Part Three Begins

Part Three of my book will have the heading "Some Policy Consequences."

Some transitional material. In chapter 10 we asked ourselves: what keeps those hungry piranha alive in the liquid marketplace? After all, they can't perform their function of continuing to eat up raw meat (profitable inefficiencies) unless there is a fresh supply of raw meat. We identified some of the sources of inefficiency. One of these is bankruptcy law, and the opportunity it affords to those willing to buy up distressed debt and maneuver their way through the system.

But of course it is not the job of public policy to make life easy for such piranha. Indeed, I propose in the following four chapters to work on the presump-tion that it is the job of public policy to make their life more difficult, to narrow the ecological niche that piranha fill.

Its first chapter, 13, concerns "Bankruptcies and Rescues."

Within US laws that now govern corporate bankruptcies, there are at least two great sources of inefficiency. The first is the degree of secrecy the system allows, and the second is the skewed incentives that it creates for trustees. We'll look at those in that order, and then we'll ask a broader question: does the U.S. really need a voluntary system of corporate reorganization at all? What might happen if the only corporate bankruptcies were the involuntary sort sought by creditors?

The Federal Rules of Bankruptcy Procedure in their current form [though amendments are scheduled to take effect this December], prescribe disclosure by an "entity or committee representing more than one credit" of the identity of the creditor involved, the nature and amount of its interest, the dates on which the separate interests were acquired, and even the amounts paid for them. If rigorously enforced, that would make life rather difficult for speculators, who depend upon the opacity of the proprietary strategies. They have resisted rigorous enforcement of that rule, creating committees that aren't really committees, for example.

In the case of Northwest Airlines (2007), this technical-sounding issue received a burst of publicity. The condition of the US airlines industry made this bankruptcy of especial interest to a broad public.

Bankruptcy and Transparency

A controversy about the rules of bankruptcy procedure, specifically rule 2019, has bubbled along for three years now and may be about to make a big change in the way corporate bankruptcies are handled in the U.S.

It all began in February 2007 with a "seemingly innocuous opinion" by Judge Gropper of the Manhattan bankruptcy court in the Northwest Airlines case.

Gropper held that under rule 2019, hedge funds that were a member of one of the ad hoc groups that form for the purposes of negotiating/arguing out the terms of a debtor company's reorganization have to turn over to their court information that hedge funds as such like to keep close to their vests -- information amount about interest held and the price at which that interest was purchased.

The funds tried to mitigate the harm to their traditional trading strategies that this threatened, by asking for permission to provide this information under seal. But Gropper, a few days later, shot that down, too.

Several other bankruptcy courts have considered the matter since then. No consensus has developed among them as to what 2019 means.

In August 2009, the Advisory Committee on the Federal Rules of Bankruptcy Procedure (Advisory Committee) proposed a significant revision of the rule In part, this came about because of the need for legal certainty. As important, though, it came about because many well-placed people think Gropper was right on policy grounds, and that it would be good to have a rule that is very clear about that.

The proposed rule revision would change the bankruptcy investing game in three principal ways: (1) it would widen the scope of who must disclose under Rule 2019; (2) it would widen the scope of what must be disclosed; and (3) it would give bankruptcy courts wider discretion to relieve or abridge disclosure obligations, especially disclosure regarding the prices of assets purchased in secondary market trading. This article discusses the proposed revision in depth, focusing on the potential consequences for hedge funds that invest in and around bankruptcies.

There is now a widespread expectation that there will be reform, that it will be in place by the end of 2011, and that the results will demand more transparency than anyone would have expected before Gropper put this ball in play.

For the possible significance of this, I refer you back to my explanation at the time of Gropper's stance.

Northwest plan

A bankruptcy court judge in New York this week gave Northwest Airlines permission to emerge from chapter 11. The company's reorganization plan drew a rare show of support ... more than 97% of the creditors eligible to vote on the plan have approved it.

The airline said in a statement that it expects to re-emerge formally on May 31.

According to the plan, NW's secured creditors will be paid in full. Most unsecured creditors will be paid subject to a discount, which will vary in size depending on the nature of their claim. They'll get as much as 83% of what they were owed, as little as 66%.

The old stockholders will get nothing. The new company will raise its initial round of operating cash by selling new shares, which will trade on the NYSE under the symbol NWA.

This is as it should be. I don't mean that the re-emergence of the airline is a good thing. My view has long been that the airline industry desperately needs consolidation, and that the revolving-door bankruptcies are part of the problem, not part of the solution. If Northwest were actually liquidated, and its fleet melted down into scrap so that none of those planes would ever serve passengers again, the remaining airlines would face that much less competition, and the industry would be closer to a sustainable equilibrium.

This would mean higher costs to passengers -- but then, passengers aren't entitled to an endless future of below-cost pricing.

What is as it should be about the plan is that the old equity owners are zeroed out. THAT will be a disincentive for them to ever invest in an airline again, and the punishment meted upon them may serve the goal of consolidation, too.

More generally, the system of corporate law in most of the world these days, a system with Anglo-American roots, links the "residual risk" borne by equity holders to their dominance as decision makers. The board of directors of any company is supposed to represent the holders of equity, precisely because they represent the folks who have no contractual interest, who stand to lose everything if the operation fails.

There is an intuitive force to this connection of ideas and it is good to see the "loss" part of the profit-and-loss equation coming to fruition.

The Forces of Secrecy Gather

My entry one week ago was entitled "A Cheer for Bloomberg News." I want to return to the subject I discussed there, because there's been a new development.

A bit about corporate bankruptcies, though, as filler here. Whether it takes the form of liquidation or re-organization, there is a well establish order of precedence.

Imagine a newly bankrupt corporation as a see-saw with a much heavier weight at one end than at the other. The lighter end, accordingly, is up in the air. The heavy end on the ground.

In terms of the right to receive a payoff, the most senior or best secured debt instruments have first dibs, and after that payments follow in legally defined sequence with the owners of equity sitting on the ground. At some point, moving down the lever/see-saw, the tangible assets of the estate run out. But, if we're assuming that there is some good will for the ongoing enterprise, there is still some value to be distributed. The instruments that represent that point are, accordingly, sometimes called the "fulcrum securities."

A lot of jockeying goes into determining the placement of the teeter-tooter. Some interests don't want their own securities to be too high on the lever. They'd rather get equity in the re-organized company, in the hope of course that it'll prove more valuable. On the other hand, if you have a high position on the lever, and jockey to lower it in search of the fulcrum, you might miscalculate, end up below the fulcrum, and get ... nothing.

It's a very high stakes game. Further, its a game with consequences for the rest of us, because the system is supposed to work in a way that lets a productive corporation re-emerge into the higgle-haggle of the market again ready to serve customers, treat employees fairly, and otherwise embody quaint ideas of productivity. Since the public interest is involved, the process is supposed to have some transparency. Anyone ready to look through the court records (which are available on line through the wonderful PACER system) can figure out who ismaking what motion, and what they have at stake in it.

All that said: in the ongoing Northwest Airlines bankruptcy proceedings, certain Wall Street speculators have tried to operate an "ad hoc committee" to jockey for position without disclosing anything -- or very little -- about their own stakes. They want such information to the "under seal," which means that it won't be on PACER, it won't be available in paper form to somebody asking at the court clerk's desk, and the other parties to the action who do see this information will be sworn to secrecy.

As I observed last week, Bloomberg News and its counsels, to their undying credit, are fighting the good fight here, trying to obtain and make public information about the Northwest Airlines proceedings.

Unfortunately, the forces of secrecy are gathering. Two industry groups that between them represent much of Wall Street have joined in assisting the speculators in their efforts to (a) persuade the bankruptcy judge to reconsider his pro-disclosure ruling, and (b) appeal over his head if they can't.

In a memo they said that such disclosure of "proprietary and highly confidential information" will quite probably "erect a substantial obstacle to the participation of many stakeholders—in particular, those sophisticated stakeholders that are most likely to have the means and the experience to make a positive contribution toward reorganization."

Get that? The speculators want to keep their secrets because keeping secrets helps them win. They should be allowed to keep their secrets because they are so "sophisticated" that they can help the court in its goal of re-organizing.

Um, sorry. No sale. This is sounding a lot like military procurement. The bankruptcy court is like a little Pentagon, the "sophisticated" speculators are like contractors selling it weapons, uniforms, vehicles, or whatever. The greater the transparency, the less the threat that the rest of the country is being ripped off by cronyism, double-dealing, and other earmarks of the sophisticates of every age since record-keeping began.

http://www.bloomberg.com/apps/news?pid=20601039&refer=columnist_pauly&sid=alsJTc7wcqFA

Do you, dear reader, want to do something in the service of such transparecy? Okay. Write to judge Allan Gropper, of the U.S. Bankruptcy Court, Southern District of Manhattan. Tell him you approve of the stand he has taken, and he should stick with it, however many Wall Street purchased amicus briefs he receives the other way.

A Cheer for Bloomberg News

Does information really "want to be free"? Of course not. A piece of information isn't a wanting or doing sort of creature.

Anthropomorphism aside, is there some natural tendency in the world, now that the world has an internet (and wireless access yet!) toward the ever-wider spread of what had been secret?

There is a historical tendency here, but it isn't inherent in technology. The tendency is one that Adam Smith would have understood quite well. If there is a demand for information (a demand in the market sense, a demand that will express itself in the payment of money), then someone will seek to supply it. The greater that demand, supply being constant, the greater the price. If we also assume constant costs, then the increase in price will make for a greater profit.

As you can see, there are a lot of assumptions involved in that reasoning. Still, private and corporate espionage both long predated the internet. What information "wants" is to be bought and sold. Free in the sense of "liberated," not "free" in the sense of "gifted."

But then there are the structures of power. And they haven't changed all that much of late. I doubt I'll get into any conspiracy theorists' hall of fame if I make the general observation that governments like to keep secrets, and they like to enable their private sector cronies to keep secrets as well. These are the would-be prisons whence information has to be liberated in order to be (freely) bought and sold.

These thoughts didn't drop down into my head out of the blue. They've come to me now because of the ongoing Northwest Airlines bankruptcy proceedings. Bloomberg News and its counsels, to their undying credit, are fighting the good fight here, trying to obtain and make public information about who owns what claims against the company in the context of that reorganization.

The issue is whether certain Wall Street speculators can use court orders -- and, thus, governmental power -- to keep certain secrets "under seal" that have a good deal of relevance to Main Street USA -- to the future of an important company within a very high-visibility and troubled industry. A ruling Friday went the way Bloomberg News wanted. It now appears that the speculators will have to disclose.

We should mark this as a small victory for the liberation of data. Information doesn't want anything, but those of us who are wanting beings should want this sort of information to be available.