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Bailing Out Bear’s Creditors?

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Angry Bear Stearns shareholders and class-action lawyers eager to represent them in the inevitable lawsuits of Bear’s sale to JP Morgan Chase are already sounding off against the deal. As soon as the deal was announced, a Bear Stearns investor asked JP Morgan executives “Why is this better for shareholders of Bear Stearns than a Chapter 11 filing?”
In the eyes of many on Wall Street, the answer is obvious. In the first place, they see Bear’s investors as risk-takers who deserve to bear the brunt of the collapse of the company. The enormous trading volume on Friday suggests that many of the investors of those currently holding shares of Bear Stearns bought the stock after news of trouble spread last week.
What’s more, the deal is seen as an important effort to stop a ripple effect from bringing down other financial institutions. It extends the guarantee of JP Morgan over Bear Stearns’s trading positions, giving Bear clients and counterparties the reassurance of a backstop in JP Morgan’s balance sheet. The Fed was desperate to avoid a bankruptcy, according to many reports, and actively encouraged Bear Stearns to accept this deal. In a statement, Bear Stearns Chief Executive Alan Schwartz said the deal "represents the best outcome for all of our constituencies based upon the current circumstances."
That’s a strange way of looking at a deal for a Delaware company, Gordon Smith points out. After the jump, find out why.

"Best outcome for all of our constituencies"? Bear Stearns is a Delaware corporation, and when the directors of a Delaware corporation are deciding whether to sell the company, generally speaking they are charged with a very narrow decision rule: get the "best value reasonably available to the stockholders."

But Delaware law also provides exceptions that allow companies to consider creditors when the company is in the vicinity of bankruptcy, Smith writes. Delaware courts have rejected pleas by investors who argued that a company should have sought bankruptcy protection rather than a fire-sale. “Equity holders will be upset, but Delaware corporate law will not come to the rescue,” he concludes.
Larry Ribstein seems to agree, arguing that the business judgment of the Bear board of directors will override investors who second-guess the deal. But it’s a close call. “Certainly this fact scenario will test the limits of this approach,” he writes.
Would a Delaware court consider the prodding of the Federal Reserve and Treasury Department officials to count in favor of the board’s decision to sell? There are good public policy reasons for a court to consider this, and the Delaware courts have often shown itself to not be adverse to allowing policy considerations to affect their decisions.
While this reasoning is helpful to Bear’s board and JP Morgan, these types of arguments could have a negative impact on share prices of troubled financial institutions. The possibility of being made the bear the risk of “ripple effects” should now be considered a risk-factor by investors. In fact, we wouldn’t be surprised if this appears as a risk factor in the next round of financial statements. If the Fed won’t allow shareholders to take residual value through a bankruptcy proceeding and will force them to accept fire-sales of the firm, this is a serious risk for capital or liquidity challenged firms.
Bear Stearns' Decision to Sell [The Conglomerate]">The fiduciary duties of Bear Stearns directors [Ideoblog]