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Laws Encourage Imprudent
Behavior On Wall Street

The New York Times ran a piece entitled, The Road to Lehman’s Failure Was Littered With Lost Chances. As we read it, we realized that our current laws may be combining with compensation practices to put the interests of executives and board members out of alignment with the public interest. Why do we say this? The focus in both law and compensation practice has been to ally the interests of executives with those of shareholders. What we have learned in this financial crisis is that, in many cases, the public interest is more concerned with the interests of creditors and keeping the company solvent, then it is with the interests of shareholders.

We have been analyzing the financial crisis in a series of pieces including these eight:

Lessons For Everyone From Bear Stearns

More To Bear Stearns/JP Morgan Deal Than Meets The Eye

AIG Bailout Gives Short-term Relief Many Dangers Long-Term

Government Bailout Requires Deeper Analysis

Perishable Thoughts — Youth, Experience And The Subprime Crisis

Pundit’s Six-Point Proposal To Fix Financial Failures

McCain And Obama Make A Proposal — The Intellectual Bankruptcy Of Our Politics May Be A Bigger Problem Than The Financial Insolvency Of Wall Street

Yet we confess that we hadn’t thought of one angle until we read this line from the story in The Times:

“Days before second-quarter earnings, Mr. Fuld called on the billionaire investor Warren E. Buffett, who would eventually purchase a stake in Goldman Sachs, but Mr. Buffett was demanding terms that Lehman considered too onerous.”

Now Warren Buffett is widely acclaimed as the world’s greatest living investor and, certainly, is not foolish or trivial. So he wouldn’t have been demanding cash that Lehman Brothers couldn’t afford to pay. What this line probably indicates is that his demands were deemed onerous in terms of the dilution to existing stock holders.

Now the law gives the board of directors a fiduciary responsibility to the SHAREHOLDERS, not bondholders or other debt holders, generally right up to the time a company becomes insolvent. It is only at that point that this fiduciary responsibility shifts to creditors of a company. In addition, by awarding stock options, restricted stock, etc., many compensation plans are all designed to tie the executives’ interests to the interests of shareholders.

Famously, Richard S. Fuld, Jr., Lehman’s CEO, saw his own stock in Lehman Brothers drop from $800 million to virtually nothing. In this sense one can say that Mr. Fuld simply miscalculated. He should have accepted Mr. Buffett’s money, dilution and all, to salvage some value.

That is true and a fair enough explanation of what transpired. Yet it leaves tantalizing questions. Suppose Mr. Fuld had not held $800 million in stock but, instead, held $800 million in Lehman Brothers bonds. Surely it is likely that he would have been more inclined to accept the dilution Mr. Buffett proposed as that equity would have made the bonds more secure. In fact if the law had given Mr. Fuld a fiduciary responsibility to secure the interests of creditors instead of shareholders, one could argue Mr. Fuld would have been legally obligated to accept the investment.

This area is a minefield of conflicting interests. First, it may not be in the interest of society to encourage such a risk-averse approach in business, as risk-taking is the source of much growth and progress. Second, it is unclear if stockholders would give their money to executives who don’t have their interests as the primary matter although it should be noted that bondholders do it every day.

Still, it strikes us that it is just recently that bankruptcy came to be seen as a legitimate business strategy and that in the not-very-distant past the moral injunction against not paying one’s debts functioned as a restraint on the use of leverage and other high-flying tactics.

We are, of course, aware of many busts from tulips to railroads and so don’t want to overstate the case, but we are also mindful that when J.P. Morgan was called before the Senate’s Pujo Committee in 1912 to testify about concentration of financial power, he spoke memorably:

Untermeyer: Is not commercial credit based primarily upon money or property?

Morgan: No, sir, the first thing is character.

Untermeyer: Before money or property?

Morgan: Before money or anything else. Money cannot buy it…. Because a man I do not trust could not get money from me on all the bonds in Christendom.

This notion — that a man’s character was the crucial thing, even in financial matters — sounds almost quaint now. The reference to ‘ Christendom‘ sounds positively archaic. The world was smaller and moral sanction easier to impose.

The public interest is not so concerned with avoiding the losses that individual shareholders might suffer if their shares are diluted, but it seems heavily focused on avoiding the panic that accompanies corporate collapse, especially of financial institutions. One wonders if a part of the answer to preventing such collapses in the future is using the law and compensation programs to compensate for the loss of moral opprobrium that one found in years past.

Perhaps a requirement that stock compensation be matched by bond compensation or that, in financial enterprises, board members have a primary fiduciary obligation to seek to maintain solvency would help align the private interest of executives and board members with the public interest.

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