The world has become accustomed to the idea of an October Surprise. It has happened in politics, in theaters of war and in the economy (see October 1929). But rarely has this phenomenon had the courtesy to actually appear on October 1st, on the dot. That happened on Wall Street today (and on Bay Street in Toronto), where, in the one case, the Dow slipped by more than 200 points, and in the other the TSX plunged by over 300.
It has become common among some strident analysts to declare the recession over and the prospect of a Dow at 12,000, and then at 14,000, easily within reach. Others, and we include ourselves in this camp, have been more skeptical. If we really had the worst recession since the Great Depression, the idea of equity markets so quickly sprinting back to the heights they reached during the subprime bubble seems perplexing. It is a little like someone suffering a massive heart attack and then expecting to win the Boston Marathon 18 months later. On the other hand, if the recession was overly hyped and not really as bad as most of us had feared, the unprecedented torrent of Fed cash and zero interest rates promises to unleash a terrible inflationary toll down the road. Neither scenario seems to be giving much confidence to investors or to the consuming public. And confidence is still the most needed ingredient in any credible plan for economic recovery.
The lesson from today’s surprise is that there is still no end of experts who are happy to be generous with other people’s money – and are determined that neither common sense nor the laws of physics will prevent them from resuming their party and the over-sized compensation that feeds it. They are the risk-oblivious, reality-blind Pied Pipers of their own self-consuming Gilded Age who led us to the brink of the abyss that was so frightening last October. Why would we think they suddenly know the way back to stability this October?
Even before the current crisis, the Fed was a powerful institution with few rivals for its Kremlin-like curtain of secrecy. Now, it seems fated to acquire even more sweeping powers, with only a few followers of Jeffersonian ideals in Congress seemingly interested or capable of questioning that move.
It is widely held that some public functions are so important that they must operate at arm’s-length from the influences of government and party politics. But, generally, the arm needs to be connected to a body that has its feet planted firmly on the ground. When it comes to the Federal Reserve Board, this anatomical connection is not entirely clear.
Exhibit A (as famed screenwriter Rod Serling used to say about scary things to come) is the apparent rejection by the Fed of a Treasury recommended review of the central bank’s structure and governance. These pages have been advocating that for well over a year, and long before it was proposed that the Fed take on even more sweeping powers.
Exhibit B is the news that the Fed will be given a lead role in overseeing pay packages at banks and in prohibiting compensation schemes that encourage inappropriate levels of risk. But the Fed wants the oversight to come in the form of the ultra opaque bank examination relationship it has with America’s financial institutions, which would effectively shield decisions from public scrutiny.
From its handling of the discount window and details about which banks and institutions are knocking on it to specifics about the Bear Stearns “collateral” it bought up, not to mention its role in the AIG bailout and the billions in payouts it approved to make good on credit default swaps with institutions like Goldman Sachs, the Fed is, and prefers to be, a creature of the shadows of cozy-club decision-making and not of the sunlight that affords transparent scrutiny. It operates in a world that hangs on its every word, yet that word is often issued by fiat, with little consideration shown to notions of public accountability. What banks and Wall Street want, however, is often a different matter. We know little about where the lives of Wall Street titans and Fed governors intersect. But if it is anything like what happens at the New York Fed, as we have noted before, where Wall Street titans are that institution’s governors, there is reason for Main Street to be worried.
As it has handled the crisis of the past year or so –the crisis it never saw coming– the Fed has taken interest rates to zero (for banks; not consumers, where credit card rates are proportionally higher than at any time in human history), smashed open the dams of liquidity, and created a Fed cash-for-clunkers program for broken-down financial assets that has no precedent in the annals of economic thought. In doing so, it has created an artificial market from which Wall Street is the most significant beneficiary, even though it was the principal source of the problems. Its moves to provide everything Wall Street wanted have permitted bonuses and huge pay days to be resumed, with barely an interruption. Outside Wall Street, job losses continue to mount and Main Street still awaits the arrival of the famous Fed-promised trickle-down economy.
Yet for all its power and soon-to-be-added authority, it is by no means clear that the Fed possesses any better vision to see another coming storm down the road, especially one of its own concoction from a combination of zero-interest, swirling liquidity, monetized debt and a floundering U.S. dollar. It is debatable whether it possesses the moral clarity, either. The fact that it was in the room and permitted the outrageous compensation decisions at AIG, and allowed billions to be passed on to other institutions in what could not be a more classic redistribution of wealth had it originated from Moscow in the 1950s, gives reason to doubt the Fed’s capacity to act in any role whatever when it comes to deciding compensation issues.
Even before the current crisis, the Fed was a powerful institution with few rivals for its Kremlin-like curtain of secrecy that cannot be questioned. With the Administration’s package of sweeping financial reforms, the Fed is taking on the trappings, along with the arrogance and the influence, of a fourth branch of government, with only a few followers of Jeffersonian ideals in Congress seemingly interested or capable of questioning that move. This is an institution, like the very bodies it regulates, where the culture needs to change dramatically; governance reforms are an important step in achieving that goal.
We think it would be a most unwise turn in public policy to seek to solve one problem, namely the risk-oblivious and compensation-obsessed Wall Street that produced the worst economic crisis since the 1930s, by creating a transparency- oblivious, secrecy-obsessed Fed with more power to shape the world as it sees it. Its sights, as we have observed before and from these recent examples, rarely extend beyond a few blocks in lower Manhattan.
There is much discussion about whether anything has changed in the culture of Wall Street in this period. Maybe it has, or maybe it hasn’t. But at least in Judge Jed Rakoff’s Manhattan courtroom today, something undeniably did.
Common sense received a well-deserved nod today in a landmark ruling from U.S. District Judge Jed S. Rakoff. The judge rejected the overly cozy settlement struck between the Securities and Exchange Commission and Bank of America. In making his ruling, he expressed skepticism that a public agency should allow shareholder money to be used to shield B of A’s management from more rigorous investigation over the Bank’s takeover of Merrill Lynch. The move was stunning in its departure from the way the courts normally handle SEC settlements.
As the judge astutely noted:
The S.E.C. gets to claim that it is exposing wrongdoing on the part of the Bank of America in a high-profile merger, and the Bank’s management gets to claim that they have been coerced into an onerous settlement by overzealous regulators…. It is quite something else for the very management that is accused of having lied to its shareholders to determine how much of those victims’ money should be used to make the case against the management go away.
As we said about this case here:
The settlement process between the SEC and securities issuers is part of the old way of doing business involving weak oversight and overly permissive regulation that helped to create the recent market debacle. Far from spurring accountability and transparency, which is generally regarded as a necessary part of financial reform, it allows companies to pay money out of shareholders’ pockets and evade any larger sense of responsibility for what they have done. In this charade, management knows it can try to get away with as much as possible and, if caught, has only to come up with a few million, which becomes another business expense. It is an easy way of creating the impression that the SEC is making progress toward reform and enforcement when it is nothing more than a mere slap on the wrist that perpetuates the culture of always skating close to the edge of the law. That is a culture that needs to change dramatically if the lessons from the market’s meltdown and credit collapse mean anything.
The decision is a poetic present as Wall Street and a still-reeling, bailout-fatigued economy celebrate the first-year anniversary of the collapse of Lehman Brothers and the dramatic weekend that saw the forced Bank of America – Merrill Lynch deal.
There is much discussion about whether anything has changed in the culture of Wall Street in this period. Maybe it has, or maybe it hasn’t. But at least in a federal building in Manhattan today, something undeniably did. Common sense was a rare witness in the courtroom. Judge Rakoff preferred her testimony.
An investing public who should more than ever be interested in the truth and in the morality of how business is run should feel grateful and a little more relieved today.
Bank of America’s settlement shows that it’s time to look at the way the SEC allows companies just to pay when they break the rules. It is part of the culture that created the financial crisis of recent months.
An interesting development is occurring in a federal courtroom in Manhattan. U.S. District Judge Jed Rakoff is departing from what most judges do when it comes to SEC settlements: he is actually asking questions about the deal struck between the SEC and Bank of America. The case involved the Bank’s failure to disclose material information to shareholders about the Merrill Lynch bonuses and expected losses. The Bank knew more than it previously admitted, according to the SEC. For its part, BofA does not admit any wrongdoing, but it will pay the SEC some $33 million to settle the regulator’s charges. Would that be $33 million in TARP funds, aka public money?
The fact is that Bank of America’s deceit here was a disgrace. It was very expensive to investors, to taxpayers and to public confidence in the marketplace at a time when it is already in short supply. The size of the settlement falls insultingly short of the magnitude of the offense. And how exactly did the SEC conclude that BofA’s investors, whom it contends were misled in the first place and suffered huge losses at the hands of its management, should now have the privilege of paying millions more on top because of management’s deception?
Perhaps these are some of the factors prompting the judge’s heightened scrutiny. As he told lawyers for both the SEC and BofA:
I would be less than candid if I didn’t express my continued misgivings about this settlement at this stage. When this settlement first came to me, it seemed to me to be lacking, for lack of a better word, in transparency. I did not know much about the facts from the complaint. I did not know much, or really anything, about the basis for the settlement.
The settlement process between the SEC and securities issuers is part of the old way of doing business involving weak oversight and overly permissive regulation that helped to create the recent market debacle. Far from spurring accountability and transparency, which is generally regarded as a necessary part of financial reform, it allows companies to pay money out of shareholders’ pockets and evade any larger sense of responsibility for what they have done. In this charade, management knows it can try to get away with as much as possible and, if caught, has only to come up with a few million, which becomes another business expense. It is an easy way of creating the impression that the SEC is making progress toward reform and enforcement when it is nothing more than a mere slap on the wrist that perpetuates the culture of always skating close to the edge of the law. That is a culture that needs to change dramatically if the lessons from the market’s meltdown and credit collapse mean anything.
If any greater reminder were needed, another recent SEC settlement involved one of the most storied names in American capitalism: General Electric. That company paid $50 million to settle an SEC civil suit over alleged improprieties in GE’s accounting. GE says it did nothing wrong but apparently just had an extra $50 million in shareholder funds kicking around and decided to throw it at the SEC to keep them happy.
One might ask the SEC where the so-called renewed commitment to principles of financial responsibility is in all of this? The approach to enforcement seen in these examples does a disservice to investors and to taxpayers, both of whom deserve more than what amounts to a pantomime of regulatory gestures and corporate nods. When you have some of America’s most capitalized and prominent institutions falling short and misleading even in the wake of the most costly financial breakdowns in generations, more than just the formalities need to be observed. Thankfully, there is a judge who appreciates that notion and is, at least for now, standing up for both taxpayers and shareholders when no once else bothered to do so.
Are we looking here at a return to the kind of circus-like justice found in the Roman Colosseum two thousand years ago, designed as much to entertain as it was to penalize?
Many things come to mind with the sentencing in Manhattan federal court of Bernard Madoff for the almost incalculable fraud he inflicted upon so many victims. Unfortunately, what stands out most about yesterday’s courtroom drama is that the extravagance of the crime appears to have been surpassed only by the exaggeration of the punishment.
What U.S. District Judge Denny Chin handed down in the biggest Ponzi fraud in American history is neither an effective deterrent nor a measured response to the offense. Here is a case where not only does the punishment overshadow the crime, making Lady Justice seem like something of a carnival figure, but it will also undermine the need to take white collar misconduct and the culture that permits it more seriously.
A century-and-a-half in prison for a man in his seventies will not deter future offenders. What it will do is minimize by comparison the crimes of people like Bernie Ebbers, Dennis Kozlowksi and others who are serving 25-year terms for their frauds. That is a mistake. What has been created is a scenario where every new boardroom villain and Wall Street fraudster, no matter how atrocious their crimes, will be able to claim “at least I wasn’t as bad as Madoff,” and look for understanding from the courts and the public on that basis. And by any comparative conviction, they will be correct.
Few voices have been as demanding of reform or more alarmed about the state of ethics on Wall Street as those raised on these pages. The crimes Madoff committed, and the magnitude of the betrayal he mounted, are undeniably deserving of a sentence that will see him spend much of the rest of his life behind bars. But what does adding at least 125 years of imprisonment to a life that will never see them do for the fact, or appearance, of justice? Will they keep his embalmed body in his prison cell for a century longer? Does it bring more solace to his victims? Are we looking here at a return to the kind of circus-like justice found in the Roman Colosseum two thousand years ago, designed as much to entertain as it was to penalize? Excessive conduct in human behavior, however repulsive, cannot excuse the vice of excess in the administration of justice.
What the sentence does is give the false impression that the criminal justice system and securities regulators, like the SEC, who dropped the ball on the Madoff file and only re-discovered it after he confessed to his fraud, have really done something big about the problems of crime and greeed on Wall Street. They have not.
If Madoff is to be the benchmark by which future white collar crimes are to be judged, we are in serious trouble. We cannot permit other egregious offenders who bring down entire companies, wipe out thousands of jobs and injure millions of investors, to be viewed as petty thieves on the new Madoff scale. It is hard to make the case that Madoff’s misdeeds, monstrous though they may have been, were greater than the combined crimes of Bernie Ebbers (WorldCom), Jeffery Skilling (Enron), Dennis Koslowski (Tyco), Sanjay Kumar (Computer Associates) and Conrad Black (Hollinger). But on a punishment basis, that’s exactly what this sentence says.
The larger risk, too, is that the need to change the culture of Wall Street and those who skate close to the edge, will be obscured by the record-shattering nature of the sentence. Why the SEC did not do more to detect Madoff’s three-decade-long scam, even when presented with numerous clues, has never been adequately explained. Nor has there been any serous 9/11 type commission to examine the causes and failures leading to the worst collapse of credit and financial confidence since the 1930s. At the rate things are moving, it may take a century-and-a-half before those issues are fully addressed. Mr. Madoff does not have 150 years to be punished, as society has indicated it prefers, but neither has society or its system of capitalism anything approaching that amount of time before they come to grips with how such things can occur and what needs to be done to raise the standards of ethics in the handling of other people’s money.
The court of public opinion needs to speak on that front with a force equal to what emanated from the Pearl Street courtroom yesterday.
Had there been no board at all at AIG, Bear Stearns, Merrill Lynch, Lehman Brothers, General Motors and so many others, it is hard to imagine how the outcome could have been any worse for those institutions and their investors. This is a stunning indictment of a vital and much relied upon function of modern business that creates real systemic risk. It should not have been overlooked as major focus for reform.
Take any defunct company or failed enterprise of major note in recent years -Enron, Hollinger, Nortel, Bear Stearns and Lehman Brothers jump to mind- and you will see the faint outline of the ghosts of its board desperately seeking to attain meaning in death which it failed to achieve in life. In many cases, the difference between the productivity of a sleeping board and one no longer breathing at all is barely perceptible in any event. These boardroom apparitions have likely tried to make contact with the administration of U.S. President Barack Obama as it prepared its sweeping agenda for reform of the financial system. They have apparently been without success in that endeavor as well.
Whenever there has been a collapse or serious threat to the survival of a company, a first slumbering-and then startled-board of directors has been discovered cowering close by. The inability of directors to properly direct and exercise the informed, independent judgment that is required of their positions was a defining feature of the 20th century’s two great financial upheavals. It is a distinguishing factor in the worst economic crisis of the 21st century, where board after board claimed to be unaware of the true depths to which their companies had fallen and most professed surprise at the extent to which management had run amok with risk and debt.
As we have observed many times in public forums and before legislative committees, no other institution in modern business has so persistently failed to perform its intended mission or brought discredit to otherwise illustrious names of accomplishment and virtue as the board of directors of the publicly traded company. At a time when their size and power have expanded to the point where companies have become too big to fail or require billions in taxpayer support to prevent their total collapse, it is unacceptable-indeed, it is an affront to any concept of sound risk management-that the board of directors is the weakest and most unreliable link in the corporate governance chain.
In the run-up to the subprime debacle that brought the world to the brink of financial collapse, boards at some of America’s oldest and most respected financial institutions were seemingly oblivious to the risks that their companies were incurring or the mortal threats that were gathering on the horizon. Many, like Bear Stearns and Lehman Brothers, seemed to have no effective oversight at all. Citigroup’s directors appeared to be in a constant state of suspended animation, acting always too slow and too late on the few occasions when they actually did anything. When AIG’s directors received warnings about the Financial Products division, whose out-of-control derivatives business eventually brought the company to the edge of ruin, they remained in denial. At Hollinger, big name directors seemed to have all the requisite skills, except the ability to read and ask discerning questions of a constantly scheming management. Even in non-financial companies, like General Motors, the board seemed indifferent to management’s repeated failure and disconnected from the changes that were reshaping the consumer market. (See these companies under categories section for more analysis).
And in virtually every case where the existence of a company has been imperiled, or it has disappeared altogether, the specter of wildly excessive CEO compensation loomed large. Rather than acting as watchful guardians of shareholders’ assets, directors too often seemed to be little more than obliging ushers, happy to facilitate the greatest transfer of wealth of its kind in history to the CEO class of management. It is the failure of boards to properly bring discipline to the compensation file that permitted a situation whereby CEOs were encouraged by oversized bonuses to take the unjustified risks that later led to a cascade of unprecedented failure and stock market calamity.
It is not a matter that accountability and director engagement have had an insufficient presence in the American boardroom. In many cases, they didn’t even make it into the company’s main floor elevator. Had there been no board at all at Enron, AIG, Bear Stearns, Merrill Lynch, Lehman Brothers, Hollinger, Nortel, Livent, General Motors and so many others, it is hard to imagine how the outcome could have been any worse for those institutions and their investors. This is a stunning indictment of a vital and much relied upon function of modern business.
So it is with astonishment that we find the issue of corporate governance and the need to make boards work as intended are nowhere to be found in the Obama administration’s comprehensive agenda for financial regulatory reform. Nor does it appear that the Securities and Exchange Commission is undertaking any significant overview of what has gone wrong at so many boards, as we recommended on these pages some months ago. Indeed, in the executive branch’s proposals for reform, the term “board of directors” as it applies to the publicly traded company appears only once-in passing-in all the report’s 88 pages.
The issue is hardly insignificant. As we said last April:
Here’s something else the SEC is missing: What exactly was the role of boards of directors in the credit and financial meltdowns of the past 18 months, and to what extent did a failure of structure or culture among directors contribute to a global crisis affecting hundreds of millions of individuals, costing trillions of dollars and eventually leading to the collapse of banks around the world?
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What boards did and did not do, and how they were organized, in recent years and months when calamity has been such a frequent guest are lessons that are too important to ignore. We suspect that what will be found is a weak and compliant boardroom culture where the most taxing job for most directors was lifting the rubber stamp marked “yes.” That, in our view, is the real definition of systemic risk.
Boards exist as stewards of other people’s money. The wise use of that trust is central to the principle of capitalism. Without it, capitalism would cease to exist. Either the board of directors occupies an important place in the functioning of the modern, publicly traded, corporation, or it does not. Either there is the need to ensure that management is held accountable and that directors answer for their stewardship to investors, or that charade should come to an end. Either the system of corporate governance that has evolved over the past 100 years and which views the board as the lynchpin of that regime should be accorded its rightful prominence, or an entirely new system needs to be created.
One thing is clear: Oversight of the operation of a company, including its management of risk, the supervision of its ethical standards, the quality of supplier, employee and customer relations and the accuracy of its financial reporting, cannot be left to outside regulators alone. Capitalism and its stakeholders cannot rely on government for every aspect of their survival. That is for other systems of economics and government, not for one that values freedom, individual choice and personal initiative. What capitalism must do is to first look within its own system to ensure that the tenets of fairness and integrity that are essential to its existence are being upheld. Companies need to self -regulate if they are to fulfill the promise of a system that is said to thrive in a climate of least involvement by government. It is the job of the board of directors to perform this self-regulating task, though, sadly, many boards betray discomfort when called upon to protect their own shareholders’ interests, much less serve as guardians of capitalism. Free market advocates and champions of limited government someday need to address this glaring gap in leadership.
Public policy periodically, and generally after some scandal or disaster, has tended to recognize the vital role that boards hold and has attempted to raise their standards of performance and accountability. This happened notably in the 1930s and again after the Enron-era accounting scandals. There is no reason to think that, in the aftermath of the most costly abuses and betrayals on the part of Wall Street and the financial sector since the 1930s, the importance of the board has suddenly been diminished or its need for reform has been averted.
If restoration of confidence in the system of capital markets is the goal of the Obama reforms-if there is a genuine desire to minimize the chances of disaster in the future-the role of the board of directors, and what needs to be done to make it more effective, cannot be overlooked. It was disappointing that the administration, which is otherwise rather astute in its comprehension of economic forces, chose to do so. We look at some ideas to bridge the gap between what boards are supposed to do, and what they have actually done, in Part 2.
