Contract Rights Under Assault

Barack_Obama_pledges_help_for_small_businesses_3-16-09In 1789, as the inchoate American government was climbing out of the mountainous debt left over from the Revolutionary War, a thorny political problem emerged.  While most of the chattering class was consumed with the debate over whether the states’ war debt should be federalized, another far more visceral controversy arose.  Because the Continental Congress lacked funds during the war, the Revolution was funded partly by wealthy private citizens who invested in bonds.  As a result of the lack of governmental money, many American soldiers were given worthless IOUs at the end of the war, as states scampered for a way to give the patriots their back pay.  Many of these soldiers panicked, and sold their IOUs to speculators for as little as fifteen cents on the dollar.  The problem was, once the federal government began repaying the debt, the value of the bonds soared.  So who should get the money: the patriots who fought bravely for their country and only sold the IOUs because of fear they would get nothing from their government, or the speculators?

The answer for many populists was easy—the veterans should not be swindled by greedy money men.  However, Treasury Secretary Alexander Hamilton knew that the price of the government breaking a contract was far more costly to a young nation’s character than the ephemeral outrage that many veterans felt.  As Hamilton told President Washington, “[t]he general rules of property, and all those general rules which form the links of society, frequently involve in their ordinary operation particular hardships and injuries.  Yet the public order and the general happiness require a steady conformity to them.  It is perhaps always better that partial evils should be submitted to than that principles should be violated.”

Because history has a way of repeating itself, it should come as no surprise that the debate over contract rights versus populist sentiment has returned with a vengeance.  The first sign of trouble came last March when President Obama urged Congress to sever the retention bonuses owed to several AIG derivative traders.  The outrage was understandable: AIG had gone belly up and was only kept afloat by the public dole.  However, the retention bonuses were agreed to before the TARP bailout; abrogating them would violate a clear contractual obligation.

This did not stop some members of Congress from seeking to pass a Bill of Attainder to recoup the bonuses via the tax code.  Congressman Barney Frank even threatened AIG CEO Edward Liddy with a subpoena if Liddy did not hand over the names of the AIG employees who received the bonuses.  Just what, pray tell Congressman, did you intend to do with those names? 

Not to be outdone on the outrage meter, Republican Senator Charles Grassley stated “I would suggest the first thing that would make me feel a little better toward them [the AIG executives] is if they follow the Japanese example and come before the American people and take that deep bow and say, ‘I am sorry,’ and then either do one of two things: resign or go commit suicide.  And in the case of the Japanese, they usually commit suicide.”  Goodness.

But the low moment came in May during the Chrysler bankruptcy proceedings.  The Obama administration was attempting to spare Chrysler from bankruptcy court by selling Chrysler’s assets to a new company owned by the United Auto Workers (UAW) and Fiat.  The only problem for the administration was that a group of plucky Chrysler bondholders refused to sell their assets on the grounds that they could get a better deal in bankruptcy court.  Because these bondholders were secured creditors, they were entitled to first priority under bankruptcy law rules.  These bondholders rightly pointed out that they owed their shareholders the fiduciary duty to hold out for the best deal possible.

But bankruptcy court would have been bad for the UAW (as it was a junior creditor), so the Obama administration brought out the brass knuckles.  Thomas Lauria, the attorney for the group of bondholders, stated that his clients were threatened by the Obama administration into taking a haircut.  For a brief moment, it appeared as if the bondholders would fight it out in court, but eventually they relented in the face of governmental pressure.  Lauria said that his clients decided against a legal battle once they concluded they could not “withstand the enormous pressure and machinery of the U.S. government.”  Bankruptcy Judge Redfield T. Baum quipped that the bondholders had about as much of a chance of winning against the federal government as “the gentleman in Tiananmen Square when the tank came rolling in.”

As we dig ourselves out of the Great Recession, investors must cope with an additional risk: the threat of government abrogation of legal rights for political reasons.  Even Warren Buffet bemoaned the Chrysler situation: “If we want to encourage lending in this country, we don’t want to say to somebody who lends and gets a secured position that the secured position doesn’t mean anything.”

 Russell Kirk once noted that “[u]pon the foundation of private property, great civilizations are built.”  Ignoring these rights is how they fall.

This Post Has 7 Comments

  1. Jessica E. Slavin

    I am no contract law or corporate law expert. But when I hear this argument, I always wonder, shouldn’t the same reasoning apply to union contracts, health care contracts, retirement contracts, and other contracts that workers have with their employers? If retrospective renegotiation or evisceration of bonuses for highly-paid workers will fundamentally undermine property rights, shouldn’t the same be true for retrospectively renegotiating or eliminating retirement, health care, and other benefits that lower-paid workers worked for, often under a specific union or other contract, in which they were promised that in exchange for their work (for their giving up opportunities for other work), they would receive those financial benefits? Yet, when such property rights are frequently renegotiated or eliminated in the wake of a company’s financial collapse, I don’t usually see this kind of outcry about how the government’s interference with property rights will destroy our civilization. What gives?

  2. Martin Tanz

    I agree with the above comment, strongly disagree with Mr. Fernholz. One of the things about our political system is that money guarantees access, and big money assures big access. So while contract rights for small players (workers, consumers, poor people), have been under assault for quite some time, the contract (and property) rights of big business has been, and will be assured for the forseeable future.

    Large stakeholders (investors) will always get a seat at the table when decisions concerning property rights are made. The problem with politics and politicians in this country is not that they disregard property rights, but rather that they disregard the public interest in favor of big money special interests.

    In addition to the above labor scenario as an example of worker’s contract rights under assault, take a look at how huge banks that take huge amounts of federal bailout money courtesy of the taxpayers, then pay out huge bonuses to their management while squeezing their customers by raising interest rates on consumer debt. The consumer has no recourse vis a vis these large institutions, as the standard credit application routinely mandates binding arbitration in the state of North Dakota, or some other distant place where the bank has the home field advantage, or at least resources. It isn’t as if the consumer has access to local courts to seek relief from unconcionable or otherwise outrageously one sided or illusory contracts. Now why is that the case? It didn’t happen by accident. The large stakeholders got to write the rules. Any attempt to strengthen consumer protection inevitably gets watered down by the banking lobby.

  3. Jackie Bain

    The parties to the contract enter into it (or should have) knowing all the potential risks. They did not, however, anticipate a third party to come in and completely change the negotiated outcome. If AIG pays back the US government, like the other investment banks, the taxpayers will not be harmed. The outcry stems from the fact that these investment banks are back to producing billions in profits while Main Street – who Congress needs on their side in order to get re-elected – is still losing jobs and their retirement nest eggs are still in the red.

    The investment banks are not the sole reason the stock market and the economy tanked. Thus, Congress needs to focus its energy on preventing another collapse instead of penalizing AIG and its workers. If Congress thinks that taxing AIG will teach them a lesson and “right the wrong,” then Congress should tax everyone because everyone is to blame for this financial crisis.

    Further, because Congress is focusing on the faults of Wall Street and big business, the role of the everyday investor in the collapse and the lessons they need to learn are lost. In most cases, these everyday investors invested in the financial products offered by the investment banks or accepted balloon mortgages on homes well outside their means without reviewing the offering documents, which includes the potential risks. It is the investor’s responsibility to read these documents. Yet, the investor, who invested in a risky product, wants someone else to blame when his/her investment tanks(although it does keep plaintiff securities attorneys busy) because they did not understand the product. If you do not understand what you are buying or the contract you are entering into, then do not do it.

    Thus,like Wall Street, the everyday investor/home owner/consumer needs to take a little more responsibility when is comes to their investments. I really hope this lesson is not lost once the economy picks up and times are good. Frugality and due diligence will pay off in the end. Read the book, “The Millionaire Next Door” by Thomas J. Stanley, and you will find that those who are financially stable are those who purchase used cars, live below their means, pay off their reasonably sized houses, etc.

    Next a quick response to Ms. Slavin. There is a main difference between the AIG employees and the union workers you mentioned: a company’s ability to retain employees v. a worker’s sacrifices to keep his/her job. AIG is paying these bonuses to retain its talented workforce. If it does not, this talented workforce that are piecing the company back together(and who arguably destroyed it) will leave for higher pay at Goldman Sachs, Bank of America, etc. AIG then will be less likely to recover and repay the government loans.

    On the other hand, the union workers make concessions to keep their job. A financially stressed company, e.g. GM, could file for bankruptcy, instead of negotiating with the workers and opt to break the union contracts. Then, if the company exited bankruptcy successfully, the workers would then need to completely renegotiate their contract. Because the workers now have much less leverage, they, most likely, would receive less benefits, pay, etc. as opposed to the contract the GM workers received when they renegotiated their contract in early 2009. And this is only if they are re-hired. Therefore, even though the workers are renegotiating their contract, it is usually in their better interest to do so instead of refusing and leaving the company to file for bankruptcy.

  4. Martin Tanz

    And consumers sign up for consumer credit not understanding what a one sided bargain they are in for. I am all in favor of better disclosure requirements for consumer credit applications. It is curious that the big banks, beneficiaries of federal bailout money oppose such reform.

  5. Matthew Fernholz

    Prof. Slavin,

    The distinction is over governmental intrusion. When a private firm goes bankrupt and all the benefits disappear, that is simply part of the risk of living in a capitalist society. However, employees and debt holders are at least offered the protection of bankruptcy court and the priority creditor system. In the Chrysler situation, no one would have mourned for the bondholders had they lost some money in the bankruptcy—that is simply the cost of playing the game. However, the bondholders accepted lower returns in good economic times to ensure that they received priority status if Chrysler ever went bankrupt. Chrysler and GM both should have gone to bankruptcy court, but the Obama administration wanted to spare a political ally—the UAW—from that pain.

    Everyone accepts that bankruptcies are bad for all damaged parties. But when the executive branch of the federal government gets involved in private disputes and picks favorites for political reasons, that creates a dangerous economic climate for all investors.

  6. David R. Papke

    Mr. Fernholz: We can garner insights and learn lessons from history, but I resist the idea that history repeats itself. Hence, I find the claims of individual Revolutionary War-era speculators who bought soldiers IOU’s at a small percentage of their face value quite different from the purported entitlements of executives at contemporary corporate giants. Capitalism – even just financial capitalism – is forever evolving, and the evolution makes it risky to analogize developments 225 years ago to those of the present.

    Ms. Bain: I don’t think there is much difference in education, ability, and competencies among the higher-level employees of AIG and other finnacial giants. Hence, I don’t buy the argument that large bonuses are necessary to retain “talent.” Really, these bonuses are just giant payments for those on the inside.

  7. Martin Tanz

    Perhaps we should all spend less time worrying about the well being of people who are more than capable of looking after their own interests. It is natural, considering the high cost of law school, to look forward to a financially rewarding career serving those masters of the universe in the corporate world. However, before we get there, let’s spend a little time thinking about how to use the law to help those who really have no voice at all. It is easy to meet people in this vulnerable position. Just take a walk a few blocks north, south, east or west of the law school and I guarantee you will meet some.

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