Culture Clash? the Miller & Modigliani Propositions Meet the United States Court of Federal Claims

Article excerpt

I. INTRODUCTION

Often it is said that there is a divide between the practice of law and the concerns of legal academics.1 This sentiment may apply with equal force to the business of banking and the pursuits of scholars of financial institutions.2 Such views arise because, in part, the realms of theory and practice do not intersect often. When they do, as they have in a set of cases following the Supreme Court's decision in United States v. Winstar Corp.,3 the intersection is worth considering.4

Winstar established the United States' liability for breach of regulatory contract in three cases in which acquirers of troubled savings and loan institutions sought favorable regulatory accounting treatment in exchange for doing the acquisitions.5 The Supreme Court remanded the Winstar cases to the United States Court of Federal Claims for damages proceedings.6 Although only three cases were involved in the appeal to the Supreme Court, there still are nearly 100 similar cases raising claims for compensation by acquirers of thrifts pending in the lower courts.7

In turn, the Court of Federal Claims has become a forum for evaluating the relevance of the basic principles of corporate finance-specifically, the Miller & Modigliani ("M&M") Propositions concerning capital structure and debt-equity ratios-to claims by savings and loan institutions for lost profits damages. In their 1958 article, Professors Merton Miller and Franco Modigliani set out a number of foundational principles of corporate finance, including the principle that the value of a private firm is independent of the mix of debt and equity used to fund its assets.8 The results thus far are mixed. The courts have not embraced the M&M Propositions, as evidenced by their decisions to allow plaintiffs to present claims for lost profits damages and, in a smaller number of cases, their discussion of the M&M Propositions. Nevertheless, courts generally have arrived at the results dictated by the M&M Propositions in awarding damages to claimants.9

The focus in the damages decisions is on whether an acquiring thrift with supervisory goodwill was damaged by the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA)10 phase-out and, if so, how it was damaged. Supervisory goodwill, as Justice Souter observed in his plurality opinion in Winstar, allowed an acquiring thrift to make more investments than it otherwise would have been able to, because it could include an intangible accounting entry in its regulatory capital requirements.11 Such an acquiring thrift could then operate with more debt and less equity than a comparable thrift that had not engaged in such an acquisition.

The United States, citing the M&M Propositions, has insisted that the only recoverable damages by a claimant are its mitigation costs-that is, the costs associated with obtaining replacement capital.12 The thrift claimants have responded that they were unable to mitigate and, therefore, should be entitled to present claims for lost profits damages.13 Furthermore, they have argued that the M&M Propositions are not relevant to the evaluation of their claims given the availability of deposit insurance, which they insist is a subsidy of that particular form of debt.14

In 1999, the Court of Federal Claims entered a $909 million judgment, one of the largest ever entered against the United States, in the first supervisory goodwill damages decision, Glendale Federal Bank v. United States.15 In allowing the thrift claimant to present a claim for lost profits, the trial court did not agree with the United States' arguments based upon the M&M Propositions and expressly rejected the testimony of Dr. Miller as "theoretical."16 The trial court did not, however, award lost profits. Subsequently, in 2001, an appeals court vacated the judgment in Glendale and remanded the case to the trial court for further proceedings.17

In the journey from the Supreme Court's decision in Winstar to the current damages decisions, the lower courts developed a more complete understanding of the economics of the savings and loan industry, and of the accounting techniques used by regulators during the 1980s. …