Author Archives: Jonathon Spagat

BofA, Merrill Lynch, and the Lawyers Who Advised

While Bank of America CEO Ken Lewis is taking the fall for the sketchy acquisition of Merrill Lynch, maybe we should also be looking at the lawyers who advised him. The bank has agreed to release more documents on the controversial deal, including legal advice. And the bank says it followed its lawyers’ counsel. According to Breakingviews, things could get uncomfortable for the lawyers.

Exhibit A is the decision by Jed Rakoff, a federal judge in New York, to reject the $33 million settlement Bank of America had reached with the Securities and Exchange Commission over disclosures, or lack thereof, surrounding the Merrill deal, including potential bonus payments to the firm’s bankers. Simply put, he wanted names to be named. He also wanted to know more about the legal advice the bank had received.

Exhibit B is Andrew M. Cuomo, the New York attorney general. His opportunistic strikes, including threats to charge bank bosses including Mr. Lewis, have helped persuade the bank to make an about-face, the publication argues. For months, the bank insisted it wouldn’t release the legal advice it had relied on. This week, it decided it would.

Law firm Wachtell, Lipton, Rosen & Katz was the main advisor for the Merrill Lynch deal.

While there it is not clear whether Wachtell’s advice “departed from the norms of previous financial sector mergers” or that the bank’s in-house counsel acted outside of the scope of Wachtell’s advice, it would be a disaster if either of these scenarios turned out to be true.


The Dark Side of Private Equity

Guy Hands, one of the few household-known private equity executives, recently provided an honest assessment of the industry – which I found to be quite refreshing. Hands’ firm, Terra Firma, is best known for its $4.73 billion purchase of EMI in 2007, which took place at the peak of the buyout boom. In an interview by DealBook’s Andrew Ross Sorkin, Hands reveals the dark side of the private equity industry.

Hands criticized the fee structure that provided executives with very little incentive to provide returns. Known as “2 and 20,” private equity firms receive 2% of the fund’s assets under management each year, plus 20% of its profits. According to Hands, firms grew to be so big that the 2% management fee was often more than the 20% performance fee. As a result, success had “less to do with performance or risk management, and more to do with bulking up,” he said.

Furthermore, individuals were investing so much money in private equity firms that they were “really investing in the same thing.” Accordingly, their capital was competing against itself, driving up prices. On the other end, Hands alleges that some firms formed consortiums to buy businesses from one another because it was easier than going “through the pain of gaining internal consensus to something contrarian.”

According to Hands, neither the banks nor private equity firms will admit that they made mistakes. As a result, firms will “live as zombies,” incapable of growing their businesses. Banks will try to recover as much as they can in fees and “postpone recognizing the full extent of the losses of their underwriting decisions.”

Nevertheless, it is certainly possible that some private equity firms will make terrific strategic decisions now and will be come out stronger when the economy improves.

General Growth Files for Bankruptcy

6a00d83451cc8269e2010535fb0479970c-320wiProclaimed as one of the biggest real estate collapses in history, Chicago’s own General Growth Properties filed for bankruptcy this morning. More information can be found here.

What are the Toxic Assets Actually Worth?

01oped_190v-jpgAs reported, FASB changed the mark-to-market pricing rules last Thursday, giving banks more discretion in reporting the value of mortgage-backed securities. Bankers bitterly complained that the current market prices were the result of distressed sales and that they should be allowed to ignore those prices and value the securities instead at their value in a normal market. But even in a “normal” market, what are the alleged toxic assets actually worth?

Treasury Secretary Timothy Geithner seems to think that these assets may actually be valuable one day, and has implemented a plan to provide “nonrecourse” loans to institutions that buy up the unwanted assets.

University of Illinois College of Law Professor Larry Ribstein, on the other hand, has declared Geithner’s plan an elaborate “shell game.” The government subsidizes private equity companies to buy the assets at inflated values. Instead of just giving them wheelbarrows of money, they get non-recourse loans for most of the purchase price. When we find out that the assets are actually worth what the banks really think they’re worth (as opposed to how they’re currently booked) the taxpayers, who provided most of the money, will bear most of the loss.

Unfortunately, he may be right. USC Business School has released a preliminary report, titled The Pricing of Investment Grade Credit Risk during the Financial Crisis, written by Joshua Coval and Erik Stafford (Harvard) and Jakub Jurek (Princeton). An overview of the paper can be found here. The paper presents three uneasy conclusions:

  1. Many banks are now insolvent. “…many major US banks are now legitimately insolvent. This insolvency can no longer be viewed as an artifact of bank assets being marked to artificially depressed prices coming out of an illiquid market. It means that bank assets are being fairly priced at valuations that sum to less than bank liabilities.”
  2. Supporting markets in toxic assets has no purpose other than transfering money from taxpayers to banks. “…any taxpayer dollars allocated to supporting these markets will simply transfer wealth to the current owners of these securities.”
  3. We’re making it worse. “…policies that attempt to prevent a widespread mark-down in the value of credit-sensitive assets are likely to only delay – and perhaps even worsen – the day of reckoning.”

So, what is the solution? Profesoor Ribstein says we should let the banks sell the assets for what they’re worth but not make them reduce their capital for regulatory purposes.

What do you think we should do?

2009 Spring Speaker Series

Chicago-Kent Corporate Law Society is proud to present the 2009 Spring Speaker Series! This year’s Spring Speaker Series will bring together prominent practitioners and professionals to offer their perspectives and insights on the current economic and financial crisis.

Our first speaker event is this Thursday, April 2, at 4:00 pm in Room C50.

We will be joined by Ed Carter (JD ’78, IIT BS, ’74), Asst. Illinois Attorney General and Supervisor of the Illinois AG’s Financial Crimes Prosecution Unit, and Patrick Coffey (JD ’84), a partner at Locke Lord Bissell & Lidell. These two distinguished attorneys, one specializing in prosecution and the other in defense, will be discussing the topic: “White Collar Crimes in the Post-Madoff Era.”

The next event will be next Tuesday, April 7, at 4:00 pm in Room C50.

Adjunct Chicago-Kent Professor Richard Mason, a partner at McGuire Woods, along with veteran bankruptcy and restructuring attorney Robert Nachman, a member at Dykema, will address “The Wave of Bankruptcies Arising from the Financial Meltdown.”

The third event will be our keynote address, taking place on Thursday, April 16 at 4:30 pm in Room C50.

Paul Forrester (JD ’85), a respected securities and finance attorney from Mayer Brown, and Adolfo Laurenti, Senior Economist at Mesirow Financial, will offer their views on “The Economic Crisis: Mistakes Made and Lessons Learned.”

The culmination of the CLS Spring Speaker Series is an Alumni Reception immediately following the final speaker, at 5:30 pm in the 10th Floor Reception Room here at Kent. Food and drinks will be served at the reception, which will be a great opportunity for students to talk with professors and network with alumni.

Please click here for more information, or contact Professor Tom Hill at

Revamping the Regulations

Treasury Secretary Timothy Geithner finally opened the can of worms last week, proposing a far-reaching plan to reform the financial system. He said the system had failed “in fundamental ways” and would require comprehensive overhaul. “Not modest repairs at the margin,” he told Congress, “but new rules of the game.” Geithner’s audience, the House Financial Services Committee, for once seemed to be satisfied with his presentation, which included regulating hedge funds and giving the government the power to seize and dismantle companies deemed a threat to the economy.

The key measures of Geithner’s proposal include:

  • Creating a new “sytemic risk regulator” that would have the authority to scrutinize and second-guess the operations of bank holding companies like JPMorgan Chase, insurance conglomerate American International Group and other institutions that are too big to fail.
  • Establishing a mechanism to seize and dismantle large institutions whose collapse or bankruptcy might threaten the nation’s financial stability.
  • Passing tougher requirements for the amount of money and assets that financial institutions need to have on hand so they can withstand economic troubles.
  • Requiring hedge funds, private-equity firms and other private investment funds to register with the Securities and Exchange Commission and tell it about their risk-management practices.
  • Setting up a new, comprehensive framework of regulation of derivatives, including a central clearinghouse for trades in that market.
  • Developing stronger requirements for money market funds so increased withdrawals won’t threaten the broader financial system.

Many of these proposals should generate a big welcoming, addressing dangers that clearly could have been addressed with simple regulatory reform. In the months ahead, Geithner said he will unveil more detailed proposals.

Nonetheless, a New York Times editorial posted today talk about the big underlying issues that Congress and the administration need to keep in mind. For instance:

  1. Is too big too fail actually exist? Such firms, like A.I.G., have proved dangerous mainly because of their involvement in a web of often conflicting financial practice and products. Geithner has called for a single regulator to police the most powerful institutions and presumably intervene in order to seize and restructure if failure seemed imminent. But, at what point should a firm ever even come close to become “too big” — i.e. too diverse, too interconnected — too fail?
  2. What are we trying to fix, anyway? Does anyone understand, with specificity, what brought on the financial meltdown? Can anyone actually sort out how much of the crisis is due to regulatory failure, how much to recklessness and greed, or how much to fraud and manipulation? Without the answers, the reform effort will be at best, hit or miss.
  3. Who is to carry out the reforms? For the last 30 years, there has been a serious political movement against regulation and for deregulation. In the last 10 years alone, opponents of financial regulation (e.g. Alan Greenspan) have been especially succesful in dismantling our financial regulatory scheme– letting the market forces run free. As a result, the very agencies that were formed to protect our interests struck out — big time. So if there is going to actually be meaningful regulatory reform, the rules will only be the first step.

Madoff Acounting Firms May Be Liable

ponzi_madoff_1215As the Madoff scandal unfolds, so are the lawsuits. And various accounting firms, who oversaw the books at Bernard L. Madoff Investment Securities LLC, may be legally vulnerable.

The National Law Journal reports that one Bloomington, Minnesota accounting firm, McGladrey & Pullen LLP, has been hit by lawsuits alleging that it failed to detect problems in two seperate Ponzi schemes — the $50 billion investment scam by New York financier Bernard Madoff and the $3.5 billion alleged “electronics” scheme by Wayzata, Minnesota businessman Tom Petters.

McGladrey & Pullen was accused of negligence and failure in its professional duty of care in audits of two investment firms that financed the allegedly fraudulent electronics purchasing scheme by Petters in a federal suit in October. Ellerbrock Family Trust v. McGladrey & Pullen, No. 08-cv-5370 (D. Minn.). Petters, founder of Petters Group Worldwide, was indicted last year on 20 counts of fraud, conspiracy and money laundering.

A second lawsuit was filed in Connecticut state court on Jan. 30 by Maxam Capital Management. Maxam accuses its own accountants of negligence for failing to detecting the Madoff fraud, in which Maxam invested all its $280 million assets. Maxam Absolute Fund v. McGladrey & Pullen, No. FBT-cv-09-5021972-5 (Bridgeport, Conn., Super. Ct.).

The article points out that there are three levels of financial reviews: audited, reviewed and compiled. An accounting firm that compiles financial information just plugs numbers into a spreadsheet, but a full-blown audit tries to independently verify financial claims.

In the Madoff case, it has been discovered that the auditors accepted financial statements generated by Madoff’s auditor from a very small unknown accounting firm. Accordingly, there is definitly reason to believe that the auditors acted negligently or with some level of knowledge.

With the astronomic size of losses at stake, lawyers will have to be creative in trying expand the scope of liability to as many people as possible.