The Bank Bailout: a License for Sovereign Securities Fraud
| Publication year | 2009 |
| Citation | Vol. 33 No. 01 |
I. Introduction
As this article goes to press, the United States faces "the most severe financial crisis since the Great Depression."(fn1) The stock market has plummeted, wiping out $8.3 trillion in wealth.(fn2) On March 5, 2009, the Dow Jones Industrial Average slid to 6,594.44,(fn3) down from its high of 14,164.53 on October 9, 2007.(fn4) Banks are restricting lending,(fn5) thus interfering with consumer spending and businesses' ability to pay costs- let alone grow.(fn6) As of June 2009, the unemployment rate had skyrocketed to 9.5% with 7 million more people unemployed than in December of 2007.(fn7) Home prices have dropped in many areas, with prices in 20 metropolitan areas declining by 18.7% from March 2008 to March 2009.(fn8) The foreclosure rate reached a record high of 3.85% in the first quarter of 2009.(fn9)
Against this backdrop, and pursuant to authority granted by the Emergency Economic Stabilization Act of 2008, the United States Department of the Treasury has implemented multiple programs to restore liquidity and stability to the financial system. Two of those programs- the Capital Purchase Program and the Capital Assistance Program-are designed to inject capital into the domestic financial institutions. Although the Treasury disputes that these programs "bail out" the banks,(fn10) the public commonly refers to these programs as the "bank bailout."
A key component of these programs is the so-called "equity kicker," which permits the Treasury, on behalf of the taxpayers, to benefit from the improved financial health of the financial institutions. Pursuant to the equity kicker, the Treasury has purchased preferred stock convertible to common stock and common stock warrants from the participating financial institutions. Congress has directed that the Treasury dispose of these securities in such a way as to maximize returns for the taxpayers.
Unaddressed by Congress or the Treasury is the potential for the Treasury to rely on material, nonpublic information when disposing of these securities. The Treasury, pursuant to contractual agreements with the financial institutions, has unfettered access to inside information about those institutions. Moreover, the Treasury has access to material, nonpublic information about future governmental and quasi-governmental conduct that could affect the price of bank securities.
Current law does not curtail the Treasury's ability to engage in insider trading. Although § 10(b) of the Securities Exchange Act prohibits insider trading, this provision does not apply to federal departments. Moreover, even if Congress extended the current prohibition on insider trading to governmental activity, not all of the government's trading on the basis of material, nonpublic information about the banks or about future governmental or quasi-governmental action would fall within the scope of such a prohibition. Further, any attempt to premise a common law tort claim on governmental insider trading would be outside the scope of the Federal Torts Claim Act. Finally, although there is a colorable argument that governmental insider trading constitutes a breach of contract and a taking under the Fifth Amendment, this argument, even if successful, would be limited in application.
Insider trading by the Treasury should, however, be constrained. Allowing the Treasury to trade on inside information would undercut the bailout's goals of promoting overall faith in the markets and buttressing bank stock prices. The potential for increased profits for the taxpayers does not outweigh the cost of decreased public confidence in the markets.
Multiple potential solutions are available, including nationalizing the banks, prohibiting the Treasury from using inside information when making investment decisions, and imposing a "disclose or abstain" rule on the Treasury. The best solution, however, is two-part and includes: (1) the imposition of an ethical wall between the persons making the investment decisions and the Treasury; and (2) the establishment of an investment plan that divests the Treasury of discretion over investment decisions.
Part II of this article details how the bank bailout affords the Treasury the motive and the opportunity to engage in insider trading on behalf of the taxpayers. Part III examines previous bailouts in order to place the bank bailout in historical context and to exemplify the potential for insider trading. Part IV analyzes whether the current legal and regulatory system imposes restrictions on insider trading by the Treasury, and Part V argues that, despite the lack of current checks on governmental insider trading, insider trading by the Treasury should be inhibited. Part VI examines multiple possible solutions and recommends the combination of an ethical wall and an investment plan.
II. The Bailout Affords the Treasury the Motive and the Opportunity to Engage in Insider Trading on Behalf of the Taxpayers
The central purpose of the Emergency Economic Stabilization Act of 2008 ("the EES Act") is "to immediately provide authority and facilities that the Secretary of the Treasury can use to restore liquidity and stability to the financial system of the United States."(fn11) At the same time, however, the EES Act mandates that such authority be used in a way that protects other important goals-such as maximizing overall returns for the taxpayers and providing public accountability for the exercise of the bailout authority.(fn12)
A key component of the Treasury's strategy pursuant to the EES Act is the injection of capital into the domestic financial institutions. The rationale is that more capital enables financial institutions to "take losses as they write down or sell troubled assets" and "supports lend-ing."(fn13) Two of the programs implemented by the Treasury pursuant to this strategy-the Capital Purchase Program and the Capital Assistance Program-afford the government the motive and the opportunity to trade in bank stocks on behalf of the taxpayers while in possession of material, nonpublic information. First, this section discusses how these programs, by granting the Treasury authority to make investment decisions about bank securities and access to inside information, afford the Treasury the opportunity to engage in insider trading. Second, this section demonstrates that the Treasury has the motive to engage in insider trading in order to maximize returns for the taxpayers. Finally, this section proffers specific examples of how the Treasury could use this opportunity to engage in insider trading for the benefit of the taxpayers.
The Treasury has the opportunity to trade in bank securities while in possession of material, nonpublic information. As explained in this section, the Treasury has the authority to make investment decisions about bank securities under the Capital Purchase Program and the Capital Assistance Program. The Treasury also has access to nonpublic information that could materially affect the price of bank securities.
1. The Treasury's Authority to Make Investment Decisions about Bank Securities under the Capital Purchase Program
The Treasury created the Capital Purchase Program ("the CPP") in October 2008.(fn14) With the goal of encouraging "U.S. financial institutions to build capital to increase the flow of financing to U.S. businesses and consumers and to support the U.S. economy," the CPP authorizes the Treasury to purchase up to $250 billion of senior preferred stock in qualifying banks.(fn15) As of February 28, 2009, the Treasury had purchased $196.7 billion of preferred stock in 467 financial institutions.(fn16)
In addition, pursuant to the CPP, the Treasury receives from the participating banks "warrants to purchase common stock with an aggregate market price equal to 15 percent of the senior preferred invest-ment."(fn17) The warrants' exercise price is "the market price of the participating institution's common stock at the time of issuance, calculated on a 20-trading day trailing average."(fn18) These warrants allow the taxpayers to benefit from the improved health of the banks resulting from the CPP funds.(fn19) As of March 30, 2009, the Treasury held unexercised warrants to purchase shares of common stock in 265 banks, many of which are publicly traded.(fn20) For example, pursuant to the CPP, the Treasury received a warrant to purchase 73,075,674 shares of Bank of America Corporation common stock at an exercise price of $30.79 per share(fn21) and a warrant to purchase 210,084,034 shares of Citigroup Inc. common stock at an exercise price of $17.85 per share.(fn22)
If a financial institution repays the CPP preferred stock,(fn23) the institution has the right to repurchase the warrants issued to the Treasury for "fair market value."(fn24) If the Treasury and the bank cannot agree on the fair market value of the warrants, the two parties will follow an appraisal procedure to determine the value.(fn25) In this scenario, the Treasury has little control over the timing of the warrants' sale.
If an institution repays the Treasury but fails to repurchase the warrants, however, the Treasury has the discretion to dispose of the warrants when and how it wishes.(fn26) As originally enacted, the American Recovery and...
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