Breach of Contract in Complex Commercial Litigation: Damage Theories and Outcomes in the Winstar Matters

1. Breach of Contract in Complex Commercial Litigation: Damage Theories and Outcomes in the Winstar Matters Presentation by Steven J. Davis Vice President, CRA International University Club of Chicago June 5, 2007

2. Outline • Thrift Industry Insolvencies and Response • The Winstar-Related Cases • On Damages in Breach of Contract • Assessing Damage Outcomes in the Winstar Matters • Some Lessons

3. I. Thrift Industry Insolvencies and Response

4. The S&L Industry in the 1980s • Historically, Savings and Loan Institutions (S&Ls) pooled small savings and time deposits and used the proceeds to fund long term, fixed-rate mortgages. • Most S&Ls became insolvent during the 1980s. • Initial wave of insolvencies caused by historically high interest rates in the late 1970s and early 1980s. As interest rates rose, • The value of S&L loan portfolios fell dramatically • Spreads between return on assets and cost of funds turned negative. • Later insolvencies caused by a combination of • Unwise regulatory reforms • Lax oversight by government officials • Fraud, mismanagement and excessive risk taking • The scale of the insolvencies vastly exceeded the reserves of the Government’s deposit insurance fund (FSLIC).

5. Supervisory Mergers • The government encouraged “supervisory mergers” to prevent the collapse of failing S&Ls and reduce demands on FSLIC. • To facilitate takeovers of failing S&Ls by stronger institutions, the Government relied on cash infusions and several other inducements: • Opportunity for acquirer to circumvent restrictions on branch banking and interstate banking • Relaxation of certain rules re loan portfolios • Assurance of continued forbearance w.r.t. capital requirements of acquirer • Use of “supervisory goodwill” to meet regulatory capital requirements • Other capital credits and allowances • Special tax breaks

6. Supervisory Goodwill • Under the “purchase method of accounting”, the excess of liabilities over assets in the acquired institution is designated as “supervisory goodwill” and treated as a form of intangible capital. • The goodwill created in this manner had an amortization horizon as long as 40 years. • Supervisory goodwill counted towards the regulatory capital requirements of the merged institution. • Effectively, the government allowed the negative net worth of the acquired institution to substitute for actual capital for the purpose of meeting regulatory capital requirements.

7. Example: Creating Supervisory Goodwill • Failing S&L has $250 million in assets and $300 million in liabilities  net worth of -$50 million. • When acquired, this excess of liabilities over assets in the failing S&L becomes “supervisory goodwill” in the merged institution. • See charts below for details and a comparison of alternative methods to account for the acquisition. • With a 5% capital requirement, each dollar of capital can support $20 of loans. • So, in this example, supervisory goodwill can support an extra $1 billion in loans (20 X $50 million). • Note: The government deposit insurance system greatly increased the feasibility and attractiveness of this strategy for poorly capitalized S&Ls.

9. Capital Ratio = Capital / Assets Leverage Ratio = Assets / Capital Debt / Equity Ratio = Debt / Equity

10. FIRREA (1989) • The Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) and its implementing regulations introduced three types of capital requirements: • Tangible capital (could not be met by goodwill) • Core capital, which permitted limited amounts of “qualifying supervisory goodwill” • Risk-based capital, a percentage of risk-weighted assets • FIRREA also mandated a rapid phase-out of supervisory goodwill and required thrifts to exit the real estate development business. • Guarini amendment in 1993 disallowed certain tax deductions promised in some supervisory mergers.

11. FIRREA (1989) • For our purposes, the chief features of FIRREA are the greatly accelerated amortization of supervisory goodwill and the strict requirements for uniform application of regulatory capital standards (i.e., no further discretionary forbearance by the regulatory authorities). • Roughly $10 billion in “qualifying goodwill” became subject to rapid phase out due to FIRREA and implementing regulations. • Almost immediately, 500 S&Ls fell out of compliance with regulatory capital standards.

12. II. The Winstar-Related Cases

13. The “Winstar” Matters • 130+ cases with related fact patterns filed in the U.S. Court of Federal Claims during the 1990s. • Common elements: • In the course of supervisory mergers in 1980s, the Government allegedly entered into regulatory contracts re the treatment of supervisory goodwill, other capital credits and forbearance with respect to capital requirements. • The contracts were allegedly breached by FIRREA and its implementing regulations (or by the 1993 Guarini amendment to FIRREA.) • Huge potential liability for Government: Estimated damages of $20-30 billion or more as of 1998-99 plus $200 million in litigation costs.

15. US v. Winstar et al. (1996) • The Supreme Court ruled that: • The United States entered into contracts during the 1980s that allowed special accounting methods in the acquisition of certain failing S&Ls. • The new capital requirements mandated by FIRREA (1989), as applied to the acquiring institutions, breached the terms of the contracts. • The Government is liable for damages in breach of contract. • The Supreme Court remanded to the Court of Federal Claims for determination of damages.

16. Early Outcomes on Damages • August 1998: initial judgment of $2.8 million against the government in Winstar. • April 1999: initial judgment of $909 million against the government in Glendale Federal Bank vs. The United States, the second Winstar-related case tried on damages. • As of June 1989, shortly before the enactment of FIRREA, Glendale had about $550 million of unamortized supervisory goodwill. • Thus, Glendale seemed to confirm concerns about huge government exposure in Winstar-related cases.

17. Glendale Federal Bank v. US • Bench trial lasted 14 months • 150+ days of testimony, 20,000 pages of trial transcripts • $100 million in litigation costs, per rough estimate of trial court judge • Judgment of $909 million for plaintiffs: • $528 million for restitution of “benefits conferred on government” • $381 million for non-overlapping (post-breach) reliance damages • The court calculated restitution as the excess of liabilities over assets in the failing institution at acquisition, less the value of (certain) benefits that Glendale received from the contract. • Reliance damages were awarded mainly for “wounded bank damages” – the argument being that Glendale lost an historic advantage in its cost of funds because the breach forced Glendale out of capital compliance. • The restitution award did not survive appeal, because the value of the benefits conferred on the government are “both speculative and indeterminate.”

18. The Complexity of Damages Determination “The court recognizes that damages, particularly involving a thrift that entered a 40-year contract 18 years ago, which was breached nearly ten years ago, necessarily is not going to be found with the precision that one could determine damages resulting from the breach of a smaller, more discrete contract.” [Trial court opinion in Glendale Federal v. United States, 43 Fed. Cl., at 399 (1999)]

19. Courts’ Attitude Toward Expectation Damages in Winstar Matters • “The complexity, breadth and length of the contract which was breached make it difficult to award expectancy damages, … which the court believes would be most consistent with the very purpose of contract law. The difficulty, as plaintiff’s model demonstrates, is the bank is operating in a dynamic market, making dynamic decisions, and responding to millions of stimuli in order to run a profitable enterprise.” [Trial court opinion in California Federal Bank, 43 Fed. Cl., at 404 (1999)] • “Expectation damages are difficult or impossible to prove due to the length of time which has elapsed since the breach of contract occurred and the fact that many of these thrifts were closed at the hands of federal regulators as a result of breach.” [Watson (1999), summarizing court’s view in several Winstar matters]

20. III. On Damages in Breach of Contract

21. Goal of Contract Law • From the perspective of economic efficiency, the goal of contract law is to maximize social welfare. • Focus is usually on parties to the contract. • In which case, efficiency boils down to maximizing the (expected) joint value of the contractual relationship to the parties. • Legal rules regarding - Contract formation - Interpretation - Enforcement - Holdup - Breach - Mitigation - Remedies and damages all affect the efficiency of contractual relationships.

22. Damage Measures • Damage measure: A rule or formula that governs what a party in breach should pay to the non-breaching party. • Damage measures affect the efficiency of contractual relationships in several ways: • Incentives to perform • Incentives to take actions in reliance on the contract • Incentives to mitigate losses in the event of breach • Cost of writing contracts • Incentives to renegotiate • Opportunities to allocate risks • Incentives to seek and form contractual relationships

23. Expectation Damages • Expectation damages compensate the injured party for the harm caused by the breach. They equal the value of performance to the non-breaching party. • Usually the preferred remedy from an economic perspective, because expectation damages provide the proper incentive for efficient performance (and efficient breach). • In practice, expectation damages can be hard or easy to calculate, depending on circumstances.

24. Example: Efficient Performance • A buyer wants to acquire a machine that he values at 50. • A seller’s cost of producing the machine is uncertain at the contract date – see table. • A mutually optimal complete contract calls for delivery only when the cost turns out to be less than 50, which occurs with probability 0.8 in this example. • That is, an optimal contract allows for non-performance when the cost of performance exceeds the value of performance. The (expected) joint value of a contract that calls for performance in all states is (.3)(50-10) + (.5)(50-30) + (.2)(50-100) = 12 +10 – 10 = 12 The joint value of the optimal contract is 12 + 10 = 22.

25. Example Continued: Hypothetical Incomplete Contract • Hypothetical contract: The manufacturer agrees to produce and deliver the machine in return for a payment of 40. The contract contains no provisions for non-performance or damages in the event of breach. • How should the law deal with breach? • Requiring specific performance in all circumstances yields a joint value of 12. • High damages, 50 or more, lead to performance in all states and, hence, a joint value of 12. • Lower damages, less than 50, lead to (efficient) breach under high costs, yielding a joint value of 22.

26. Example Continued: Expectation Damages and Efficient Performance • Expectation damages yield efficient performance: • The value of performance to the non-breaching party is 50 – 40 = 10. This is the harm to the buyer if the seller breaches. • Setting damages to 10 yields performance under low and mid costs but not under high costs, replicating the efficient outcome. • Expectation damages continue to provide the proper incentive to perform in richer examples (continuum of possible costs) and in broader circumstances (uncertainty about seller costs and buyer values). • Damages above the expectation level yield too little breach. • Damages below the expectation level yield too much breach.

27. Expectation Damages and Mitigation • An efficient damage measure provides incentives to mitigate harm caused by breach when the resulting savings exceed the cost of mitigation. A proper measure of expectation damages takes this point into account: • Expectation damages (reformulated): (Expected) losses that would be sustained by the non-breaching party had he optimally mitigated – whether or not he actually did so – plus the costs of optimal mitigation. • This damage measure deters inefficient breach and encourages cost-saving mitigation.

28. “The general rule of a non-breaching party’s responsibility for mitigation is that ‘damages are not recoverable for loss that the injured party could have avoided without undue risk, burden or humiliation.” [Restatement (Second) of Contracts, Section 350 (1) (1979), as quote in Commercial Fed v. U.S., 22 January 2004] “Further, ‘[a]s a general rule, a party cannot recover damages for loss that he could have avoided by reasonable efforts.’”

29. Expectation Damages and Reliance • Under certain conditions, expectation damages mimic the outcomes of a completely specified contract that is mutually preferred by the parties (at contract formation). In this limited but important respect, expectation damages are optimal from an efficiency perspective. • Expectation damages provide strong, but imperfect, incentives to take actions in reliance on the contract. • E.g., expectation damages can induce excessive expenditures in reliance on performance, because the non-breaching party receives the value of full performance even when breach is efficient. • Neither expectation damages nor any other simple, practical damage measure achieves optimality in all circumstances.

30. Restitution • “When proof of expectancy damages fails, the law provides a fall-back position for the injured party – he can sue for restitution. The idea behind restitution is to restore – that is, to restore the non-breaching party to the position he would have been in had there never been any contract to breach. …In other words, the objective is to restore the parties to the status quo ante.” [Quoting from the 9th Circuit opinion in Glendale, 16 December 2001, emphasis added.]

31. Reliance Damages • The purpose of reliance damages is to place the injured party “in as good a position as he would have been in had the contract not been made.” [Restatement (Second) of Contracts] • Unlike restitution, reliance damages include “expenditures made in preparation for performance or in performance, less any loss that the party in breach can prove with reasonable certainty the injured party would have suffered had the contract been performed.” • The comments to the Restatement point out that restitution may be equal to the reliance interest, but ordinarily restitution is smaller because it does not include “expenditures in reliance that result in no benefit to the other party.”

32. Reliance vs. Expectation Damages • It is often said that reliance damages are less than expectation damages, “because it would be irrational for a contracting party to plan to spend more on reliance than performance is worth; otherwise, the contract would have negative worth to the party spending on reliance.” • This logic is correct but easily misapplied when – as in the Winstar matters – the breach occurs years after contract formation. • When breach occurs long after contract formation, the value of remaining performance can be much smaller than the value of performance already delivered. • Hence, reliance damages can greatly exceed expectation damages (i.e., the value of remaining performance).

33. IV. Assessing Damage Outcomes in the Winstar Matters

34. How Did the Breach Affect Plaintiffs? • FIRREA greatly shortened the time period over which supervisory goodwill could be counted towards regulatory capital requirements. It also eliminated certain other capital credits created in supervisory mergers. • As a result, many S&Ls fell out of compliance with regulatory capital standards. • Non-complying S&Ls had three main options: • Shrink liabilities and assets to achieve compliance • Re-capitalize to achieve compliance (or cut dividends) • Exit

35. Analyses of Lost Profits, Use Value, etc., in the Winstar Matters An expectancy approach, yes, but in practice, one with several problems: • Highly speculative, not subject to any ready source of discipline • Difficult issues of causation • Keenly susceptible to hindsight bias and undue optimism by plaintiffs re returns on their but-for investment strategies • Lost profits analyses also tended to ignore or downplay opportunities for plaintiffs to mitigate the cost of breach.

36. Estimating Expectation Damages Caused by Lost Supervisory Goodwill • Key economic insight: The cost of re-capitalizing is an upper bound for the harm to shareholders caused by the breach. • Why? • S&L need not forego good investment opportunities because of reduced scope for leverage caused by the breach. • Instead, it can raise whatever additional capital it needs to preserve such valuable opportunities. • Could S&Ls, in fact, access capital markets? Yes. • S&Ls that did not raise new capital (or reduce dividends) to restore compliance presumably concluded that the costs of raising capital exceeded the net value of the foregone opportunities.

37. Could Thrifts Raise Capital in the Wake of FIRREA? • “Between the end of 1989 and the end of 1993, there were nearly 500 equity and debt offerings by thrifts and thrift holding companies with total amounts of between $250 million and $1.3 billion per quarter.” [Expert Report of Jonathan Arnold and Steven Davis in Southern National Corp. vs. United States] • In total, the industry raised more than $15 billion in capital during the period. (In comparison, recall that FIRREA affected about $10 billion in qualifying goodwill.) • Thrifts in every region of the country raised capital during this period. • Some capital-raising thrifts had supervisory goodwill on the books at the time of FIRREA’s enactment, some did not.

38. Costs of Re-Capitalizing • Flotation costs (direct cost of issuing new equity): • Registration fees • Management and underwriting fees • Cost of legal and accounting services • Other direct expenses • Adverse information effects on equity price • A potentially relevant factor when “insiders” with private information determine timing and amount of equity issue. • Not very relevant when the fact and timing of equity issue are compelled by external forces. • Of doubtful relevance anyway in a heavily regulated industry subject to routine examinations and compulsory disclosure of detailed financial information. • Wealth transfers from S&L stockholders to debt holders and other creditors – including the government deposit insurance fund.

39. Cost of Recapitalizing: Advantages as a Measure of Damages • Promotes efficient contractual relationships • Proper incentive to perform • Proper incentive to mitigate • Strong incentive to rely • Obviates need for speculative lost profits analysis • Easy to quantify, especially relative to lost profits or restitution of conferred benefits • Cuts through complexity and inaccuracy of the accounting numbers • Does not deter efficient regulatory reform

40. Glendale Court’s Reaction • “The court finds the testimony of Nobel Laureate Merton Miller, a brilliant scholar, regarding the value of leverage of little utility in this case. Professor Miller testified that any contention that Glendale lost something of value was meritless because leverage, standing alone, has no value. Plaintiffs convincingly point out that, notwithstanding the general principle of finance for which Dr. Miller won the Nobel prize in Economics in 1990, the situation of thrifts and other lending institutions is different, because they have access to low-cost government insured borrowings (retail deposits) which are unavailable to other institutions.”

41. Notes: Three cases with positive damages involved Guarini-related litigation.

42. V. Some Lessons

43. Lessons • A proper economic analysis can deliver a sound, practical approach to expectation damages in complicated cases. In the Winstar cases, the cost of recapitalizing provides an upper bound to damages caused by the loss of supervisory goodwill • The cost of recapitalizing is quantifiable using hard data. • This damage measure has desirable efficiency properties. • It obviates the need for a speculative analysis of lost profits. • It cuts through the inaccuracy and complexity of the accounting numbers.

44. Lessons • Firmly establish factual predicates for damage measures and the underlying economic theory, even when they are well known or “obvious” to informed experts. • Use simple formulations of economic insights that are easy for the non-expert to grasp. More general formulations are more powerful but can also be harder to understand.

45. Lessons • Some courts give undue weight to problematic accounting measures. • The law should promote efficient contractual relationships. Applying this principle can help to identify undesirable features of certain damages measures. • In matters that involve breach of contract by the government, damage measures should be designed to maximize the joint value of the contractual relationship (as in ordinary contract law) and to promote efficient legislative responses to regulatory problems.