This article was originally published in the Globe and Mail on November 12, 2008.
There has been no shortage of victims in this financial crisis. Pensions and retirement savings have been severely reduced, jobs have been lost and once powerful financial institutions have failed. But, there is, perhaps, another victim that has largely gone unnoticed: the rule of law.
In his Evil Empire speech before the British House of Commons in June 1982, President Ronald Reagan refocused American political values on the rule of law.
The more zealous proponents of the Reagan legacy sometimes appear to suggest that President Reagan invented the rule of law. In actual fact, by rekindling the embers of the rule of law, the President was reaching back at least to Aristotle, was embracing the Magna Carta (King John was made subject to law) and was tipping his hat to Thomas Payne's Common Sense. As Payne's 1776 pamphlet stated: "For as in absolute governments, the king is law, so in free countries the law ought to be king; and there ought to be no other."
Since President Reagan's 1982 speech, subsequent American administrations have demonstrated, at least in commercial matters, an unwavering commitment to the rule of law and have repeatedly insisted to developing countries that their living standards cannot possibly rise without establishing and adhering to the rule of law.
In modern democratic societies the rule of law underlies not only personal freedoms but also the certainty of legal outcomes upon which commerce relies.
The rule of law means that government must exercise its authority in accordance with established law and due process. That process must give effect to laws enacted through democratic procedures. Government cannot act in an arbitrary manner. All persons must be treated equally. Government cannot be selective in its administration or application of its authority. Government cannot use its immense power to coerce parties to do the government's bidding, no matter how well intentioned. There must be transparent process that leads to predictable legal and commercial outcomes.
Legitimacy is achieved and maintained by consistency of process and result. If you don't pay your debts, your lender can enforce its rights in court. If you commit a crime, you risk being punished. Bankruptcy law allows stakeholders to know the results of an insolvency: the value of the assets of the insolvent will be distributed first to senior secured creditors, then to unsecured creditors, then to preferred shareholders, with any residue being distributed pro rata to the common shareholders. And, in commercial terms, predicated on these legal certainties, each stakeholder's stake is priced in advance based on the risk attached to that stake.
The rule of law is the foundation of the commercial life of modern society. This concept is so fundamental to the way we live our lives, to how business is conducted, that its primacy is easily forgotten.
In the unprecedented events of the past few weeks, the question is whether the actions of US authorities reveal unusual deviations from the rule of law principle. More incisively, the concern is whether the ongoing lack of confidence in the global financial system can be traced in part (and clearly along with a range of other factors) to actions which erode the supremacy of the rule of law.
Against this backdrop, let's examine the following recent seminal transactions orchestrated by US government authorities relating to Bear Stearns, Merrill Lynch & Co. Inc., Lehman Brothers Inc., American International Group Inc. (AIG), Washington Mutual Savings Bank and Wachovia Corp.
From a rule of law perspective, the two most conventional transactions, at opposite ends of the spectrum, are the Lehman insolvency and the Bank of America acquisition of Merrill Lynch. In Lehman, we have the customary operation of bankruptcy law. Court protection was sought. Stakeholders will receive recoveries in an established sequence supervised by a court.
In Merrill Lynch, all non-equity stakeholders in effect replaced Merrill Lynch risk with Bank of America risk (supported by its huge retail deposit base). The shareholders of Merrill Lynch are even slated to receive a price that included a premium to the trading price of their Merrill Lynch shares at the time the Bank of America acquisition was priced. In each case, however, with obviously dramatically different financial consequences, the rule of law test appears, from the formal record, to have been met. And the monstrous disparity in result between the two may be attributed to the financial health of Merrill Lynch versus that of Lehman.
We will have to wait for the many autobiographies these events will inevitably spawn to see if the rumours are true that there was undue influence from US authorities forcing Merrill Lynch to sell itself to Bank of America over a weekend.
Contrasting the results of Lehman with Bear Stearns is telling. In the first meaningful U.S. government intervention in this financial crisis, in March 2008, U.S. authorities orchestrated a sale of Bear Stearns to JP Morgan that ultimately saw shareholders receive $10 (U.S.) a share. As part of the sale, the Fed absorbed losses of up to $29-billion on Bear Stearns' trading obligations and JP Morgan was on the hook for only the first $1-billion of losses.
So, why did all stakeholders of Bear Stearns enjoy at least some returns from a government supported sale, while most Lehman stakeholders will probably enjoy little, if any, return?
The most bizarre sequence of events surrounds Wachovia. On Monday, Sept. 29, the retail banking assets of Wachovia were to be sold to Citibank for $2-billion with the U.S. government absorbing losses above $42-billion on the troubled asset portfolio of Wachovia.
Four days later, the board of directors of Wachovia accepted an offer from Wells Fargo for all of Wachovia for $15-billion, with no government support. Under the terms of the Citibank transaction, the shareholders of Wachovia would largely have been left sharing the paltry $2-billion in addition to whatever the balance of Wachovia was worth. In the Wells Fargo transaction, the Wachovia shareholders will receive a modest return, and the position of all other stakeholders is effectively preserved by becoming Wells Fargo risk.
Did the board of directors of Wachovia, in choosing to maximize shareholders return by accepting the higher Wells Fargo bid, allow the rule of law to prevail in the face initially of extreme contrary pressure from government authorities to accept the lesser Citibank offer? If a better result for Wachovia stakeholders was available so quickly, why did government authorities initially cling to their value destroying transaction? Was the government motivated by a desire to ensure Citibank would have the benefit of Wachovia's very sizable retail deposit base of $448-billion? Is this an appropriate use of government power?
A startling comparison can be made of the Lehman insolvency with the AIG conservatorship. AIG received an $85-billion secured credit facility (subsequently increased) from the Federal Reserve Bank of New York. The U.S. Treasury Department acquired 79.9 per cent of the equity of AIG. In terms of the rule of law, the AIG conservatorship is noteworthy because U.S. federal authorities do not actually regulate AIG. State law regulates.
Also the AIG bondholders presumably retain their right to some return (perhaps only a faint hope in light of the priority of the Fed loan). But, why should the AIG bondholders have the benefit (as a result of the Fed loan) of a more orderly process within which to maximize their return as compared with the Lehman bondholders? Did the AIG bondholders get this benefit over the Lehman bondholders because of the lapse of one extra week? Lehman filed for court protection on Sept. 15, 2008. The AIG conservatorship occurred on Sept. 22, 2008.
Did U.S. authorities posthumously realize the consequences of the Lehman insolvency and thereby decide to act in AIG but not in Lehman? Was letting Lehman fail a desperate attempt by government to cling to the moral hazard principle? Is this consistent with the rule of law?
A three way comparison of Lehman, Bear Stearns and the Washington Mutual transaction is also revealing. Federal regulators seized control of WaMu and immediately sold it to JP Morgan for $1.9-billion. WaMu's Board of Directors and CEO were unaware of the seizure or the deal until it was a fait accompli. Common and preferred shareholders, as well as apparently most WaMu bondholders, will receive nothing.
The modest purchase price was justified on the basis that JP Morgan will absorb losses on WaMu's troubled asset portfolios (even though it acquired $182-billion in WaMu deposits, an invaluable source of low cost funding in the current environment).
In examining the consequences for the stakeholders of Bear Stearns, AIG, Lehman and WaMu, the distinguishing ingredient producing the vastly different outcomes for the various stakeholders was the use (or non-use) of government authority and support, and the manner in which that authority and support was used.
The central issue is not whether government support should also have been provided to Lehman. Rather, the key question in terms of the rule of law analysis is why government support was used in Bear Stearns to produce a very positive result for Bear Stearns stakeholders, used in WaMu and AIG to produce quite negative results for WaMu and AIG stakeholders and not used at all in Lehman.
Has there been a consistent, transparent, non-arbitrary application of specifically legally-authorized government power? Was there a selective use of government authority? By rescuing financial institutions from their mistakes, is the government only encouraging more risk-taking, the so-called moral hazard of government bailouts? Is government picking winners and losers?
Should it be doing so, given how vastly the results for various stakeholders of the companies involved deviated from customary legal outcomes? Does an apparent motivation to save the financial system as a whole justify picking winners and losers when the authority of government was not specifically granted in law to do so? I suspect the stakeholders of Lehman, AIG and WaMu may not think so.
I would submit their position is well founded in the absence of a pre-ordained legal authority granted by statute to government to designate a particular financial institution as systemically important, and a transparent process by which such authority was exercised in certain cases but not in others.
There are those who will argue that, after a crisis period during which ad hoc responses by government prevailed, the U.S. rescue plan legislation enacted on Oct. 3 represents the re-emergence of the rule of law principle. That argument is not compelling.
The first act of U.S. authorities under the new legislation was actually not to use the authority for its stated purpose: buy troubled assets. Rather, the first $250-billion was immediately deployed as direct equity investments in U.S. financial institutions. Furthermore, press reports suggest at least some of the first nine financial institutions identified by U.S. authorities to receive these investments would have preferred to decline the government investment. That option does not appear to have been available. Arbitrary and selective use of government power remains alive.
The foregoing commentary poses more questions than it answers. And, I caution the reader that all the facts are not known. I certainly do not know all the facts. A select few do. But, it is clear that using a Darwinian process of selection orchestrated by government to determine which banks will survive the financial crisis is entirely inconsistent with the rule of law. And, for government to do so without clear authority and transparent process places the rule of law at risk.
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