Next Tuesday, the country will elect its President for
the next four years. Exactly one week later, Congress will return to take up a
critical piece of deferred business that could dramatically affect the country
for the next four years and even beyond, regardless
of who wins the Presidential election.
In a culmination of circumstances that collectively
embody the current dysfunctional political climate in Washington, the country
faces what has been called a "fiscal cliff."
Unless Congress is able to implement some remedial steps, after December 31 a
host of temporary tax cuts will expire and a series of dramatic spending cuts
will kick in. If Congress does not act, the changes could have a significant
impact on the country's economy. The impacts could also have serious negative
implications for a wide variety of businesses and industries.
In this post, I first take a look at the details of the
impending "fiscal cliff." I then review the range of alterative paths that
events might take and consider the possible implications for affected
industries and companies. I conclude with an appraisal of the business risks
these possibilities might present. As discussed below, the potential
consequences could include, among other things, at least the possibility of a
heightened litigation risk.
What is the "Fiscal Cliff"?
The phrase the "fiscal cliff" refers to a likely budget
crisis and to a corresponding projected slowdown in the economy if specific
laws are allowed to expire or to go into effect at the beginning of 2013. The
changes include tax increases that will go into effect due to the expiration of
Relief, Unemployment Reauthorization and Job Creation Act of 2010, which
had among other things extended the Bush-era tax cuts. The expiration of
the tax cuts would result in an increase in all income tax rates, as well as
the rates on estate and capital gains taxes. In addition, the alternative
minimum tax will revert to 2000 tax year levels; federal unemployment benefits
will expire; and the 2% federal payroll tax reduction will terminate.
The changes also include the automatic spending cuts
("sequestrations") mandated by the Budget Control
Act of 2011, because the Congressional budget "supercommittee"
created by the legislation failed to agree on a deficit reduction plan. Annual
cuts of $109 billion per year will go into effect, with over half of the cuts
coming from defense spending.
Just to complicate matters further, the federal
government will likely hit its current debt level limit in early 2013, which
could introduce yet another destabilizing budget issue that Congress must
address at or about the same time.
As detailed in an October 9, 2012 post on the New York
Times Economix Blog (here),
if the changes go into effect, "almost everyone who pays taxes will see a hit
to take-home pay in the first paycheck in January." The White House estimates
that a family of four with an income of $50,000 to $85,000 would pay an
additional $2,200 in taxes during the 2013 tax year.
The spending cuts will also have an enormous impact. The
Bipartisan Policy Center is predicting
that the cuts alone could cost one million jobs in 2013 and 2014. The
Congressional Budget Office predicts
that economic growth would decline by 2.9 percent during 2013. There is a real
risk that the country would experience a
"double-dip" recession. I note parenthetically that most of the
discussion about the possible effects if the U.S. goes over the fiscal cliff is
focused exclusively on the consequences for the U.S. There undoubtedly will
also be consequences for the global economy as well, at a time when a host of
other economic factors already threaten to undermine the still-fragile recovery
from the credit crisis.
To be sure, there is some reason to believe that while
the increased taxes and budget cuts could have serious short-run negative
effects, the longer run effects could produce not only significantly reduced
deficits (as much as $7.1 trillion reduction in the national debt over the next
ten years, versus a $10-11 trillion increase if current policies are extended
for the next ten years), but also the reduced deficit and debt could lead to
higher long-term growth prospects. Indeed, because of the significant long-term
problems associated with the country's current and growing debt level, if
Congress merely extends current policies, growing interest costs will become an
increasingly significant drag on the country's economy.
There are those who believe that perhaps the country would
be better off taking the "strong medicine" associated with the tax increases
and across the board spending cuts (more about which below). However, automatic
spending cuts, no matter how effective as a way to reduce the deficit, do not
necessarily represent good policy, or really policy of any kind. To cite but
one example, even if cuts to defense spending are a good idea, cuts affecting
our military capabilities should only occur in a careful and considered way,
not simply by lopping off a huge slice of the defense budget. As serious as are
the problems associated with the deficit, defense budget cuts can't be
administered without knowing whether or not they could compromise national
On an even more immediate level, if Americans were to see
their take home pay slashed dramatically simply due to Congress's failure to
act, there would be a political firestorm of epic proportions. The political
backlash could be even further intensified if Congressional inaction results in
economic constriction and massive job losses.
The Congressional Alternatives
There is enormous pressure for Congress to act. Indeed, the conventional view is that the consequences of inaction are so severe
that Congress will almost certainly do something, even if it is just to kick
the can down the road for a few more months. The problem for the country and
for Congress is that the picture is scrambled. The current budget issue
will soon become an economic and financial problem but at the present moment,
at least for the members of Congress who will have to address the issue, the
situation represents a political problem. It is not just the uncertainty due to
a Presidential election that remains extremely close. Many Congressional and
Senate races also are also close, and the outcomes of a number of individual
races could have an impact. Margins of victory and shifting majorities could
also come into play. The Congressional body that will have to address these
issues before year end will be composed of an as yet indeterminate number of
lame duck politicians whose motivations and interests could be effected by next
week's elections. Add to this volatile political mix the possibility of a lame
duck President, as well.
There are a variety of other factors that could further
complicate Congressional efforts to confront these issues. Perhaps the most
significant is the scarcity of working days between November 13 and year end.
There is not much time for Congress to grapple with issues that are both
complicated and controversial. In addition, notwithstanding the serious threat
that the looming budget crisis presents, there will inevitably be a certain number
of Congressmen who, with an eye to the 2014 elections, are willing to provoke a
crisis in order to be able to try to pin the blame on the other party.
In addition, there are serious commentators and observers
who believe that the best thing for the county would be for the automatic tax
increases and budget cuts to go into effect. As discussed in an October 26,
2012 Washington Post article (here),
those who subscribe to this view (who are known as "cliff divers") believe that
only the exigencies of the crisis will put enough pressure on Congress to reach
a "grand bargain" that represents a comprehensive and considered approach to
the country's deficit and debt problems. These commentators also believe that
if Congress rushes to act in the little time remaining, a short-term sub-par
deal could result, that, once in place, would make it harder for Congress to
find the will to grapple with the fundamental issues.
One additional consideration that must be taken into
account in assessing whether or not Congress will act is the obvious fact that
merely because the country faces a looming economic crisis does not mean that
Congress will find a way to do something. The reason the country is approaching
the fiscal cliff in the first place is because of the adversarial
parties' past failures to work together and the willingness on the part of some
to engage in political brinksmanship. The forces that have produced past
stalemates could take the country right off the cliff. All it takes for
the country to go off the fiscal cliff is a little bit of political gridlock --
which happens to be the specialty of this particular Congress.
What This Means for Business
There are a host of problems that could arise quickly in
the new year if Congress does not act before year end. But the looming crisis
is already having an impact. As detailed in an October 25, 2012 Washington
Post article entitled "Fiscal Cliff Already Hampering U.S. Economy" (here),
companies "are bracing for the fallout by laying off workers, letting jobs go
vacant and postponing major purchases." According to the article,
Department of Commerce data show that business investment stalled in September.
Some companies have already begun laying off workers as a cost-containment
effort in anticipation of further downturn next year.
These problems will quickly accelerate if Congress fails
to act to avert the tax increases and spending cuts. Among other things, the
impact will quickly be felt in the defense industry, where the sequestrations could
quickly result in layoffs. The budge cuts could
also have a significant impact on the many small businesses that depend on
government contracts. The potential problems for many other industries may be
more difficult to discern now, but the impacts could be diverse and wide-spread.
For example, there are predictions
that there could be significant adverse impacts on the commercial real estate
sector as vacancy rates climb. Manufacturing, which only recently has begun to
rebound from the ill effects of the credit crisis, could
also be affected. A sharp increase in taxes would likely produce a sharp
downturn in consumer spending, particularly for discretionary and luxury
products. Even the purchase of consumer staples (such as appliances and
furnishings) could face a sharp decline.
At a minimum, businesses face a climate of uncertainty.
With uncertainty, comes risk. In light of this uncertainty and risk, some
advisors are cautioning companies to be sure to incorporate precautionary
disclosure in the public statements as a way to forewarn investors about the
potentially harmful impacts that could arise if Congress fails to act.
For example, in their October 23, 2012 memorandum
entitled "The 'Fiscal Cliff': Look Before You Leap Into the Securities
Litigation Trap" (here)
the Choate, Hall & Stewart law firm advises companies to "assess their
exposure to the fiscal cliff" and if the risks are sufficient to "factor the
relevant trends and uncertainties" into the earnings guidance, as well as into
their public filings and statements to investors, particularly during the
current quarterly reporting season.
It is worth emphasizing the reasons the law firm is
advising that companies take these steps; the memo notes that in light of the
potential consequences for companies from the budget crisis, the companies can
be sure that the plaintiffs' lawyers "will be on the lookout for targets of
'stock drop' securities fraud class action litigation." Companies that suffer
adverse impacts from the looming crisis could face allegations that resulting
stock price declines are the result of a company's misrepresentations with
respect to, or failure to adequately disclose, these risks. The memo observes
that "a company that warns with sufficient detail that its forecasts are
subject to uncertainty because of the fiscal cliff events may both discourage
litigation before it starts and have a better chance of prevailing should it be
Congress and the county are approaching a dangerous
crossroad. Though Congress can defer the day of reckoning temporarily by
(again) kicking the can down the road, the ultimate showdown can only be
postponed, and only then for a short time. Sooner or later Congress will have
to confront the problems associated with the growing cumulative deficit and
enormous debt. The country's best interests would be served if Congress were to
be able to reach the so-called "grand bargain" that addresses both revenue and
spending concerns and puts the country on a long-term path towards meaningful
debt reduction. Whether a sharply divided Congress (representing a
sharply divided electorate) can reach this type of agreement could prove to be
a very tough proposition.
In the meantime, both households and businesses face an
environment of uncertainty and attendant risk. Businesses already face
difficult choices about what steps to take in order to be prepared for the
possibility that Congress might fail to act. The risks companies face take a
number of forms, but among the risks is the increased litigation exposure that
can arise when companies' fortunes take a sudden negative turn. As we saw
during the credit crisis, adverse economic circumstances can beget a huge
increase in litigation. In light of these risks, companies would be well
advised to follow the recommended course of precautionary disclosure outlined
in the law firm memo linked above.
D&O underwriters also face a difficult task in this
environment. The question whether or not to adjust underwriting and risk
selection in the current atmosphere will be challenging, as it unclear whether
or not there really be any kind of crisis that could produce adverse claims
events. It is will be equally challenging to try to anticipate which companies
- or even which kinds of companies --- will be most adversely affected if there
really is a crisis. As if that were not enough, events will be moving fast over
the next few weeks, much faster than the usual efforts to adjust underwriting
practices and policies require.
Among the questions the D&O underwriters will have to
consider is whether or not to begin taking a more cautious approach to the
industries that will most obviously be affected if Congress fails to act, and
if so, which industries to target. The underwriters will also have to consider
how to scrutinize company disclosures in order to determine whether or not a
particular company has been sufficiently precautionary. And the D&O
underwriters will also have to adjust their positions as events unfold.
It will be interesting to see the outcome of next week's
election. I have to say, as an Ohio resident, this election can't end soon
enough. The around-the- clock political ad bombardment to which Ohio has been
subjected is more than anyone should have to bear. But while it will be great
to finally come to the end of this year's electoral season and it will be
interesting to see how the voting unfolds, there will be little break after the
election is over. Regardless of who wins, there will be some serious issues for
this country's political leaders to face, right away.
In closing, I want to quote Minneapolis Star-Tribune
Columnist D.J. Tice (here):
"The smart way to resolve the debt crisis" will require a little more from
Americans and their representatives. It will "require that Americans broadly
stop telling themselves that only somebody else is responsible for the
country's budget mess, that only somebody else needs to pay higher taxes, and
that only programs somebody else values need to be cut. It would require that
politicians start telling the truth, and that voters reward them for it."
Tice's position is absolutely correct. Unfortunately, he may also have
identified the precise reasons why the crisis may not be averted.
Perhaps because of the vivid imagery involved in the characterization of the
looming budget crisis as a "fiscal cliff," the prospect of the country plunging
off the budgetary precipice has inspired a number of cinematic allusions. The
most evocative is the reference to the cliff divers' approach as representing a
prescription with a certain "Thelma and Louise" quality - desperate and doomed.
If Congress were to fail to act and the country were to
race off the fiscal cliff, I think the experience for many Americans will be
much like that of Wiley Coyote, shortly after chasing the Roadrunner off of a
cliff - like the cartoon character, our legs will pump empty space briefly, and
then, after a sudden and startling recognition that we are hanging in mid-air,
we will plunge into the abyss.
And a Congressional debate in which some voices will
contend that the best course for the country is to hurtle off the cliff will
resemble the quarrel that Butch Cassidy and the Sundance Kid had as they argued
about whether to try to escape their pursuers by jumping off a cliff into a
raging torrent below:
Butch Cassidy (played by Paul Newman): Alright. I'll jump
Sundance Kid (played by Robert Redford): No.
Butch Cassidy: Then you jump first.
Sundance Kid: No, I said.
Butch Cassidy: What's the matter with you?
Sundance Kid: I can't swim.
Butch Cassidy: Are you crazy? The fall will probably kill
For those who don't remember the movie, the two do jump
off the cliff and they manage to survive the fall. However, they don't escape
their pursuers and they ultimately are taken down in an epic gun battle.
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