The last chapter of Kate Kelly's Wall Street Journal epic on the decline and fall of Bear Stearns tells us that the "hurried deal" to keep Bear Stearns out of bankruptcy included a "loophole" that gave Bear Stearns investors leverage to seek a higher price. By now this story of the loophole is well-known, thanks in part to a New York Times front page story that first reported it. In time this story is likely to harden into conventional wisdom, especially now that it's been endorsed by both the Times and the Journal.
Unfortunately, the story probably isn't true.
The first anyone heard of the so-called loophole was on March 24th, when the New York Times reported that JP Morgan Chase chief executive Jamie Dimon was "apoplectic" to discover that that the documentation for JP Morgan Chase's acquisition of Bear Stearns included several mistakes, including a clause in a guarantee agreement that allowed JP Morgan's guarantee of Bear's trading position to survive a vote against the deal by Bear Stearns shareholders for up to a year, and possibly forever.
Kelly more or less repeats this tale, spicing it up with a wonderful anecdote about what happened when Dimon called Bear Stearns chief executive Alan Schwartz to renegotiate the guarantee.
By Tuesday morning, J.P. Morgan's lawyers were arguing with their counterparts at Bear Stearns over the yearlong guarantee.
"Don't you understand that we have a problem?" Mr. Dimon asked Mr. Schwartz the next time the two talked. "Shareholders may vote this down!"
Mr. Schwartz, who had been taking a beating over the low price, knew an opening when he saw one. "What do you mean, 'we' have a problem?"
It was a rare moment in his three months as CEO when something wasn't Mr. Schwartz's problem. He was inclined to make some concessions, he told his advisers, but not without a higher offer.
But was the broad and lasting guarantee a "loophole" or was this a case of buyers remorse?
We were surprised when we first heard the guarantee described as a misstep by the lawyers documenting the deal. You see, we were on the investor and analyst conference call on the Sunday night the deal was announced, and this provision got a lot of attention on that call. The JP Morgan bankers were very clear that the guarantee would survive a negative vote by Bear Stearns shareholders. The guarantee would survive the life of the guaranteed transactions, JP Morgan's bankers said on the call.
The transcript of the conference call backs up our recollection. Steve Black, the co-head of J.P. Morgan's investment-banking division, at one point says: "The guarantee applies to all transactions on the books today and any transactions that are entered into while that guarantee is in place."
We reported our skepticism about what he had come to think of as the "loophole legend" the morning the story appeared in the times. The next day a story in the Wall Street Journal by Ashby Jones supported the skeptical view. Jones quoted law professor Lawrence Cunningham who said the measure "seems rational" because JP Morgan was trying to signal to the market that it would stand by Bear's obligations. "Bear was fighting for its life and a handful of forces were at play and it makes sense that J.P. Morgan would want to add credibility to the deal by giving a big guarantee," Cunningham told Jones.
Recall that at the time, Bear was facing a modern day version of a run on the bank, with customers and counterparties fleeing for every available exit. In order to slow the exodus, Bear's counter-parties needed strong reassurance that their trades with Bear were good and that it was safe to continue to do business with Bear. A temporary guarantee contingent on Bear shareholders accepting $2 per share might not have been acceptable to counter-parties.
Today's Wall Street Journal story also casts doubts on the loophole legend. Kelly reports that Dimon was annoyed by the guarantee and that JP Morgan tried to walk away from it, almost cratering the deal. But she stops short of attributing it to a "misstep" by lawyers or an "apparent oversight," terms that the Times used. In fact, some elements of her story seem to indicate that the guarantee wasn't a mistake at all. Bear Stearns considered suing to enforce the guarantee, a move that would be unlikely to succeed if it really was a mistake. And Bear Stearns did indeed use the renegotiation of the guarantee as a way of getting a higher price. Would JP Morgan have been willing to pay three-quarters of the billion dollars to negotiate away a drafting mistake?
It seems far more likely that the guarantee did exactly what it was supposed to do by covering all transactions on Bear's books at the time the deal was signed and any transactions that would be entered into for up to a year during which the guarantee would be in place, even if Bear shareholders rejected the deal. If there was a loophole, it wasn't in the drafting. It was, rather, in the heads of JP Morgan executives who belatedly realized they had handed Bear shareholders a powerful negotiating tool.
Law professor Gordon Smith agrees that the loophole legend is probably just a case of "buyer's remorse" being twisted after the fact. "In other words, Dimon's indignation at his lawyers looks like a pretext for another problem with the original deal, namely, that Morgan no longer wanted the deal to stay open for a whole year if Bear's shareholders rejected it," Smith wrote on The Conglomerate blog.
Tellingly, no one involved has ever gone on the record supporting the loophole legend. Every time it has come up, it has been attributed to anonymous sources or not attributed to anyone at all. This was a crucial aspect of the deal--a deal that involved unprecedented involvement by the Federal Reserve and the Treasury Department--yet no one has gone on record to clear up this confusing history.
When Bear Stearns did go on the record about how deal was negotiated, the loophole legend was quietly dropped. In late April, Bear Stearns filed a latest proxy statement with the Securities and Exchange Commission detailing the transaction. These filings are painstakingly edited by bankers, accountants and lawyers, and false statements in them can have serious legal consequences. The omission of the loophole legend suggests that the executives at Bear Stearns and JP Morgan weren't as comfortable telling that particular tale in a forum where they could be held to account for their veracity.