Time was when reasonably well-informed people knew just what the Federal Reserve Board is supposed to do. As the executive arm of our central bank, it regulates the creation of money and credit. But that changed on Jan. 8.
As a result of a too little noted rule on the use of what are pejoratively known as junk bonds, the Fed has greatly expanded its scope. It can now function as a corporate takeover review board, making it a truly major player in battles to change the managements of publicly held companies. And in that new role, there's the danger that the Fed will inflict losses on shareholders and diminish the efficiency of the economy.
Here's what the Fed did. First, in an unprecedented move, it extended Regulation G to junk bonds issued in hostile takeovers. Reg G, authorized in 1934, protects lenders against losses on loans that are secured by stocks and bonds. Buyers have to put up at least 50 percent in cash and secure their loans by pledging the purchased securities. The Fed's rationale for bringing the hostile raiders' junk bonds under Reg G is that they are "indirectly secured" by the stock of the targeted company.
Second, the Fed limited the new extension of Reg G to bonds issued by a "shell corporation," an entity with no business operations, no cash flow and no significant function other than to acquire the stock of the targeted company. Hence the Fed would have exempted Pantry Pride, an operating company, in the Revlon takeover.
Now you don't have to be a corporate raider to argue that the Fed's move was bad, and here's why.
Flaw One: The Fed stretches credulity in contending that junk bonds are indirectly secured by the targeted company's stock. Buyers of junk bonds know fully well that they are secured by the income and assets of the acquired company. And that's perfectly obvious when the shell merges with the target and retires its stock.
Flaw Two: The shell test flies in the face of financial realities. Why, in corporate takeovers, are consortiums of wealthy individual investors and large financial institutions viewed as less credit worthy than operating companies?
Flaw Three: The new rule discriminates against those seeking to oust incumbent managements. The new G-rule doesn't apply to friendly takeovers or leveraged buy-outs in which insiders float scads of junk bonds to take companies' private stock. Those exemptions contradict the warnings of Fed officials that corporate debt is dangerously high. Actually it isn't.
But the most important and harmful consequence of the Fed's action is that it hobbles takeovers. That's why the new G-rule was supported by the Business Council, the National Association of Manufacturers and the AFL-CIO. What will happen if the new G-rule is effective is that investors will be deprived of gains because stock prices usually rise sharply in takeovers. And the barrier to the removal of inept managers will make it more difficult for this country to hold its own in an increasingly competitive world.
Less this be misconstrued as Fed- bashing, it should be said that the board responded to strong congressional pressure, which, in turn, was elicited by the howls of threatened corporate managers. So what the Fed did was something that Congress as a whole would not have voted to do. All of which demonstrates that a bad government practice -- bypassing the legislative process through pressure on a regulatory agency -- makes for bad public policy.