested a combined $821 billion into GSE bonds and MBS to support the markets for these securities. This already comprises more than 15 per- cent of the total GSE mortgage holdings and guarantees of about $5.4 trillion as of March 2009. The two GSEs are now, in effect, wards of the state, and this status can be expected to continue at least until losses from the subprime mortgage crisis end and the financial and mortgage markets return to a more normal situation.
Sooner or later, however, the Congress and the Administration will have to determine a new and proper structure for the long-term status and regulation of the two GSEs, and many observers believe it is useful to begin considering the
∗This chapter is in part an updated and summarized version of material that originally appeared in Jaffee (2009).
617 Lessons from the Financial Crisis: Causes, Consequences, and Our Economic Future
by Robert W. Kolb Copyright © 2010 John Wiley & Sons, Inc.
possibilities sooner. Federal Reserve chairman Ben Bernanke (2008), speaking in the fall of 2008 at a University of California, Berkeley, subprime mortgage symposium stated:
Our task now is to begin thinking about how best to reestablish a link between homebuyers and capital markets in a way that addresses the weaknesses of the old system. In light of the central role that the GSEs played, and still play, any such analysis must pay particular attention to how those institutions should evolve.
Just recently, the Senate Banking Committee held hearings in June 2009 on the issue, which no doubt will be followed by many such inquiries, with the ultimate goal to determine how to reregulate the GSE.
The goal of this chapter is to provide a framework that the Congress and the Administration can use to help them determine the proper and feasible future role for the GSEs as entities in support of the U.S. mortgage market.