18 The Moral Hazard Question

OCTOBER 2003

Moral hazard, a term of art, exists where participants in financial processes bear little, or no, risk of loss if things go wrong. The term moral hazard usually refers to the situation in lending by commercial banks where if a money default occurs, the commercial bank can count on being made whole through grants or gifts bestowed by governments, government agencies or quasi-government agencies. Such a no lose situation for the banks gives the banks incentives to be extremely careless in their lending policies, knowing that if there are to be money defaults, the institution will be bailed out by third parties.

Moral hazard, or the lack of downside for participants in financial processes, is pervasive, encompassing many more areas than just bank lending. U.S. bank deposits insured by the FDIC for up to $100,000 become riskless for depositors. The “hot money” put into emerging market currencies in the 1990’s — Thailand, Philippines, Russia, Indonesia — were also riskless because the monies could be converted to other currencies and repatriated easily, and without penalty, to other countries merely by zapping a computer key. Unlike what would occur under Chapter 11 in the U.S., hot money creditors to foreign sovereigns are not stopped from pulling out funds through the operation of an “automatic stay.”

Activists involved in all financial processes try, if they can, to eliminate risks. If participants in financial processes do not take risks, gross abuses seem certain to occur, and have occurred, with regularity. This is not good for societies or economies. However, most financial processes do serve important social and economic purposes, even when moral hazard exists. These processes ought not to be abolished. Rather, they ought to be structured so that the various participants have “skin in the game” — i.e., something to lose.

Four areas of moral hazard very much affect Third Avenue Value Fund (TAVF). These areas are as follows:

  1. Bank loans
  2. Class action litigation
  3. Executive compensation and entrenchment
  4. Compensation paid to lawyers and investment bankers when dealing with troubled companies

While TAVF has done okay in its Japanese investments made from 1997 on, the Fund would have done a lot better had Japanese banks not been so careless in their lending practices. These poor bank lending practices probably were the most significant factor causing the six-year business recession/depression in Japan. The banks seem to have counted on government bailouts when making loans. From a societal point of view, commercial banks, their managements, and their securities holders, especially their common stockholders, ought to be made to suffer the consequences of imprudent lending practices. However, the banks themselves ought not to be made to suffer so much that the underlying economy is harmed, albeit this does not mean that managements shouldn’t be fired, and common stockholders wiped out. It is important, though, that the lending institutions survive in one form or the other. In Japan, the banks themselves suffered too much, and until recently, were reluctant to lend at all, exacerbating the deterioration that was taking place in the Japanese economy.

Fortunately, it does not appear as if either the U.S. banking system or the TAVF portfolio of bank common stocks are going to be victimized by huge amounts of bank loans becoming “scheduled items” or “non-performing loans” in the period just ahead. Third Avenue has restricted its investments in depository institutions to the common stocks of extremely well-capitalized regional and community banks, none of which appear to be troubled. Nationally, it appears as if the banking system has never been sounder, at least in areas where I think we at TAVF are knowledgeable. Corporate lending by banks has never been more conservative, the growth of securitizations has reduced portfolio risk for most banks, and banks in general have learned to grow fee income, a higher quality source of profitability than interest spread income. Admittedly, I am hardly knowledgeable about the investment risks the larger banks are taking in derivatives, and I don’t know much about the credit risks in consumer lending, especially in credit card portfolios. But overall I feel comfortable about the banking system in general and about TAVF’s policy of buying the common stocks of well-capitalized regional and community banks when they are available at discounts from book value.

If I were to suggest any reforms for the banking system, it would be to reduce the ability of managements of underperforming banks to continue to be entrenched in office, or to get large severance packages if they are forced to leave office.

The problem with class action litigation is that it is controlled by class action lawyers who incur little, or no, downside risk by bringing lawsuits. In general, these lawyers don’t have to worry too much about the underlying merits of any one lawsuit because if they have a portfolio of lawsuits, the lawyers are bound to make a very good living indeed. The vast majority of these lawsuits are settled before trial and the lawyers’ cash fees, earned on a contingent basis, are usually approved without opposition.

Yet, class action lawsuits are the best protection passive investors such as TAVF have against overreaching by insiders, fiduciaries and professionals such as auditors. Class action lawyers, as private cops, tend to be a lot more alert in protecting stockholder interests than are the Securities and Exchange Commission (SEC), State “Blue Sky” Regulators, and Self-Regulatory Organizations (SROs) such as the New York Stock Exchange and the NASD. This is part and parcel of what goes on in our mixed economy: frequently, but far from always, the private sector (i.e., class action attorneys) are more aggressive and more able than public sector bureaucrats (e.g., the SEC) in obtaining constructive results.

Most of the world operates under the “English System” in protecting, or not protecting, outside passive minority shareholders. Under the “English System,” there is no class action possible; each shareholder exercises his or her own rights at his or her own expense. Small shareholders under the “English System” have, as a practical matter, no recourse when there has been corporate wrongdoing. In contrast, in the U.S., theoretically a holder of only 100 shares of Microsoft Common can bring a class action lawsuit on behalf of the outside holders of, say 9 billion shares of Microsoft Common. This ability for suits to be brought on behalf of a class makes legal actions by stockholders economic. Under the “English System,” if the plaintiff loses the lawsuit, he probably would be liable for the defendants’ costs and expenses. Under the “American System,” the losing plaintiff will very, very rarely ever be liable for any of defendants’ costs and expenses.

TAVF would much rather operate under the “American System” than under the “English System.” For example, at October 31, 2003, the Fund had approximately $162,000,000 invested in Toyota Industries Common Stock (“Industries Common”), which as a Japanese company, grants stockholders rights under the “English System.” Toyota Industries is the largest holder of Toyota Motor Common (“Motor Common”), owning about 5% of the issue outstanding. Motor in turn owns about 24% of the outstanding Industries Common. The Fund’s investment in Industries is predicated, in great part, on the fact that it has acquired an equity interest in Motor at a 30% to 40% discount based on Industries’ common stock price in Tokyo and Motor’s common stock price on the New York Stock Exchange. If Motor, for example, ever decided to acquire a greater interest in Industries on the cheap in a manner that would forcibly eliminate TAVF’s interest in Industries (which I wouldn’t put past Motor), TAVF would, as a practical matter, be without recourse. That would not be the case were Industries incorporated in Delaware.

I think the “American System” overall would work better were U.S. Courts––Federal and State––more willing, and more able, to assess to plaintiffs the defendants’ costs and expenses for bringing suits which are deemed to be frivolous. If moral hazard, i.e., the absence of downside risk, is pervasive anywhere, it is pervasive among the top managements of American corporations. As a group, these people are grossly overcompensated, and whether they perform capably or not, they tend to be very much entrenched in office. No entity seems to be in a position to show top managements any downside risk. This is supposed to be the duty of Boards of Directors. Most outside directors seem too busy, and too friendly with top managements, to be much more than rubber stamps.

Yet, a high degree of management entrenchment seems justified both for society as a whole, and for TAVF in particular. Almost all the companies represented in the Fund’s common stock portfolio seem to be extremely well managed. The last thing Third Avenue would want is for these top managements to be easily removable from office just because the price of the common stock is depressed. Indeed, that is why TAVF acquired the common stock in the first place: the company seems well managed and the price of the common stock seems depressed.

Let’s face it: the market is utterly inefficient when it purports to measure the quality of management by the price of the common stock. Rather, the common stock market seems to measure more management’s ability to promote, rather than management’s ability to run a business day to day. Promoting common stocks is probably not a good use of management time unless the company is in need of reasonably regular access to capital markets, especially equity markets. TAVF goes out of its way to acquire the common stocks of companies that either don’t need access to capital markets, or are so financially strong, that the managements completely control the timing of when the corporation ought to access capital markets.

When all is said and done, there is too much management entrenchment. A good start toward achieving a more equitable management-shareholder balance might revolve around banning the “poison pill.” A “poison pill” is a device used by almost all corporations whose common stocks are publicly traded, which dilutes a potential acquirer of control to such an extent that it becomes uneconomic for anyone to engage in a contest for control.

My personal bete noire for where moral hazard exists, and seems utterly destructive, is payments to professionals––lawyers and investment bankers––involved in the restructuring of troubled companies, whether under the Bankruptcy Code or out of court.

Payments to professionals are different for troubled companies than for other companies. Once a company might have trouble paying its bills, the tendency is for ad hoc creditor committees, and even equity committees, to be formed. These groups hire lawyers and investment bankers, which are paid, almost always very handsomely, by the troubled company. Under Chapter 11 of the Bankruptcy Code, there is a requirement that an Official Committee of Unsecured Creditors be formed, with the Committee’s professionals paid by the company seeking relief, i.e., the debtor. Professionals retained by other creditors, as well parties in interest, will be paid by the debtor also. The amount of these administrative costs for professional services are huge, off the charts; and they are paid on a pay-as-you-go basis. These professionals also enjoy a super priority over pre-petition creditors when it comes to getting paid by the debtor. Before Kmart could be reorganized and out of Chapter 11, these professional costs were running at a rate of $10 million to $20 million a month. It is estimated that such costs in Enron (with which thankfully TAVF is not involved) will aggregate approximately $1 billion. These huge costs come out of the hide of creditors. Third Avenue gets involved with troubled companies only as a creditor.

From TAVF’s point of view, these administrative costs tend to be so large that it is hard to get involved in any investment in a non-giant troubled company unless the Fund can do so as an adequately secured creditor, or pursuant to a pre-packaged Plan of Reorganization. Even in giant companies, these professionals bring investment risks to TAVF that are frequently unacceptable. As a matter of fact, if one failed in reorganizing Kmart in a relative hurry, there likely would have been nothing left for the creditors. It would all have gone to the lawyers and investment bankers who incidentally had considerable financial incentive to keep Kmart in Chapter 11 rather than to reorganize that company expeditiously.

This “Professionals Problem” traces back to the Bankruptcy Reform Act of 1978 (“The 1978 Act”). Congress in its wisdom decided that a higher caliber of professionals would be attracted to bankruptcy practice if these professionals were paid on a regular basis for services performed. There seems to be no basis for Congress’ implicit assumption that attorneys working for hourly rates are more competent, or higher quality, than contingent fee attorneys. Prior to the passage of The 1978 Act, professionals, other than the debtor’s professionals, in Chapter X cases were paid basically at the end of a case, and only if they demonstrated to the Bankruptcy Court that they had made a “substantial contribution” to the reorganization.

TAVF, as a creditor, would like very much to go back to the pre-1978 way of paying professionals. It hopefully would contribute much to the reorganization of troubled companies both in court and out of court. In writing to you about class action lawsuits, top management compensation and entrenchment, and professionals’ compensation in the reorganization of troubled companies, I highlight some of the problems TAVF faces as a non-control investor. My griping, however, should not overstate the reality that, while elimination of certain moral hazards would help, the Fund still seems to operate in a pretty good investment climate.

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