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.
Sandy MacHoots says:
I have to say I’m extremely impressed with what you’re doing. I wish I had some useful things to say, but all I can say is thanks for posting here! I’ll be sure to read the whole thing.
October 15, 2009, 9:40 pmDave says:
Why do you think this is this even provocative? I assumed this sort of thing was intended from day one of the bailouts, and assumed that everyone involved knew it.
October 15, 2009, 10:05 pmLior says:
Does the government’s sovereign immunity extend to companies it has a controlling stake in?
Assume that Citi does offer different terms in battleground states. The government would be immune from ordering the company to do things. Company officers, however, hold fiduciary duty to all shareholders. Won’t lending this way subject the CEO, CFO etc to junior shareholder suits?
October 15, 2009, 10:52 pmkazinski says:
Yeah, but the company officers could argue that the current administration has so much control over the corporation that angering the current administration would be to the detriment of the company, and injure all the shareholders.
And they would probably be right.
October 15, 2009, 10:57 pmpmorem says:
Another form of abuse to consider is “Friends of Angelo”.
October 15, 2009, 11:08 pmArthurKirkland says:
Is this is offered as scholarship, or a TownHall column?
October 15, 2009, 11:26 pmSteve says:
From the title I thought Neil Cavuto might be guest-posting.
October 15, 2009, 11:34 pmRepublicWindows says:
While it wasn’t acting as a controlling shareholder, Bank of America was certainly forced to make uneconomic decisions in extending further credit to an already bankrupt Republic Windows and Doors in Chicago late last year. Politicians threatened to cut off state business with the bank, even though as a creditor it was already facing loss of principal: http://www.chicagobusiness.com/cgi-bin/news.pl?id=32120. Wells Fargo was facing similar opprobrium over its DIP loans to Hart Marx (story).
Put Citigroup today in B of A’s position then, and it is hard to imagine calls not being placed from Washington to “encourage” credit to be extended, whether that serves the shareholders’ interest or not. One could also make the argument that severe restrictions on pay are not in the non-government shareholders’ long term interests, if they cause defections of key executives. See, for example, Andrew Hall of Citi, who despite being paid a percentage of profit (clearly in all shareholders’ interests) was under severe pressure not to collect on his contractually-obligated pay package. One may believe that he was wildly overpaid to begin with, but that is an economic question, not a political one.
October 16, 2009, 1:27 amJohn Frederick says:
A Government and business marriage will tend towards such shenanigans in the short run. In the long run a heavier hand informs other market participants that opposition is not just unwelcome, but hazardous.
October 16, 2009, 2:24 amFriday Highlights | Pseudo-Polymath says:
[...] mortgage crises was so much fun … let’s line up another. And not unrelated … more bailout problems noted. Here [...]
October 16, 2009, 6:58 amJR says:
Ugh. Lamentably underdeveloped. I take it that the likely downsides to government control of private industry are obvious, or at least given, as textbook economics. This still doesn’t take into account several unique characteristics that distinguish TARP et al. from the textbook example. Notably, the government hasn’t purchased financial company securities as part of a “buy and hold” strategy but rather in its role as lender of last resort. This naturally leads to the question whether Treasury is going to spin those securities off, whether to some private equity consortium or in a public offering or otherwise, once the banking situation has stabilized and investors are seeking to reenter the financial sector, or whether the federal government is going to remain a significant or control shareholder. If the former, then the concern about control shareholders warping corporate policy evaporates in the long-term, and in the short term has to be compared to the prevention of a series of bank failures along the lines of the Lehman collapse. (Also unexplored is whether Treasury will have to file 13Ds or 13Gs! I mean, one should consider his audience…)
When one asks the question whether the government should have invested in financial services firms, the qualifiers “assuming a perpetual investment” or “assuming redemption within 2 years” are going to have massive effects on the likely answer. Before even beginning to undertake the comparison of the financial bailout’s costs to its benefits (assuming one believes there was some benefit post-Lehman to shoring up banks’ balance sheets, it seems the responsible argument would make some effort to approximate or at least roughly describe that benefit in order to contrast it with the attendant costs; assuming one doesn’t believe there was any such benefit, it probably would be in service to the transparency of the argument at least to note as much), it seems obviously necessary to describe if not quantify the costs, as well as to identify, at least, the benefits.
But Prof. Verret makes no attempt even to explore any of this. So without a showing either that (a) government control of private entities inevitably continues into the long-term, or (b) government control of these specific financial entities, whether or not it’s inevitable, in fact will continue into the long-term, this argument demonstrates quite little. Possibility (a) seems ill-taken; indeed, given the medium-term history in this country of privatizing utilities, prison administration, etc., it appears that actually-existing political trends are contrary to the fear expressed in these guest posts. Possibility (b) remains alive; however, it’s a speculative possibility about the future. There may be some evidence for it, but I wasn’t aware of any before reading Prof. Verret’s contributions, and I’m not aware of any now.
October 16, 2009, 8:12 amStudent says:
I believe fiduciary duty suits are torts, so you may want to be careful with the Tucker Act analysis.
Restatement (Second) of Torts § 874. Violation Of Fiduciary Duty
One standing in a fiduciary relation with another is subject to liability to the other for harm resulting from a breach of duty imposed by the relation.
October 16, 2009, 9:40 amRhode Island Lawyer says:
Pretty thin gruel that you offer as “evidence”.
October 16, 2009, 9:41 amCalderon says:
I assume it’s too early to tell what Citibank has been doing, but if it’s possible to get the data on loan rates across states it should make for an interesting empirical test.
Also, not to nitpick too much, but like Student this phrase jumped out at me: because fiduciary duty violations aren’t traditionally understood to be torts. I’ve always understood that breach of fiduciary violations are torts, and case law at least in Illinois support the idea. I guess the rule might be different for breaches of the duty of loyalty or duty of care for corporations, as I’m not familiar with what Delaware law says on those topics.
October 16, 2009, 10:12 amAndrew J. Lazarus says:
Not only that, but I hear that the Post Office sells stamps cheaper in blue states.
October 16, 2009, 10:22 amjust another cynic says:
I think we’ve seen powerful evidence from the role of State pension funds as shareholders. The big ones have long thrown their weight around in shareholder governance, and in recent years have been lead plaintiffs in securities litigation. In fact, federal law on securities litigation now expressly favors State funds as plaintiffs.
State legislators have long pushed state funds to divest from “bad products” (e.g., tobacco, porn) or companies doing business in “bad countries” (South Africa in 80s, Iran today), and so on.
So I find it hard to believe that there won’t be pressure, if the feds own Citibank or Chrysler, for plants to stay open in Ohio, and so on. Didn’t we already see hints of that this spring? Also, look at how smart Pentagon contractors have always ensured that a new plane or tank had parts made in committee members’ districts, with final assembly in the chair’s backyard. Nothing new here, and in fact, it’s such an obvious ploy that it’d be surprising if it did NOT happen, given the incentives.
October 16, 2009, 10:56 amJust Dropping By says:
I’ll pile on the “fiduciary duty =/= tort” point by noting that breach of fiduciary duty is a tort under Colorado law: Resolution Trust Corp. v. Heiserman, 898 P.2d 1049, 1056 (Colo. 1995) (“a breach of the fiduciary duty is a tortious act which satisfies the element of unlawful act associated with the definition of civil conspiracy”).
October 16, 2009, 10:56 amHarry Schell says:
Behold the really poltical economy!
If schoolchildren can be induced to sing the praises of the deity, and the pay czar can dictate this year’s pay based on last year’s work and pay (see Lewis, Ken, ex-BoA chairman, 2009 “negative salary”) why wouldn’t Citi’s behavior be influenced by its government owners?
Their goals are not to make money on the stock as much to see poltical agendas fulfilled. This is why FHA is heading for bankruptcy doing exactly the same thing that brought on the mortgage crisis, and CRA is to be invigorated with more money and overt race-based lending quotas, if Maxie Waters has her way.
Get over the idea politicians are your friend (particularly those on the left) and have good intentions. They seek power and continuing to rule. Any move supporting these goals is reasonable.
Why do you think Obama’s stimulus package for construction deals was limited to unionized contractors, shutting 84% of the construction workforce out? The tariff on Chinese tires?
October 16, 2009, 1:12 pmegd says:
Actually, it does. You just don’t realize the real economics.
Democrats are now the party of the rich, representing a majority of the richest districts. Therefore, we can assume Democrats have a higher income than Republicans.
A stamp costs a fixed amount. As a percentage of cost of living, Democrats necessarily pay less than Republicans.
Therefore, shouldn’t there be a progressive stamp tax, costing low-income individuals 5 cents for a stamp, while the rich making over $250,000/year can afford to pay 40 cents for a stamp. For the real rich, those with incomes over a million dollars a year, they should pay $5 for a stamp.
Why should lower income Americans be subsidizing the postal extravagance of the wealthy who refuse to pay their fair share?
October 16, 2009, 5:11 pmHalftrack says:
“Citigroup has already agreed to limit its visa program to hire foreign workers.”
Do these limits go beyond the restrictions added by section 1611 of ARRA? I guess I should read the paper before commenting. Much easier this way though.
October 16, 2009, 5:56 pmConstantin says:
Agreed. If it’s not praising Barack, it ain’t real scholarship.
October 16, 2009, 6:03 pmAndrew J. Lazarus says:
Wow. Innumeracy in spades. Democrats also represent a majority of the poorest districts. (Says so in your very own link.) Therefore your assumption is a complete non sequitur. Can’t you at least concoct snark that follows logically?
October 16, 2009, 6:51 pmTwirlip says:
“Citigroup has already agreed to limit its visa program to hire foreign workers.”
Given the huge unemployment rate in America, what justification is there for any company in America to hire foreign workers?
The finance industry hires a large number of H1B’s to work in the tech sector. The wisdom of this is doubtful even for a private company, but its insane for a semi-state body to be doing it.
October 16, 2009, 7:51 pmConcerned Citizen says:
“…thus losing money for Citigroup and causing it to violate its fiduciary duty to its shareholders.”
Fiduciary duty means nothing anymore for controlling shareholders. Courts will almost never enforce whatever weak laws are on the books that were written by large business interests themselves (i.e. Delaware law). If you think courts will do something to the government, you’re dreaming. Judges are appointed by politicians and they know where their bread is buttered. It’s the Age of Law’s End and all kinds of people will knowingly harm others to make more profit for themselves.
If you are a minority shareholder, you only have to look as far as GM to understand the consequences of having Uncle Sam as your “partner”.
October 16, 2009, 8:00 pmChrisTS says:
Andrew L:
Oh sure, you pinko. Next you will be demanding true premises, relevant evidence, and entailed conclusions. Have you no decency, Sir?
October 16, 2009, 8:33 pmDrew Kelley says:
When the actions of government take it beyond the constraints of the “soap box” and the “ballot box”, that leaves only one other box to use to keep them accountable.
October 17, 2009, 4:36 pmTRUTH ON THE MARKET » TOTM Welcomes New Permanent Blogger J.W. Verret says:
[...] pleased to announce a new permanent member, J.W. Verret (George Mason). J.W. has been blogging at Volokh Conspiracy recently, but he’s been a guest over at The Conglomerate, and the Harvard Law School [...]
October 19, 2009, 2:01 pmBoonton says:
“While it wasn’t acting as a controlling shareholder, Bank of America was certainly forced to make uneconomic decisions in extending further credit to an already bankrupt Republic Windows and Doors in Chicago late last year. Politicians threatened to cut off state business with the bank, even though as a creditor it was already facing loss of principal:”
I think there’s a distinction here between being a simple bank customer and a major shareholder of a bank. Here Chicago could take their bank business wherever they wanted. They had no duty to look out for the shareholders of the bank (in fact, their duty is to look out for Chicago’s welfare which would not have been helped by a business stiffing a large number of workers on their pay).
But let’s imagine a case where Pepsi owns 51% of Clearview Cinemas. They use their majority ownership to force the company to sign a deal with Pepsi making it the official soda of the movie theatre, paying a huge above market markup for the soda supplies. The 49% of shareholders have an argument that they are being harmed. However this sounds kind of odd to me. Couldn’t Pepsi fairly point out that the 49% of shareholders are helped by the fact that Pepsi is holding and not selling 51% of the available shares? If Pepsi was ordered not to force this deal they could simply sell the shares and the shareholders would be hurt much more than by the slight decline in profitability due to overpaying for soda.
The only thing I don’t like about this post is the title. First off, it’s not true. There’s no evidence that Citi is lending more in ‘battleground’ states. Unless you have some don’t feed the anti-Obama wackos….esp. when it’s so easy to just cite the sexy ‘headline’ as the evidence.
Second, it’s not even clear that makes sense. Why lend at good terms to ‘battleground’ states? How will those who get the sweet loans know they owe the gov’t the favor? What about the fact that half of those loans may go to those who are politically opposed to you (after all, by definition, battleground means that the state is roughly divided)?
October 20, 2009, 2:14 pmBoonton says:
“State legislators have long pushed state funds to divest from “bad products” (e.g., tobacco, porn) or companies doing business in “bad countries” (South Africa in 80s, Iran today), and so on. ”
This too indicates the ‘customer’ point. Pension funds or ‘ethical investing’ mutual funds simply sell their shares of companies they feel are doing things that are immoral. But this whole ‘duty to other shareholders’ thing raises what seems to be a major problem.
Say the “Catholic Investor’s Mutual Fund”, the “Born Again Christian Fund”, and the “Feminist Fund” all happen to own some shares of a big entertainment company. It is discovered this company owns a very profitable division that makes porn. All three shareholders, though, instead of simply selling off the shares, decides to introduce a shareholder resolution requiring the company to shut down the division. This resolution passes with 51% of the shareholders.
Can the other 49% lay a claim that they are being forced to see shareholder value destryoed? It seems to me that you’re running into a property rights problem. If you own a company don’t you have a right to run it in a way that is less profitable than it otherwise could have been? If the owners vote to do something that hurts profitability, do minority owners really have a right to overrule that on the grounds that their profit interests trump the property rights of the other owners?
October 20, 2009, 2:24 pm