In a recent post on this blog (here), I commented on a May 29, 2012 Dealbook blog post entitled “Why S.E.C. Settlements Should Hold Senior Executives Liable” (here), which had been written by two University of Minnesota law professors, Claire Hill and Richard Painter. After my post appeared, I contacted Professors Hill and Painter to let them know about my post and to invite them to respond to my post if they would like. Professors Hill and Painter (who are pictured to the left) did, in fact, have some comments in response to my post, and I am pleased to be able to publish their comments below as a guest post.
I am very grateful to Professors Hill and Painter for their willingness to provide a detailed response to my post and for their willingness to allow me to publish their comments here. The Professors comments follow.
Senior executives in investment banks and other financial services firms make a lot of money a lot of the time. Jamie Dimon, the CEO of JP Morgan, for example will receive total compensation of $23 million this year, even though JP Morgan has suffered a $2 billion (or more) loss incurred by an improvident and unsupervised trader known as the “London Whale.” MF Global’s board had approved an $8 million pay package for CEO Jon Corzine the year before MF Global collapsed, it having “lost” $1.6 billion in customer funds that were apparently comingled with its own. Senior executives at Bear Stearns, Lehman Brothers and Merrill Lynch “earned” similarly large pay packages in the years before those firms collapsed.
In a law review article, two op-eds in the New York Times dealbook section, here and here, and in a forthcoming book on the ethics of investment bankers, we express our concern that for too many senior executives in financial services, their work has become a game of “heads I win, tails you lose” played with investors and creditors, and, when there is a government bailout, with taxpayers. This we think is wrong – and it is not the way the banking game was always played.
We are not ivory tower academics who don’t like bankers (many of our friends and family members are bankers or have been bankers). We just think that bankers should play the game with some more of their own money. We also think that, if they did, they might play the game differently.
In the 1970s the largest investment banks – Morgan Stanley, Lehman Brothers, Salomon Brothers, Goldman Sachs and others — were general partnerships. A firm’s capital belonged to the partners, so when they made an investment, or authorized a trader to take a position, they were investing their own money. If the firm was socked with an SEC fine or civil judgment for violating the securities laws, the fine came out of the firm’s assets, which meant it came out of the partners’ pockets. If the firm went bankrupt, the partners not only lost the investment they had in the firm, but they were personally liable for debts that the firm could not pay.
Investment banks took big risks in those days – but nowhere near the magnitude or risks that in 2008 caused three of the five largest investment banks in the United States – Bear Stearns, Merrill Lynch, and Lehman Brothers – to fail.
The fact that these banks, as most all others these days, were operated not as partnerships but as corporations, with limited personal liability for their executives, has, we think, something to do with what happened. Banking for them is a game of “heads I win, tails you lose.”
To fix this we have proposed that the most senior bankers (those making more than $3 million) be asked in return to make a substantial portion of their personal assets (all except perhaps a few million dollars) available to pay the debts of the firm if it fails, and/or have a portion of their compensation be assessable stock that would be subject to a capital call if the firm becomes insolvent. More recently, we suggested (and one of us suggested two weeks ago in Congressional testimony) that senior executives of a financial institution be asked to pay, perhaps out of the bonus pool, a significant portion of any fine that the SEC or other regulator levies against the bank for illegal conduct. This, we think, is fairer than imposing the entire cost of the fine on the bank’s shareholders, who had no role in the illegal conduct or responsibility for supervising the individuals who engaged in it.
None of what we propose has anything to do with collective guilt or finding of fault without due process, as has been implied in a well-written post by the host of this site. What we propose has to do with collective responsibility for the consequences – both good and bad – of corporate conduct in the financial services industry. Financial services firms devote a very substantial portion of their revenues to salaries and bonuses (more than many other industries), something we do not in principle object to. We only suggest that when firms break the law, or lose so much money that they become insolvent, the persons responsible for managing those firms should bear a portion of the cost. Banks, shareholders and creditors, and society as a whole, would be better off if bankers went back to playing an honest game of “heads I win, tails I lose.”’
Why should bankers be treated differently than executives of other firms? Why shouldn’t they get the limited liability that executives at other incorporated firms have? Financial services firms are different from other businesses in several respects including the fact that leverage ratios are high, financial assets such as derivative products are extremely hard to value, it is difficult for shareholders, creditors and regulators to assess risks that managers are taking, and senior managers are paid extremely well when their bets pay off. Also, for creditors, other financial services firms and the economy as a whole, the repercussions from risks that bankers take can be enormous. The impact of financial managers’ risk taking turns on, among other things, the types of activities they and their firms engage in, their firms’ size, and the extent to which the firms are interconnected with one another and with other entities. High risk-taking may lead to a firm’s failure, but the firm has a good chance of being bailed out given its size and interconnectedness. The moral hazard – e.g. incentive for managers to take enormous risks – is very strong.
Although limited liability has advantages for raising capital and attracting talented employees, it sometimes has downsides. Bankers know this, and before they extend credit to riskier incorporated enterprises they often insist on personal guarantees from the principals. Bankers know that corporate borrowers whose managers have guaranteed corporate indebtedness will be managed more conservatively than corporate borrowers whose managers have not made personal guarantees. Indeed, up until the 1980s, almost all of the largest investment banks operated as partnerships, with partners personally liable for firm debts. Now, after 2008, we know that the greatest risk exposure that financial institutions face comes from imprudent decisions by persons in the executive suite who have every incentive to maximize short term profits and bonuses, but not enough incentive to avoid excessive legal and financial risk.
Limited liability for officers of businesses is generally acceptable, but there are exceptions. Investment banks and most other financial services firms should be an exception. Solvency guarantees and partial payment of fines for illegal firm conduct by the most highly paid financial services executives are a reasonable quid pro quo for the enormous pay packages that they receive.
Worth Reading: Here at The D&O Diary, we never rest from our task of making sure our readers are fulliy informed, and in is in that spirit that we pass along the following links for all of our readers.
First, in a excellent June 12, 2012 article on her On The Case blog (here)., Alison Frankel takes a detailed look at Delaware Vice Chancellor Travis Laster’s June 11, 2012 opinion in the Allergan derivative litigation, in which the Vice Chancellor, as Frankel puts it, "blasts first-to-file firms" in shareholder derivative and M&A litigation. It is a long-ish article but very much worth reading in full.
Second, Victor Li’s June 12, 2012 article on Am Law Litigation Daily (here) takes a look at the ruling entered Monday in the Western Distrcit of Pennyslvannia in the long-running RICO action brought in that court against Alcoa and others by Bahrain Aluminum BSC (Alba), in which Alba accuses the defendants of bribing Alba officials and other senior Bahrain government officials. As Li explains, Monday’s decision rejected the defendants’ attempt made in reliance on the U.S. Supreme Court’s decision in Morrison v. National Australia Bank to have the case dismissed.
Third, a June 11, 2012 Reuters article entitled "SEC Probes Hit a Wall in Uncooperative China" (here) takes a look at the problems that the SEC is having trying to investigate fraud allegations involving Chinese companies. According to the article, the SEC is finding that "cooperative cross-border investigations are completely foreign to China."