In a seminal exchange, David Faber, the CNBC host, asked Schwartz about counterparty risk and rumors that the investment bank Goldman Sachs would not trade with Bear Stearns. Schwartz responded: “There’s been a lot of volatility in the market… . We are in a constant dialogue with all of the major dealers and the counterparties on the street and we are not being made aware of anybody who is not taking our credit as a counterparty … Our liquidity position has not changed at all. Our balance sheet has not weakened at all… .”12
The exchange was cited as Bear Stearns’s first public death blow. Banks run on trust and confidence, and Faber’s remark was seen as publicly alerting the markets to a growing lack of confidence. But it is unfair to pin Bear Stearns’s fall at this point on Faber’s questions. The rumors were gathering, and a storm was about to hit. Bear Stearns was in that precarious of a position. Thursday was when it all ended for Bear Stearns. By that day, the rumors were rampant, traders were en masse refusing to conduct business with Bear Stearns, and asset managers, particularly hedge funds, continued to rush to pull funds from the bank. The hedge fund D.E. Shaw & Co. alone had withdrawn $5 billion in cash. More perilously, Bear required daily financing of approximately $75 billion to function. These funds were obtained in the short-term repurchase (repo) market, with Bear putting up collateral assets in exchange for cash liquidity. On Thursday morning, Bear was unable to obtain approximately $20 billion of the $75 billion required.13
By Thursday night, Bear Stearns’s liquid reserves had dropped from $18.3 billion the week before to $5.9 billion, and it owed Citigroup $2.4 billion.14 The next day’s available borrowings in the repo market looked ready to decline even further. The rapid decline of Bear Stearns’s liquidity showed the perils of using prime brokerage accounts (i.e., hedge fund deposits) and daily repo lending for liquidity purposes, as Bear Stearns had done. These funds could be pulled at any time by these sophisticated clients and lenders. When that happened, Bear Stearns concluded on Thursday that without outside assistance it would have to file bankruptcy the next day.15 Bear had experienced a classic run on the bank driven primarily by a collapse in repo lending with an able assist due to prime brokerage account flight.
After the market close, Schwartz contacted JPMorgan CEO Jamie Dimon and Timothy Geithner, then president of the New York Federal Reserve. Schwartz’s sober news: Bear Stearns was going to be insolvent in the morning unless a lifeline was put together. Faced with the sudden collapse of Bear Stearns and the shock it would cause to the financial markets, the Federal Reserve overnight decided to guarantee a 28-day loan from JPMorgan to Bear Stearns in the amount of $30 billion.16
The Federal Reserve had no choice. The markets were shaky as it was, and a quick collapse of Bear Stearns would be likely to bring on a chain reaction that would cause a wave of financial institution collapses. Bear Stearns was saved, and it now thought it had 28 days to find a lifeline. Additionally, the market thought that Bear Stearns’s situation was likely to be achieved through a stockholder-friendly resolution. Bear Stearns’s stock closed that Friday at $30 a share.
The decision did not sit well politically with Secretary of the Treasury Henry Paulson. Moreover, Bear Stearn’s financial situation appeared to be further destabilizing that Friday, and according to Geithner, the run even accelerated.17 That Friday evening, Schwartz was informed by Paulson and Geithner that the guarantee and loan would be terminated in 72 hours by the Fed, leaving Bear Stearns to find an alternative transaction by that time or declare bankruptcy.18 The reasons for the government’s reversal of course on Bear Stearns still remain somewhat murky, though the government has since adamantly claimed that it had no choice due to the continuing deterioration of Bear Stearns. The next move by the government was less mysterious.19 It apparently already had an idea about a buyer for Bear Stearns.
There were two prospective bidders: JPMorgan and a consortium led by private equity firm J.C. Flowers.The Fed and the Treasury Department, which were both actively involved in structuring this bailout, were unable to commit to provide the approximately $20 billion in financial assistance J.C. Flowers required to make an acquisition, essentially locking the J.C. Flowers group out of the process.20 Furthermore, Treasury pushed JPMorgan to offer as low a price as possible for Bear Stearns, a company that on Friday had closed at $30 a share and on Monday had closed at $70 a share. Under Secretary of the Treasury Robert Steel would later testify that Secretary Paulson encouraged this low price in order to prevent future moral hazard by financial institutions.21
JPMorgan had maximum leverage, and Secretary Paulson deliberately encouraged JPMorgan to price the transaction low. When the final per-share price was announced, it was shocking. JPMorgan agreed to pay $2 a share for a company that a year ago was trading as high as $172 a share. The Federal Reserve had also agreed to continue guaranteeing Bear Stearns’s liabilities up to $30 billion. The Fed’s subsidy was a pure wealth transfer to JPMorgan’s shareholders. On that Monday, JPMorgan’s stock closed up 10 percent as the broader market declined. The stock price rise increased the bank’s market capitalization by more than $12 billion.This was the market’s measure of the amount of money JPMorgan had earned on its acquisition.
For those who follow their history, this deal was similar to the Goodbody one. In 1970, Merrill Lynch was picked as the biggest banker on Wall Street to pay $15 million to take over Goodbody & Company. In the process Merrill demanded, and received, a backstop guarantee of $30 million from the rest of the Wall Street community and made tremendous profits in securing Goodbody’s brokerage operation. This time, the Federal Reserve had put together a similar bailout, with benefits going to the market leader.22
The market erupted in frenzied debate over the implications of this bailout with many decrying the bargain basement price forced on Bear Stearns. Others criticized the help provided, insisting that Bear Stearns should have been allowed to collapse. For deal watchers, though, the most interesting thing about the Bear Stearns deal was not the price, but its terms. Over the weekend, the lawyers for JPMorgan—Wachtell, Lipton, Rosen & Katz—had managed to negotiate a number of unique provisions in the acquisition agreement to ensure that the deal would be completed.
JPMorgan and its lawyers were attempting to address two problems: First, the deal price offered was so low that Bear Stearns’s shareholders might revolt and simply decide that bankruptcy was a preferred option. Second, the employees of Bear Stearns were unlikely to welcome JPMorgan’s takeover and needed firm oversight even before deal completion. The agreement Wachtell negotiated pushed the legal envelope, going much further than Delaware law typically allows for deal protection devices. But in their haste, Wachtell would soon prove too clever. The agreement had several features that were designed to ensure that Bear Stearns could not escape JPMorgan’s embrace, but these provisions would soon turn out to be more beneficial to Bear Stearns than to JPMorgan.
JPMorgan’s Grip
The acquisition agreement placed Bear Stearns in a tight grip until the acquisition closed. It provided JPMorgan the right to direct the business of Bear Stearns in its reasonable discretion, down to having a veto right on Bear Stearns’s ability to hire, promote, or terminate “employees in the position of vice president or above.”23 This was highly unusual. Acquisition agreements typically contain negative control rights over a company. So, for example, a typical acquisition agreement would contain provisions preventing the target from selling material assets or declaring unusual dividends. But these agreements seldom contained affirmative rights like those JPMorgan had obtained. The reason was that these provisions probably violated Delaware law as an undue delegation of corporate control by the target’s board to the buyer. Bear Stearns was incorporated under the laws of the State of Delaware, and so Delaware law governed the validity of the Bear Stearns board’s actions in agreeing to this transaction.
Bear Stearns’s Put
Delaware law requires that the shareholders of an acquired company in a merger have a vote,
and so the acquisition agreement provided for Bear Stearns to hold a shareholder meeting for its shareholders to approve the transaction. If Bear Stearns’s shareholders voted no, the acquisition agreement required that the companies negotiate a restructuring of the transaction and resubmit the deal to Bear Stearns’s shareholders for approval at the same $2 a share price. This obligation lasted for a full year until March 16, 2009. Moreover, the agreement only permitted the Bear Stearns board to change its recommendation if a higher bid emerged. The Bear Stearns board could terminate the agreement only after one year. JPMorgan thus had the option of waiting a full year before Bear Stearns could terminate its agreement to accept a higher proposal.24
The provision was designed to ensure that JPMorgan would have a second, and possibly a third, bite at the apple if Bear Stearns’s shareholders voted no. It was highly unusual. Almost always in the case of a no vote, a target can terminate the acquisition agreement with its only obligation being a possible termination fee payment to a buyer.The net effect was still probably favorable to Bear Stearns’s shareholders. The provision effectively provided Bear Stearns’s shareholders a put right for a year to JPMorgan. During that time, Bear Stearns’s shareholders could theoretically keep voting no while waiting for a better option to appear and for Bear Stearns and the markets generally to stabilize.
The Bear Stearns Headquarters
In 2001, Bear Stearns had built a beautiful 47-story headquarters building in Midtown Manhattan, which was named one of the best new skyscrapers for that year. Under the agreement, JPMorgan was granted an option to purchase Bear Stearns’s headquarters for $1.1 billion.25 An asset option of this type was not unusual in distressed sales. Dynegy Inc. had negotiated an option to purchase Enron’s Northern Natural Gas pipeline when it agreed to a distressed purchase of that company and an investment of $1.5 billion. The option was eventually exercised, even though Dynegy escaped buying Enron, which ignominiously fell into bankruptcy.26
The JPMorgan building option was a weaker form than Dynegy’s and exercisable in circumstances where the acquisition agreement was terminated and Bear Stearns’s board had either changed their recommendation or the agreement was terminated after the one-year anniversary thereof and another bid was pending at the time. This was actually a relatively minor form of deal-protection device. It applied only in confined circumstances and allowed Bear Stearns to keep its building if Bear Stearns’s shareholders voted no simply because of an objection to the $2 a share price.27
The Uncapped Option
In connection with the execution of the acquisition agreement, Bear Stearns issued JPMorgan an option to purchase 19.9 percent of Bear Stearns at $2 a share. The option was limited to only 19.9 percent of Bear Stearns because of the requirements of New York Stock Exchange Listing Rule 312. Rule 312 prohibits a company listed on the NYSE from issuing 20 percent or more of a listed company’s voting stock without prior shareholder approval.28
This type of option is not unusual. It first arose as a form of termination fee that also functioned to kill pooling accounting. In prior times, the exercise of the option and issuance of such a significant number of shares meant that a subsequent bidder could use only purchase accounting in their acquisition, not pooling accounting. This was a significant deterrent because the use of pooling accounting meant that a buyer did not have to write off good will to its earnings. Pooling accounting had been eliminated in 2001, but these options continued to linger, particularly in bank deals. The reason is that they provide a cash-free form of compensation if the option is exercised since the bidder is compensated in shares of the target.
In Bear Stearns’s case, it probably did conserve cash, but the option contained a unique feature. It was an uncapped option; in other words, if a higher bidder emerged, then JPMorgan’s compensation on the option was not limited. This type of option, one where the payment could presumably exceed the 3 to 4 percent maximum limit generally imposed by Delaware law, had in other circumstances been ruled an inappropriate deal-protection device for a company involved in a change of control in the seminal case of Paramount v. QVC.29
Appraisal Rights
Finally, JPMorgan offered stock consideration to Bear Stearns’s shareholders instead of cash. Presumably, this was done to avoid providing appraisal rights to Bear Stearns’s shareholders under Section 262 of the Delaware General Corporation Law.30 Appraisal rights allow a shareholder to go to the Delaware court and have the court independently assess the value of his or her shares. The shareholder receives this court-ordered amount, which can be higher or lower than the consideration offered by the buyer.
If JPMorgan had offered cash, these rights would have been available, and Bear Stearns’s stockholders could go to a Delaware court to seek a determination of the fair value of their stock. Given the bargain basement price being paid here, there was a real risk that appraisal rights could provide Bear Stearns’s shareholders substantial compensation. The distinction highlights a flaw in the appraisal rights statute. Simply by altering the consideration, parties could take away the right. The distinction here made no sense, but was leveraged by JPMorgan to its advantage.
JPMorgan’s Out
In exchange for agreeing to these deal protections, Bear Stearns negotiated an equally tight death grip on JPMorgan. The acquisition agreement did not have an out for any further deterioration of Bear Stearns and particularly did not have a MAC clause.31 Unless Bear Stearns deliberately breached the agreement or the guarantee, JPMorgan was bound to complete this deal.
Bear Stearns’s Fury
In the ensuing uproar after announcement of the deal, Bear Stearns’s shareholders and employees claimed that the government had not only forced Bear Stearns into the arms of JPMorgan but also done so at a penalizing price. Two days after the acquisition agreement was signed, James Dimon, JPMorgan’s chief executive, ventured out in the rain to Bear headquarters to speak to the wounded Bear employees. Landon Thomas Jr. and Eric Dash of the New York Times relayed this exchange:
“In this room are people who have built this firm and lost a lot, our fortunes,” one Bear executive said to Mr. Dimon with anger in his voice. “What will you do to make us whole?”
The packed room of senior managing directors applauded.
Mr. Dimon responded gingerly. “You’re acting like it’s our fault, and it’s not. If you stay we will make you happy.”
But the Bear employee was not satisfied. “I think it’s galling you come into our house and you call this a ‘merger,”” the Bear executive went on.
This time, Mr. Dimon was silent.32
This debate missed the only other alternative for Bear Stearns, given the government’s position: bankruptcy. Given Bear Stearns’s substantial assets, the question was whether its equity holders would reap more than $2 a share in bankruptcy. This may have been a possibility for an industrial company with hard assets like factories, but Bear Stearns was principally a brokerage operation. Brokerage operations are not permitted to file bankruptcy under Chapter 11, which permits a reorganization and allows a bankrupt company to keep any going concern value. Rather, brokerages are required to file under Chapter 7, which requires that they sell off their assets and liquidate. The rule is designed to protect the security holders who have deposited securities with the brokerage. However, here it significantly handicapped Bear Stearns. It would have to find enough cash to keep the brokerage operating until it could be sold and otherwise sell off other assets to do so while the main holding company entered into bankruptcy.
This made the bankruptcy option substantially more uncertain than normal. Bear Stearns would ultimately decide not to pursue this option, claiming that there was insufficient liquidity in its operations to manage such a sell-off. In fact, reports of the board deliberations would later emerge indicating that only ex-Bear Stearns CEO James Cayne would support a bankruptcy filing, and only as a means to punish the U.S. government for its conduct.33
But another force was working to benefit Bear
Stearns’s shareholders. The agreements Wachtell had designed to tightly bind Bear Stearns to JPMorgan and prevent its escape were having a different effect.
JPMorgan’s Dilemma
JPMorgan’s problem arose from the interaction of its guarantee with the voting provisions in the acquisition agreement. Under the acquisition agreement, Bear Stearns had a year to keep the deal outstanding, during which time its only obligation was to repeatedly hold shareholder meetings to approve the transaction. JPMorgan’s guarantee required JPMorgan to keep guaranteeing Bear Stearns’s liabilities incurred during that time period. That is, even after the rejection from Bear Stearns’s shareholders, JPMorgan’s guarantee would continue to apply to any liabilities Bear Stearns accrued up to the date the agreement was terminated.34
The provision allowed Bear Stearns’s shareholders to seek a higher bid while Bear Stearns could still trade safely in the shadow of JPMorgan’s guarantee. Although the guarantee would not apply to liabilities accrued after termination of the acquisition agreement, it may have been much broader than JPMorgan and Wachtell meant it to be. This is because the guarantee was retroactively terminated only if there was a change of the recommendation by Bear Stearns’s board, not a negative vote by Bear Stearns’s shareholders. The language in the guarantee also suggested a scenario where an offer could be made and the board could recommend that shareholders reject the third-party offer, but still permit shareholders to tender into the new offer. So, Bear Stearns’s board could simply sit tight, wait for its shareholders to reject the deal for a year, and then when things had stabilized, seek a better transaction.35
Apparently, over the course of the week after the announcement of the deal, JPMorgan began to realize this issue and the unintentional option it had provided Bear Stearns.This was confirmed by news reports stating that Dimon was “apoplectic” at Wachtell for negotiating these provisions and was seeking to have the guarantee modified.36 Publicly, JPMorgan stated things differently. They asserted that the uncertainty as to JPMorgan’s acquisition was creating continued liquidity problems with Bear Stearns, and so the guarantee needed to be tightened. Nonetheless, the Wall Street Journal relayed this conversation between Dimon and the CEO of Bear Stearns Alan Schwartz over the guarantee:
Gods at War: Shotgun Takeovers, Government by Deal, and the Private Equity Implosion Page 17
