What if corporate decision makers lost money when they made bad decisions?

Back in January, criticizing the Supreme Court decision equating the free speech rights of corporations with those of individuals, I pointed out the insanity of considering corporate and other business entities as rational actors of the sort many economists consider people to be. The problem is that corporate decisions are made by individuals and are therefore driven to benefit those individuals, not the corporations (and their shareholders). As I wrote:

Individuals at AIG were making individual fortunes based on the income they were bringing into AIG for selling credit default swaps. Those individuals were making and would retain those fortunes even if, as turned out to be the case, AIG might not have sufficient funds to pay off the obligations those credit default swaps imposed on AIG. In other words, if one treated AIG as a rational person, one would suppose AIG would never expose itself to a real risk of obligating itself to pay more than it had in reserve. But AIG is merely a corporation, and the individuals actually making the decisions on behalf of AIG had every incentive to get what they could, subject AIG to irrational risk, and be able to walk away with their tens of millions of dollars.

I wasn’t just engaging in paranoia. I spent too many years with investment bankers to entirely forget their reality. And I have data to back me up:

In a study late last year, three Harvard Law School researchers examined public documents to assess whether one “standard narrative” of the crash was true — that “the meltdown of Bear Stearns and Lehman Brothers largely wiped out the wealth of their top executives.” It turned out to be a fairy tale. “In contrast to what has been thus far largely assumed, the executives were richly rewarded for, not financially devastated by, their leadership of their banks during this decade,” the Harvard Law team wrote. The top five executives at both Lehman and Bear collectively took home $2.4 billion in bonuses and equity sales — that’s nearly a quarter-billion dollars each — between 2000 and their 2008 demise.

Last week, William D. Cohan made much the same point in connection with the entire Wall Street ethic:

What if the biggest rewards on Wall Street went to those who thwarted dangerous and excessive risk-taking instead of to those who enabled, approved or simply ignored it?

What if every senior Wall Street executive had to worry that he could lose his entire net worth at any moment — including his mansions in Greenwich, Conn., and Palm Beach to say nothing of his job — if the revenue he was generating turned out to be unprofitable or excessively risky?

Wouldn’t that combination of potential rewards and fear of calamitous personal loss instill in every Wall Streeter a zealous desire to insist that the products his firm was peddling were safe for others to buy?

If such simple incentives had been in place on Wall Street, wouldn’t the latest crisis — as well as the multitude of others that have been perpetrated on us in the past 25 years — been largely avoided? . . .

The obvious answer to these questions is that human beings always do what they are rewarded to do and always have, especially on Wall Street. Rewarding prudent risk-taking on Wall Street while punishing recklessness would result in a new ethic on Wall Street, one not solely driven by generating as much revenue as possible in a given fiscal year with no regard to the long term.

To that end, shareholders must demand that corporate boards of directors revamp the entire compensation structure on Wall Street away from one based on revenue generation to one that rewards long-term profits. For goodness sake, what other business on the face of the earth, aside from Wall Street, pays out between 50 percent and 60 percent of each dollar of revenue generated to employees in the form of compensation!

And yet the Wall Street Journal’s stance on financial reform is the same as its stance on health care reform: “Once ObamaCare becomes law, the next big legislative rush is going to be for financial reform, but as we look at Senate Banking Chairman Chris Dodd’s latest draft we can’t help but wonder: Why the hurry?”

Indeed, why? There’s money still to be made . . .

Corporations = individuals? Confusions in economic theory and First Amendment jurisprudence

Metaphors are tricky things. Corporations are “persons” under the law in many respects, just as you and I are. And we treat corporations as rational individuals in the market. These figurative equations of legal fictions with human beings certainly have their utility, but they easily can be pushed too far. Individuals at AIG were making individual fortunes based on the income they were bringing into AIG for selling credit default swaps. Those individuals were making and would retain those fortunes even if, as turned out to be the case, AIG might not have sufficient funds to pay off the obligations those credit default swaps imposed on AIG. In other words, if one treated AIG as a rational person, one would suppose AIG would never expose itself to a real risk of obligating itself to pay more than it had in reserve. But AIG is merely a corporation, and the individuals actually making the decisions on behalf of AIG had every incentive to get what they could, subject AIG to irrational risk, and be able to walk away with their tens of millions of dollars.

And now the Supreme Court has overturned over 100 years of precedent permitting limits on corporate contributions to political campaigns because such limits constrained free speech and, according to the truism announced by Justice Kennedy’s majority opinion, ”Speech is an essential mechanism of democracy, for it is the means to hold officials accountable to the people.” But corporations don’t make decisions about how to spend money on campaign contributions — the individuals who control the corporations do. So what the Supreme Court has done is to remove any limits we might put on corporate CEOs to spend corporate money to advance the interests that indubitably are intended to redound to the benefit of those individual CEOs. I wouldn’t limit the ability of CEOs and shareholders to make individual contributions to political campaigns, but why are we treating purely legal entities like they are made of flesh and blood?

As Buzzflash pointed out recently, Thom Hartmann in his book Unequal Protection explains:

Prior to 1886, corporations were referred to in U.S. law as “artificial persons.” but in 1886, after a series of cases brought by lawyers representing the expanding railroad interests, the Supreme Court ruled that corporations were “persons” and entitled to the same rights granted to people under the Bill of Rights. Since this ruling, America has lost the legal structures that allowed for people to control corporate behavior.

Why do we enforce contract promises?

Over the course of my professional career, Law and Economics has grown from one school of thought among many to one so dominant that many of its postulates have virtually become unquestioned premises from which legal reasoning begins. The Law and Economics school of thought is wide-ranging, but might fairly be described the way Wikipedia puts it: Law and Economics is an “approach to legal theory that applies methods of economics to law. It includes the use of economic concepts to explain the effects of laws, to assess which legal rules are economically efficient, and to predict which legal rules will be promulgated.”

One of the most influential premises of Law and Economics is that contractual promises are enforced purely because of their capacity to maximize the society-wide allocation of resources. Thus, it is said that the contractual promise has no moral value over and above its economic value. This view both explains why typically someone suing for breach of contract can recover only the financial equivalent of the benefit they would have received had the contract been performed. There is no additional quantum of damages added to provide an incentive not to breach.

Thus, it is said, a contractual promise is in fact a promise either to fulfill the promise or to pay the damages that result from breach. This view, it is argued, has long been the view of the common law, as exemplified by Oliver Wendell Holmes’ late 19th Century statement that “the duty to keep a contract at common law means a prediction that you must pay damages if you do not keep it, and nothing else.” Thus, the thinking goes, if someone who has made a contractual promise can make out better by breaking the promise, paying damages for breach, and entering a different deal, that result is not merely tolerable — it is to be desired. Such a breach of promise is known as an “efficient breach” because it theoretically results in an increase in overall resources: the party injured by the breach is supposed to get everything he was supposed to get under the contract, the breaching party is getting something better, and the new party with whom the breaching party contracts is getting a deal he would not otherwise have gotten.

The Law and Economics view is by no means the only one current in the theorizing about the basis for enforcing contractual promises (and the interpretation Law and Economics devotees put on Holmes’ statement is disputed). As a contracts professor and litigator, though, my experience is that the idea that the contract promise has no moral value over and above its economic value is a very, very influential one.

It is a view, too, that is of a piece with the rise to virtual unquestioned dogma that unregulated free markets always result in the highest social good. One problem, though, is that unregulated free markets entrench the power of the wealthiest. So people bound by promises (the “promisor”) can force the person to whom they are bound (the “promisee”) to change the terms of the promises if the promisor has greater financial ability to force the promisee into a legal resolution that is unacceptable to the promisee.

The disparity in economic power the theory of efficient breach does not account for is on display in the power corporations hold to renegotiate employment contracts.  Since an employee can only recover for breach whatever damages are available to him through law, the threat of being limited to that remedy can be a powerful one. Thus, as the New York Times pointed out last week,

Contracts everywhere are under assault.

The depth of the recession and the use of taxpayer dollars to bail out companies have made it politically acceptable for overseers to tinker with employment agreements.

But, as David Skeel, a law professor from the University of Pennsylvania quoted in the article points out,

We run roughshod over some contracts and not over others. . . . Right now, employment contracts seem to be the type of contract that is viewed as eminently rewritable.

So we have Larry Summers, President Obama’s Chief Economic Adviser, arguing in connection with the bonuses paid to AIG employees that the contractual promises are too sacred under the law to undo: “”We are a country of law. . . There are contracts. The government cannot just abrogate contracts. Every legal step possible to limit those bonuses is being taken by Secretary Geithner and by the Federal Reserve system.” On the other hand, the UAW’s agreement to give up rights under its contract with the auto companies was required by the government as a condition of the federal monies the automakers received.

So, are contractual promises “sacred” in some way, or are they only worth whatever the parties to them can extract given their relative financial strength and political influence? I don’t think I know.

Greenberg v. AIG: the evidence and the truth

The difference between journalists and lawyers?  Journalists, at least as they practice their craft these days in this country, practice a pretended objectivity by giving voice to both sides of a dispute.  I presume the purpose is to leave the reader to be the judge.  It’s a way of going about thet job that gives the impression of being as fair as it is possible to be.  Fox News has grounded its entire image  in precisely this perception of what is most fair: “We report, you decide.”

I’ve bemoaned before the absence of critical thinking that goes into this style of reporting.  The New York Times is at it again today, this time on a subject far more important than whether a hot artist’s most valuable products infringe the copyrights of other creators — how AIG got our country into the financial mess it’s in and whether we ought to trust the people who brought us here to lead us out.  Hank Greenberg, the long-time head of AIG who was deposed in 2005, testified yesterday to Congress and claimed that the Obama administration should have let AIG go bankrupt, that the administration’s policies have deprived AIG of its most valuable assets by driving off the people who led AIG into its catastrophic state, and that Mr. Greenberg’s policies — which included the creation of the credit default swaps that “insured” the mortgage backed securities that were doomed to failure — had nothing to do with the eventual failure of AIG.  He might not have provided reserves to allow AIG to afford the liabilities it had assumed when it sold the credit default swaps (thereby earning itself enormous amounts of money, profits that of course contributed to the fortunes made by Mr. Greenberg and the other geniuses who our government has driven away), but, he says, he would have set aside reserves to meet those liabilities (thus averting the necessity of the bailout) had he been allowed to stick around.

The story does give the other side of the story, quoting a spokesperson for the current management of AIG contradicting Mr. Greenberg and asserting flat out that he lacks any credibility:

“Hank Greenberg continues to deny his role in allowing [AIG's Financial Products Division] to write the multisector credit-default swaps which sowed the seeds for AIG’s troubles,” the company said, referring to the financial products unit. It went on to denounce Mr. Greenberg as evading questions and lacking credibility as a business strategist.

“He refuses to acknowledge that he approved entry into the credit-default swap business, approved more than $40 billion of swaps written on C.D.O.’s containing subprime loans, and didn’t hedge or put up reserves against them,” the company said. Collateralized debt obligations are securities made from pools of loans and other forms of debt.

“We don’t understand how he can be viewed as having any credibility on any AIG issue.”

My problem with this type of journalism is that it doesn’t make judgments that can be made.  It often may be difficult to tell right from wrong with certainty, but there are often clear judgments to be made about which position is better and which worse.  Mr. Greenberg’s self-interest in these matters, his lifetime of self-promotion in the interests of building an immense personal fortune, and his rank hypocrisy are legendary.  A journalist is capable of giving both sides of an argument and of understanding context and making judgments.  To fail to do so leaves the reading public to do that work themselves, something that people simply don’t have the time to do.

Lawyers, on the other hand, do contend always with adversaries setting forth evidence that seems to contradict the evidence they are presenting on behalf of their own clients.  But setting forth the evidence is only part of a lawyer’s job.  The lawyer also structures that evidence into arguments on behalf of his client’s position, explaining specifically how that evidence should be viewed.  Then decision makers (juries, judges, arbitrators, etc.) decide.  The lawyer doesn’t rely on the decision-maker to figure out how to explain the evidence.  The lawyer gives the decision-maker the means of understanding it.

I don’t know why journalists don’t do so more often.

War is Peace, or They can sue, but you can’t.

There is wisdom and responsible citizenship, and then there is mindless use of law to advance whatever selfish interests one has when one has them.  May my students know the difference, and may they not serve clients who want the latter at the cost of the former.

In November 2006,  the Committee on Capital Markets Regulation issued a report arguing for cutting back on regulation of financial markets, for limitations on private lawsuits and on lawsuits by state attorneys general, and for increased restrictions on the ability of the Securities and Exchange Commission to issue new rules. The Committee on Capital Markets Regulation was a private group, but it had prominence.   Its co-chairs were R. Glenn Hubbard, the dean of the Columbia University Graduate School of Business, and John L. Thornton, the chairman of the Brookings Institution, its formation was endorsed by then-Treasury Secretary Henry M. Paulson Jr., and a significant part of its funding came from the Starr Foundation, started by Maurice R. Greenberg, who had in 2006 recently been deposed as Chairman of AIG.

Greenberg and AIG were notoroius for their hostility to lawsuits.  It figures — AIG is (was?) an insurance company, and liabilities are what insurance companies are supposed to pay for.  As the founder of one law firm I worked for, Gene Anderson, always says, “Insurance companies are in the business of collecting premiums and denying claims.”

Now, though, Greenberg no longer heads AIG and AIG showed itself incapable of paying for the liabilities it had collected premiums to insure.  So their minds seem to have changed.  Greenberg has become a lawsuit enthusiast, most recently suing AIG for for securities fraud based on alleged “‘material misrepresentations and omissions’” that  caused him to acquire New York-based AIG shares in his deferred compensation profit-participation plan at an ‘artificially inflated price.’”

And I just read that AIG commenced a lawsuit last month against the federal government seeking a return of $306 million in taxes it claims it should not have paid.  The claims include taxes paid in connection with AIG’s financial products unit (“the once high-flying division that has been singled out for its role in A.I.G.’s financial crisis last fall”), and “AIG offshore entities whose function centers on executive compensation and include C. V. Starr & Company, a closely held concern controlled by Maurice R. Greenberg and the Starr International Company.”

As the New York Times puts it:

A.I.G. is effectively suing its majority owner, the government, which has an 80 percent stake and has poured nearly $200 billion into the insurer in a bid to avert its collapse and avoid troubling the global financial markets. The company is in effect asking for even more money, in the form of tax refunds. The suit also suggests that A.I.G. is spending taxpayer money to pursue its case, something it is legally entitled to do. Its initial claim was denied by the Internal Revenue Service last year.

And if you think corporations should be liable to individuals for damages their products cause, that taxes should be raised on the people who earn more than 95% of our citizens, and that we should tax the inheritances of heirs who have done nothing to earn that money, you’re accused of engaging in “class warfare”?  I’ve got news for you: they struck first.

A better solution to the mortgage crisis, the federal governments bailout policies, and AIG’s failures to meet the obligations it took the risk of not meeting

I have several thoughts about the AIG bailout apart from what I consider the justifiable outrage over multi-million dollar bonuses being paid to the very people who set up the house of cards AIG had constructed.

First, I can’t understand why anyone would be surprised, much less outraged, that AIG paid much of the bailout money it received to other financial institutions.  Those institutions (Goldman Sachs, for example) owned mortgage backed securities and had purchased from AIG the “credit default swaps” that were, in essence, insurance that the owners of the mortgage backed securities would not earn from those securities what they were supposed to. Goldman Sachs had not received what they were owed on the mortgage backed securities because the crash in the housing market meant that homeowners were not making the mortgage payments that made up the pools of money out of which the owners of mortgage backed securities were to be paid.  Thus, when Goldman Sachs was not paid what it was supposed to be paid from the homeowners, Goldman Sachs turned to AIG and asked to be paid pursuant to the insurance policies it had purchased from AIG (that is, the credit default swaps).

AIG had never planned for such a shortfall in mortgage payments.  It had essentially sold the credit default swaps to earn easy money (the “premiums” for the sales) that it did not believe it would ever have to pay out on.  Thus, when in fact it did have to pay out on those credit default swaps, AIG was threatened with bankruptcy because its obligations to the owners of mortgage backed securities far exceeded its assets.

The U.S. could not afford to let that happen.  AIG is the world’s biggest insurer.  It’s failure would set off massive insecurity in every single aspect of life in which people and institutions depended on the availability of its insurance.  Neither could the U.S. afford to let the financial institutions fail.  That would mean a collapse of our banking system, an even greater and more profound impact on the functioning of our credit markets and other aspects of our economy — in short, a Depression on the order of The Depression.

Here’s what I don’t quite understand.  The underlying problem was that too many homeowners were unable to make their mortgage payments.  Why not readjust everyone’s mortgage payments (by, say, automatically cutting mortgage rates to the current low rates).  The owners of the mortgage backed securities would not make as much as they otherwise would have had the original rates been paid, but too many of the original rates weren’t paid to make enough of the mortgage backed securities assets with any material value.  The owners of the mortgage backed securities would make some of the money they had expected.  They would still be able to look to AIG under the credit default swaps for the difference between what they had expected to make under those securities and what they made under the readjusted, low rates, but AIG’s exposure would have been considerably lower — not the entire value of the mortage backed securities but, rather, the difference between what those securities earned under the new adjusted mortgage rates and what they originally were supposed to have been paid.  To the extent that obligation still threatened AIG’s existence, the government could make up the shortfall, but the amount of federal dollars required to do so would have been far less.

One objection, of course, is that we’d be rewarding those homeowners who took the risk of assuming mortgages they couldn’t afford.  The problem with that argument, of course, is that the owners of mortgage backed securities took the risk they wouldn’t get paid either through the securities from the pools of mortgage payments or from AIG, but we’re bailing them out.  And AIG, of course, took the risk in selling its credit default swaps that it would not be able to meet its obligations under them, but we’re bailing them out.  We’re doing so because we have to.

But we have to bail out the homeowners too.  The very existence and health of our cities depends on us doing so.  Why are the homeowners any more to be the victims of “moral hazards” than the financial institutions.

Everyone wins.  Homeowners stay in their homes at today’s mortgage rates.  The lenders don’t get what they contracted for, but they get what, given the circumstances we’re in, is a perfectly reasonable rate of return.  More importantly, the lenders don’t fail as a result of mortgage defaults and the insufficiency of foreclosure as a remedy to make up the loss resulting from the default.  The banks that own the mortgage backed securities are made whole (or almost so), and AIG is made whole (or almost s0).

Could anyone tell me what I’m missing here?  I do not claim to be an expert on these matters, but I am smart enough to follow the money and the trails of contract obligations, and I’m not quite sure where my logic fails.  I’m sure it must, but where?