Monday, October 5, 2009

Res Ipsa Loquitur

Subsequent to my recent half-hearted cudgeling of the Shaggy Horse of Shareholder Governance as an important contributor to the excessive pursuit of risky returns by publicly-owned financial institutions, my argument received overwhelming reinforcement today in the pages of the The New York Times Dealbook from the person of scarily smart and excessively erudite Delaware corporate jurist Leo E. Strine, Jr.

Not only did Herr Professor Doktor Strine take the heretofore only slightly bruised nag out back and decisively beat it to death, he skinned it, deboned it, rendered its fat for glue, and gilded its hooves into four rather fetching ashtrays for the Court of Chancery's waiting room. In short, in your Humble Correspondent's considered opinion, he nailed it.

In a nutshell, the Esteemed Vice Chancellor most assuredly does not agree with those who believe that all public shareholders were innocent dupes taken along for a ride by evil, greedy, grasping investment bankers and their bosses in the recent run-up to the crisis:
Whatever the possible causes of the recent financial debacle, it seems clear that there is one cause that can be ruled out: that the directors and managers of the failed firms were unresponsive to investor demands to take measures to raise profits and increase stock prices.

Rather, to the extent that the crisis is related to the relationship between stockholders and boards, the real concern seems to be that boards were warmly receptive to investor calls for them to pursue high returns through activities involving great risk and high leverage.

He continues:

During the last 30 years, it is indisputable that: (1) regulatory standards have been greatly relaxed, giving the financial industry free rein to leverage itself to the hilt and to engage in a wide range of speculative and increasingly opaque, complex activities, often without rigorous safeguards; (2) the power of stockholders to influence the composition of corporate boards and the direction of corporate strategy has been markedly enhanced; (3) institutional investors who hold stocks, on average, for a very brief period of time and are highly focused on short-term movements in stock prices have become far more influential and prevalent; and (4) “pay for performance” compensation systems were implemented to align the interests of managers with stockholders by giving managers incentives to pump up corporate profits in a manner that will increase the corporation’s profits and stock price immediately, rather [than] durably.

This is consistent with my view, that public shareholders of investment banks, as a group, did not act to brake the risk taking of their employees at all, but rather encouraged and rewarded it, or—what is perhaps more pertinent—punished any executive who did not embrace such activity wholeheartedly.

* * *

What I find most interesting about Mr. Strine's remarks is the salient distinction he draws among the motivations and behavior of different kinds of public shareholder. To the best of my admittedly limited knowledge, this is the first instance I am aware of where anyone has focused on this issue to this extent. He draws from it some useful policy prescriptions:

Therefore, if the correct policy balance is to be struck regarding regulation of the financial industry and other industries that pose large systemic and societal externality risks, policy makers cannot continue to avoid the obvious alignment problem that now vexes our corporate governance system.

Most Americans invest with a rational time horizon consistent with sound corporate planning. They invest with the hope of putting a child through college or providing for themselves in retirement. But individual Americans don’t wield control over who sits on the boards of public companies. The financial intermediaries who invest their capital do. These intermediaries have powerful incentives — in important instances, not of their own making — to push corporate boards to engage in risky activities that may be adverse to the interest of long-term investors and society. That is, there is now a separation of “ownership from ownership” that creates conflicts of its own that are analogous to those of the paradigmatic, but increasingly outdated, Berle-Means model for separation of ownership from control.

Unless these incentives and conflicts are addressed, it should be expected that corporate boards will continue to face strong pressures to manage their enterprises in a manner that emphasizes the short term over the long term, and that involves greater risk than is socially optimal. As a result, more stringent than optimal prudential regulation will have to be in place to bar the financial sector from taking risks that endanger society as a whole, rather than simply the capital of their investors and the employment of their employees.

Of course, this analysis and argument applies more broadly than just to publicly owned financial institutions. However, given the extreme sensitivity said financial institutions have proved to have toward excessive risk taking, and the genuinely calamitous negative externalities they have inflicted on society at large as a result, I think the Honorable judge's recommendations have particular force in their case.

In any event, I believe Mr. Strine's analysis should conclusively disabuse participants in the current debate over financial regulatory reform of two related notions. The first is the red herring that somehow stronger corporate governance by public shareholders over investment bank Boards and executives would have prevented the kind of reckless risk taking that brought these firms—and the global economy at large—to the brink. The second is the canard that all public shareholders are alike, and they all share the same interests and motivations.

Realizing that the second of these is false, and that Fidelity Investments and SAC Capital do not have the same investment timeframe and objectives as Aunt Millie or even the Ohio Teachers Pension Fund, would have a highly salutary effect on the beliefs and behavior of truly long-term shareholders.

If nothing else, getting Aunt Millie to realize she is the only one in the shark tank without a safety cage should do her a world of good.

© 2009 The Epicurean Dealmaker. All rights reserved.