Why are you working harder for less? Scientific Management, management consulting, and leveraged buyouts – a century of being conned.

I described leveraged buyouts the other day — in connection with the demise of the maker of the Simmons Beauty Rest Mattress — as a symptom of why we don’t trust Wall Street. You might wonder why, if I’m right, we allow people again and again to “buy” companies by borrowing enormous sums of money — in essence, we allow the buyers to suck money out of successful companies for their own benefit in the same way we allowed home owners in a rising housing market to suck money out of their homes by means of home equity loans.

It’s perfectly clear why we allowed homeowners to do that — all involved figured the market would continue to rise at least until they could make their money and get out. But why do we let this keep happening on a much larger scale on Wall Street?

I hadn’t considered the question specifically at the moment I wrote that post about Simmons. It was enough for me that throughout the 25 years of my career both practicing (in connection with, among many things, leveraged buyouts) and teaching I’ve seen the phenomenon again and again. But this week I came across Jill Lepore‘s article “Not So Fast” in the New Yorker, an article which asks the question, “Scientific management started as a way to work. How did it become a way of life?” Lepore’s article is about the rise in the early 20th Century of “Scientific Management,” the foundation of modern “Management Consulting.” Scientific Management was created by Fredrick Winslow Taylor, who, as Lepore writes, sold himself as someone able to make businesses more efficient:

Speedy Taylor, as he was called, had invented a new way to make money. He would get himself hired by some business; spend a while watching people work, stopwatch and slide rule in hand; write a report telling them how to do their work faster; and then submit an astronomical bill for his services. He is the “Father of Scientific Management” (it says so on his tombstone), and, by any rational calculation, the grandfather of management consulting.

The problem, as Lepore notes, is that Taylor was a fraud, and Taylorism’s grandchild, management consulting, is as well.

What does all this have to do with leveraged buyouts? Plenty. The entire rationale of the leveraged buyout is that the buyers can take a company with a lot of unrealized value and realize it. How? By making the company more “efficient.” The debt taken on to buy the company (and to reward the “buyers” with profits along the way) will, the argument goes, easily be paid off given the as yet unrealized efficiencies. Thus, we’ve had decades of “downsizing” (massive layoffs), “consolidations” (elimination of competing businesses), and arguments that advances in productivity brought about by our new technologies would redound to the benefit of all (when the only benefit would redound to whoever could pull the money out quickest).

We’ve been had.

At least we have one consolation — none of us have been alone in being conned. The focus of Lepore’s work is Louis Brandeis, someone I’ve always thought was a very bright guy and who against all evidence remained convinced his entire life that Scientific Management would benefit the working person:

Neither unions nor businesses have lived up to Brandeis’s optimism. “If the fruits of Scientific Management are directed into the proper channels,” he wrote, “the workingman will get not only a fair share, but a very large share, of the industrial profits arising from improved industry.” Lately, that share has been going to shareholders and C.E.O.s. Home and work, separated since the first stirrings of the Industrial Revolution, have been growing back together again: BlackBerry on the nightstand, toaster in the photocopy room. Efficiency was meant to lead to a shorter workday, but, in the final two decades of the twentieth century, the average American added a hundred and sixty-four hours of work in the course of a year; that’s a whole extra month’s time, but not, typically, a month’s worth of either happiness minutes or civic participation. Eating dinner standing up while nursing a baby, making a phone call to the office, and supervising a third grader’s homework is not, I don’t think, the hope of democracy.

You’ll also find worthwhile on this topic the New York Times video series entitled “Flipped: How Private Equity Dealmakers Can Win While Their Companies Lose“

All the cash has been sucked from Simmons’ mattresses.

Is it any wonder we don’t trust Wall Street?

I saw it back in the 80′s up close and personal, when the debt was called “junk,” but the practice goes on and on and on. When credit markets are good, investors (called “private equity firms” or “merchant bankers” or “leveraged buy out firms” or the like among their peers and minions) will sell a company’s bonds to finance their purchase of the company, take fees for issuing those bonds, issue more bonds later on to take cash out of the company for themselves (and fees for the new issuance), and then, when the debt becomes to burdensome for the company, the purchasers of the bonds are left high and dry — that is, broke or, at best, with equity in a new, reorganized, and crippled company worth a fraction of what they paid for their bonds.

The latest victim? Simmons Bedding Company, the maker of the Simmons Beauty Rest Mattress. As the New York Times reports:

Simmons says it will soon file for bankruptcy protection, as part of an agreement by its current owners to sell the company — the seventh time it has been sold in a little more than two decades — all after being owned for short periods by a parade of different investment groups, known as private equity firms, which try to buy undervalued companies, mostly with borrowed money.

For many of the company’s investors, the sale will be a disaster. Its bondholders alone stand to lose more than $575 million. The company’s downfall has also devastated employees like Noble Rogers, who worked for 22 years at Simmons, most of that time at a factory outside Atlanta. He is one of 1,000 employees — more than one-quarter of the work force — laid off last year.

But Thomas H. Lee Partners of Boston has not only escaped unscathed, it has made a profit. The investment firm, which bought Simmons in 2003, has pocketed around $77 million in profit, even as the company’s fortunes have declined. THL collected hundreds of millions of dollars from the company in the form of special dividends. It also paid itself millions more in fees, first for buying the company, then for helping run it. Last year, the firm even gave itself a small raise.

Wall Street investment banks also cashed in. They collected millions for helping to arrange the takeovers and for selling the bonds that made those deals possible. All told, the various private equity owners have made around $750 million in profits from Simmons over the years.

Who should most influence the creation and intepretation of our laws?

Where did our laws go wrong and help create the current financial crisis?  My own experience over the 28 years since I began law school has been that at the intellectual level we have become more and more enamored of the idea that the free market is the best measure of all value and that at the professional level we have become more and more obeisant to the financial industry.  Markets do a lot of good, but it boggles my mind when complex legal problems involving competing values and belief systems are in facile ways reduced to a weighing of measurable quantities.  And the investment bankers I worked among during my years as a lawyer in New York City were bright, but they were no smarter than the lawyers, painters, non-profit fundraisers, contractors, social workers, doctors, nurses, teachers, writers, and engineers I knew.

As Simon Johnson, a Professor at MIT’s Sloan School of Management and former chief economist of the International Monetary Fund, points out in the Atlantic, it might precisely be our willingness to defer politically to the people we referred to as financial “wizards” that got us in this mess:

Top investment bankers and government officials like to lay the blame for the current crisis on the lowering of U.S. interest rates after the dotcom bust or, even better—in a “buck stops somewhere else” sort of way—on the flow of savings out of China. Some on the right like to complain about Fannie Mae or Freddie Mac, or even about longer-standing efforts to promote broader homeownership. And, of course, it is axiomatic to everyone that the regulators responsible for “safety and soundness” were fast asleep at the wheel.

But these various policies—lightweight regulation, cheap money, the unwritten Chinese-American economic alliance, the promotion of homeownership—had something in common. Even though some are traditionally associated with Democrats and some with Republicans, they all benefited the financial sector. Policy changes that might have forestalled the crisis but would have limited the financial sector’s profits—such as Brooksley Born’s now-famous attempts to regulate credit-default swaps at the Commodity Futures Trading Commission, in 1998—were ignored or swept aside.

The problem is that, as Joan Walsh points out, the Obama administration’s efforts to “fix” the financial industry seem to perpetuate the misplaced reliance on the financial industry that the Democratic Party started back in the Clinton administration and that continues, unabated, to this day in the actions of Tim Geithner and Charles Schumer, the Democratic senator from New York.

Perhaps, though, we’re in on the beginning of a trend in a direction other than the one we’ve taken in the 30 or so years of my professional life.  With the demise of investment banks we’ll no longer see the best and the brightest of our college graduates flowing into investment banking and financial consulting jobs.  At a recent job fair at Columbia University, Kevin Long, a recruiter for Environ, which provides international consulting services on environmental sustainability, cleanup and other issues, was quoted as follows:

We’re delighted. In the past, we have had to compete with investment banks, hedge funds people that were pulling the best engineers and scientists out of these schools. And this year, because of the conditions of the economy, we’re getting an opportunity to go after those students.

Who knows?  If the people we consider the smartest are engineers and medical providers and social workers, maybe we’ll pass laws that enrich them rather than laws that enrich investment bankers.  And maybe that will be better.  Certainly it will bring in a broader range of views.  I don’t mean we should ignore the financial industry, but we should realize when someone tells us by making laws and policy that are intended to directly enrich them we will indirectly be doing ourselves the greatest good, we should perhaps start checking our wallets.

Courts are supposed to do justice even if doing so costs individuals a lot of money.

Joe Nocera writes in the New York Times that to even suggest “that maybe, just maybe, deals that stop making sense ought to be called off, or at least rejiggered, especially in the middle of a once-in-a-lifetime financial crisis – invites withering scorn, especially if you say it to someone on Wall Street or in the legal profession.”

I’ve worked in the legal profession on Wall Street, and I like to think that when what the law seems to compel makes no sense the law has the capacity to adjust, to do justice instead of nonsense.  My thinking isn’t purely the product of naivete and idealism.  There really  is a legal (or,  rather, for the lawyers among my readers, an equitable) argument to stop the particular deal Nocera is writing about.  Moreover, that argument is precisely that the deal makes no sense to an interest — the public — much more important than the individuals who would profit mightily from the deal.

Here’s the deal:  “Last summer, the Dow Chemical Company won a heated auction for a well-run, highly valued specialty chemical company called Rohm & Haas. . . . The price it agreed to pay was high: $78 a share in cash, a 74 percent premium, for a total of about $15.3 billion.”  The problem is that in light of the global financial crisis and a collapse of the chemical business, if the deal goes through the resulting Dow/Rohm & Haas entity “could be badly damaged, saddled with high-priced debt in a horrible business environment, and a junk bond credit rating.”

What does that mean? It means that if the deal goes through Dow would need to strip itself to the bare bones to survive or would collapse altogether.  This while “Dow Chemical employs around 45,000 people; Rohm & Haas employs more than 15,000.”  This while “the American chemical industry – which was suffering even before the financial crisis because of the rise of commodity chemical companies in China and elsewhere – is going to be in a bad place for the foreseeable future.”   This “[a]t a time when every job matters, and when the economy is holding on for dear life . . .”

In return, the shareholders of Rohm & Haas will get $15.3 billion.  According to Answers.com, ‘the Haas family, descendants of one of the company’s two founders, continue to control a substantial ownership interest of nearly 30 percent” of those shares. So the the Haas family and the other Rohm & Haas shareholders are suing for “specific performance” of the contract with Dow; that is, they are asking a Delaware court to order Dow to go through with the deal to buy Rohm & Haas for $15.3 billion.

I’m not sure why there’s “withering scorn” for the suggestion that a court might refuse to enforce a deal that threatens 60,000 jobs and, as Nocera writes,  would probably destroy “billions of dollars of value.”  It’s no stretch to suggest that at a time of global economic collapse and at a time when President Obama is fighting to inject billions of dollars into the economy, the deal is not in the public interest.

Why am I willing to defy the withering scorn of the Wall Street experts?  Because specific performance, the remedy Rohm & Haas is asking the court to grant, is an what is known as an “equitable” remedy.  In order to show it is entitled to equitable relief, Rohm & Haas must show that the outcome makes sense even after the court balances “all the equities” involved.  In other words, the court must determine whether, considering all of the interests at stake in the lawsuit, ordering the deal to go through would be more fair than unfair.  The public interest plainly is one of those interests the court must consider. Because the deal poses such a great threat to the public interest, the equities do not favor the deal; the equities, in fact, weigh heavily against enforcing the contract between Dow and Rohm & Haas.

In legalese, Corporate and Commercial Practice in Delaware confirms that this is the law in Delaware:

[I]f specific performance of a contract would cause significant public harm, then the Court has discretion to deny such relief, even where a breach of contract and substantial harm to plaintiff have been established . . .

1-12 Corp & Commercial Practice in DE Court of Chancery § 12.03 (Matthew Bender 2008), citing Alro Assoc., L.P. v. Hayward, CA 19544 (Del. Ch. Oct. 31, 2003), mem. op. at 22-26 (holding that where plaintiff had established breach of contract by Delaware Department of Transportation and where Court had assumed irreparable harm to plaintiff, specific performance was not appropriate  due to a balance of equities weighing strongly in favor of public interest).

Courts really are supposed to do justice notwithstanding the fact Wall Street expresses withering scorn at the thought.