Gods at War: Shotgun Takeovers, Government by Deal, and the Private Equity Implosion

by Steven M. Davidoff

  The deal machine subsequently assigned winners and losers in this battle. The failure to acquire Wachovia left Citigroup’s new CEO Vikram Pandit looking weak and Citigroup itself further debilitated. It was viewed as having been out-dealt by Wells Fargo and unable to afford a competing bid. Meanwhile,Wells Fargo CEO John Stumpf was viewed as a daring corporate executive. He had snatched a jewel of a corporate banking property from one of his rivals in the face of government opposition.

  The Saving of Morgan Stanley

  The last pre-TARP episode of the government as dealmaker occurred over the weekend of October 11. On Friday, October 10, 2008, it did not appear that Morgan Stanley would survive. The S&P 500 Index had declined 18 percent that past week, mirroring a decline with the rest of the general stock market. Morgan Stanley closed at the end of Friday at $9.68 a share, down 57 percent in the space of a week. The next Tuesday, October 14, Morgan Stanley was scheduled to close its $9 billion investment from Mitsubishi Bank for 21 percent of Morgan Stanley at a price of at least $25.25 per share.55 However, the stock price of Morgan Stanley reflected market perception that this injection would not occur. Morgan Stanley was now trading with a market capitalization less than Mitsubishi’s entire investment. Mitsubishi had signed a definitive purchase agreement to make its investment but over that weekend invoked the MAC clause in the agreement in an attempt to escape its obligations.56

  The investor agreement between Morgan Stanley and Mitsubishi contained a buyer-friendly form of MAC clause.57 It did not contain the large number of exclusions typical of these clauses, most notably an exclusion from the MAC definition for changes to stock prices and for general and industry economic conditions. Moreover, the investor agreement was governed by Delaware law and, as discussed in Chapter 3, Delaware strictly construes MAC clauses and requires that any adverse change must be long-term and durational to be an MAC. It was unlikely that a court would find a simple stock decline of this nature to be a long-term and durational event without more occurring. Unfortunately, for Morgan, there was more. It would later emerge that there was a massive withdrawal of prime brokerage deposits occurring at Morgan Stanley that was impairing Morgan Stanley’s liquidity. It was caught in the same death spiral as Bear Stearns and Lehman Brothers.

  Morgan Stanley’s dilemma was not new. Back in the crash of 1987, Jardine Strategic Holdings had agreed to purchase 20 percent of Bear Stearns for $400 million. Jardine then claimed a MAC had occurred, based on trading losses by Bear Stearns of $100 million and a “precipitous drop” in Bear Stearns’ stock price from $19 to $13, or more than 32 percent.The New York Supreme Court ruling under New York law in Bear Stearns Co. v. Jardine Strategic Holdings58 held that a trial was necessary to determine the meaning of the MAC clause but also indicated that Jardine should have understood that Bear Stearns was in a volatile, cyclical business and the loss and stock price decline could not be considered a MAC.

  Mitsubishi would face the same uphill battle unless it could find a substantial and actual long-term deterioration in Morgan Stanley’s business due to the flight of capital.The bankruptcy of Morgan Stanley due to this capital flight would clearly be something material and adverse, but then the question would be whether, given the financial crisis, this was a known possibility at the time of Mitsubishi’s investment. Against this uncertainty, the government acted to ensure a deal. Over that weekend, the Treasury Department reportedly privately assured Morgan Stanley that it would support the investment bank if the Mitsubishi investment failed.This addressed the liquidity issue.

  The government also provided assurances to Mitsubishi that if it was subsequently forced to provide capital to Morgan Stanley, the government would not significantly dilute Mitsubishi’s investment. The government’s prior requirement that shareholders be significantly harmed in any bailout was beginning to inhibit private solutions as parties refused to invest, fearful of later government action. It was at this point that the government abandoned this position for future transactions. With these government assurances, Morgan Stanley and Mitsubishi agreed to a minor reworking of their transaction. On Monday, the investment was completed, and Mitsubishi invested the full $9 billion in Morgan Stanley.59 The investment was deemed a big success for Morgan CEO John Mack, still thought to be one of the best dealmakers on the Street.

  TARP, Citigroup, Bank of America, and Beyond?

  By the time of the Morgan Stanley transaction, the government had already decided to abandon its dealmaking model for a more holistic response in the form of the TARP. Secretary Paulson at first resisted a larger, more programmed response, but he reportedly changed his mind when Federal Reserve Chairman Ben Bernanke informed him that the Fed could no longer respond in an ad hoc manner.60 The weekend of September 20, Paulson agreed and submitted a three-page bill for a $700 billion TARP to Congress. The outcry was immediate. Many claimed this was a power grab and cited the administration’s poor history in Iraq, where Congress had also delegated the administration virtually unlimited power. Yet, the final bill actually gave Paulson more power than he had asked for.

  In the initial version of the TARP bill, Paulson requested that the Treasury Department have authority to purchase up to $700 billion of “mortgage-related” assets. In the final bill, Congress gave Paulson far more authority. The bill did so in the following manner. First it defined “troubled assets” to include “any … financial instrument that the Secretary, after consultation with the Chairman of the Board of Governors of the Federal Reserve System, determines the purchase of which is necessary to promote financial market stability… .”61

  Under this definition, troubled assets were essentially any financial securities the Treasury Secretary deemed appropriate. This was a much broader provision than the one restricted to mortgage-related assets that Paulson had asked for. Moreover, another provision defined the institutions who could participate in this program. These institutions were defined as “any institution … established and regulated under the laws of the United States or any State.”62 Under this definition, Paulson could conceivably buy securities from any institution in the United States. This could be the dry cleaner down the block, credit card receivables, student loans, and the automakers. The last on this list would soon realize this benefit.

  Paulson quickly put the money to use. On October 15, he ordered the CEOs of the nine largest financial institutions to Washington. In a several-hour meeting, he cajoled them to accept a $125 billion TARP injection. Reportedly, some of the CEOs objected to this forced government infusion. The injection was on generous terms, so their protestation could not have been that hard. The preferred shares issued would pay only a 5 percent dividend, going up to 9 percent after five years.The government would get minimal control rights, exercisable only in an event of default, and dividends would not be prohibited. At least initially, executive compensation restrictions were also minimal, limited mainly to restraints on golden parachutes. Finally, the government took a warrant equivalent to 15 percent of the value of the injection but priced the warrants on a 20-day look back, putting the warrant significantly out of the money from day one, due to the declining stock market.63

  Secretary Paulson quickly burned through the first $350 billion of the TARP program. Another $40 billion went to AIG and the remainder to a variety of smaller banks.64 The automakers and their financial affiliates also received $25 billion in late December and early January 2009 after a series of dramatic Congressional hearings and Congress’ ultimate refusal to pass a separate bill bailing these institutions out. President Bush thereafter proclaimed his willingness to save the automakers, stating that to allow them to go under would not be “responsible.” He directed that TARP funds be provided to them, funds that General Motors and Chrysler eagerly accepted.65

  The last two bailouts in the waning days of the Bush presidency were of Bank of America and Citigroup, two of the three largest financial institutions in the United States. In these two bailouts, the Treasury showed that it was willing to change d
irection yet again as circumstances dictated. But it also showed that the Treasury Department could not kick the dealmaking habit.

  Citigroup was yet another bank to get caught in a death spiral.This time, the stock price went in the space of two weeks from about $14 a share to as low as $3 a share. But Citigroup was much more complicated. An inefficient behemoth in the best of times and referred to by some government officials as the Death Star because of its soulless capability to destroy the U.S. capital markets, it now appeared to be coming apart. The weekend of November 23, the Treasury stepped in again to stabilize the beast.

  The Treasury, Federal Reserve, and FDIC collectively agreed to fund the off-balance sheet purchase of about $306 billion of Citigroup’s troubled assets. This was essentially the bad bank model that Lehman Brothers had proposed; it also appeared to be modeled on the initial Wachovia-Citigroup deal. Treasury agreed to take the first $5 billion of losses, the FDIC the next $10 billion, and the Federal Reserve the remainder. All of this was subject to a loss-sharing agreement by which 10 percent of the losses were paid by Citigroup. In addition, Citigroup agreed to guarantee the first $29 billion in losses. Learning from AIG, the Federal Reserve agreed only to charge a relatively low interest rate on this loan of approximately 5.3 percent. 66

  In exchange for this maneuver, the government received $27 billion in preferred shares in Citigroup through an injection made by the TARP program: $20 billion for its direct investment and $7 billion as compensation for the loan guarantees. Citigroup would pay an 8 percent dividend rate on these shares. Unlike other beneficiaries under the TARP, this preferred barred paying dividends above 1 cent per share for three years and had a higher interest rate than the 5 percent paid on other TARP injections. Citigroup was being slotted in the middle bailout category, between the stable financial banks and the systemically failing ones like AIG. Finally, the Treasury received $2.7 billion in warrants. Again, though, these warrants were priced on a 20-day moving average, so the strike price was $10.61 per share, which was laughably out of the money compared with Citigroup’s trading price of $3.78 the Friday before the deal announcement.

  The Treasury took only 10 percent of the total preferred being issued by Citigroup in warrants, as opposed to the 15 percent it had taken in other transactions. The reason was undisclosed, but probably it was to keep the government’s ownership interest below a certain threshold.67 On January 2, 2009, the government created a new program, the Targeted Investment Program, to encompass bailouts like Citigroup that were neither investments in systemically failing or stable financial institutions.68 The government was ex post facto justifying its conduct and abandoning its hollow moral hazard principles.

  The Citigroup model and this new program would be used to bail out Bank of America in early January 2009. At the time, Bank of America claimed that its need for funds was related to a massive $15.3 billion loss at the newly acquired Merrill Lynch, a fact that Bank of America apparently learned of some time between late November and mid-December. In mid-December though, and after the December 5 vote of Bank of America shareholders on the transaction, Bank of America began to question the wisdom of the acquisition and began to claim that an MAC to Merrill had occurred. At that time Bank of America had had discussions with the government about providing further support to ensure that it did indeed acquire Merrill Lynch.

  In a series of meetings and calls, the government had questioned the ability of Bank of America to walk from its transaction, given the strength of the agreement Merrill had negotiated. In addition, the government had implied a threat to Bank of America CEO Ken Lewis’s job if he attempted to walk from the transaction. In the wake of these apparent government threats and their offer of a bailout, Lewis agreed to complete the Merrill acquisition. This may have been Lewis’ strategy all along—knowing the weakness of his claim he claimed a MAC to win government support. Here, Lewis was a victim of the overly generous deal terms he agreed to in September to acquire Merrill. Unfortunately for Bank of America’s investors, the company never disclosed these facts until January, on the cusp of its own bailout.The total TARP investment in Bank of America would amount to $45 billion, plus the offer of the FDIC and Treasury to enter into a loss-sharing arrangement with respect to $118 billion of Bank of America’s troubled assets.69

  At this point, “bailout creep” had become the norm as the government incrementally struggled to save the financial system along the way, arranging for bailouts of the automakers and small community banks. Meanwhile, in the waning days of the Bush administration, criticism was heaped on the Treasury for negotiating too generous terms and for its opaqueness. It was at this time that the Obama administration took office, promising a new, more consistent program, with heightened transparency and accountability. In February 2009, the Obama administration would announce a turn from dealmaking again. Newly appointed Treasury Secretary Geithner would instead propose a program to purchase troubled assets directly, as Secretary Paulson had initially proposed.70 The government would also proceed to renegotiate its prior bailouts, impose harsher executive compensation requirements, and restructure its assistance to both Citigroup and AIG as well as the automakers. In Citigroup’s case, the government converted part of its preferred shares into up to 36 percent of Citigroup’s common stock.

  Assessing Government by Deal

  In terms of halting systemic panic, the government’s regulation by deal had its short-term benefits, ameliorating the pain and avoiding total collapse of the financial markets, but it is still unclear whether it cured the disease. Government by deal at times appeared to reduce confidence in the markets. The government’s reactive response also failed to address the root cause of the distress, the housing crisis. Instead, the government, led by Secretary Paulson, lurched from deal to deal. First, the government acted out of a need to save institutions but punish shareholders in the name of fighting moral hazard. Then it acted more benignly to shareholders as the bailout progressed and the government realized that its stance on moral hazard was increasingly harmful. The government and Paulson were learning and limited by the law in acting in full force, but their ad hoc response appeared to fail to fully restore confidence to the system. Moreover, the rigid structures the government created led it to repeatedly restructure its bailouts.

  Despite its broader failure, government by deal showed that dealmakers, given freedom by the government, could creatively order deals in the shadow of the law. In doing so, dealmakers would look to preexisting precedent but would be willing to create new deal structures. This spoke to the incredible power of the U.S. government as dealmaker, able to structure deals of this nature safe in knowing that no state regulator or court, such as Delaware, would challenge them.

  But it also spoke to the power of dealmaking and its ability to implement sophisticated solutions in high-pressure, time-sensitive environments.

  The government’s dealmaking also showed the bad side of dealmaking. At times, the government implemented their specific goal—a deal—to the detriment of wider purposes. And Paulson’s dealmaking spree showed the addictiveness of dealmaking. In the heat of crisis, dealmaking becomes a definable solution and the deal-junkie in every dealmaker rises to the occasion. But here a dealmaking solution could not offer a permanent solution. The government, to some extent, appeared to recognize this at times, but other than the TARP program never sought wider legal authorization to seize and lend to financial institutions.

  Government by deal also had a more pervasive effect on dealmaking generally. The government’s deals were modeled on normal strategic deals. But the government stretched this model, pushing for deal certainty and a structure meeting its own political needs. Learning from the government, private actors began to advantage themselves of these structures. The Wachovia deal is a good example. There, Wells Fargo took advantage of government backing to arrange a 39.5 percent share issuance by Wachovia to Wells Fargo to vote through Wells Fargo’s acquisition. Coercive deal protections of this type would proba
bly have been struck down by courts in normal times. Normal times will hopefully return, but some of these extreme terms are likely to creep into dealmaking on a more permanent basis. The result is likely to stretch the scope of permissible deal protection devices under Delaware and other state laws.

  Chapter 11

  Restructuring Takeovers

  The last 10 chapters have been a whirlwind tour of recent deals and dealmaking. The final two chapters look to the future to ascertain how these recent events will foster change.This chapter explores the regulatory structure governing takeovers, the most prominent aspect of dealmaking, and possible areas for reform and improvement. Chapter 12 synthesizes the lessons of the preceding years and traces the future direction of deals in this crisis and global age.

  Takeovers are defined by many forces, but a principal one is their applicable regulations and regulators. The current regulation of takeovers is a product of our federal system. The federal government has promulgated both procedural and substantive regulation governing the conduct of public takeovers. This skein consists primarily of the 1968 Williams Act rules governing tender offers and the 1934 Exchange Act’s proxy rules governing the solicitation of proxies for shareholders’ votes. There are also special Exchange Act rules governing going-private transactions (i.e., transactions where a significant shareholder, officer, or director of the company squeezes out the remaining shareholders), Securities Act rules governing the registration of securities to be issued in connection with an acquisition, and rules embodied in Section 13(d) of the Exchange Act governing the reporting of acquired interests in a public issuer. Other federal laws also apply to the process, such as the Hart-Scott-Rodino Antitrust Improvements Act, providing an antitrust waiting and review period prior to the completion of a transaction, and the Exon-Florio amendments, providing national security review of acquisitions by foreign buyers.