utrecht talk on corporate governance

Failed Governance and Perverse Compensation

Caused the Current Crises

William K. Black

Associate Professor of Economics and Law

University of Missouri – Kansas City

Governance of the Modern Firm

Universiteit Utrecht

December 12, 2008

An unusual U.S. perspective

Staff leader of successful reregulation of S&L industry in face of political opposition

Heterodox law & econ. scholar

White-collar criminologist: elite fraud & corruption

Expert for the regulator in its case against Fannie Mae’s former senior leaders

U.S. Governance: abject failure

Most elite & sophisticated firms

In a law & econ. paradise

Plus: governance reforms (SOX),

advanced governance research, &

an info./modeling revolution

In “the great moderation”

Produced a catastrophe

But it’s worse than that

An “epidemic” of mortgage fraud

Virtually no corp. heroes

Virtually no corp. leadership – except to corp. socialist trough and for accounting fraud

Virtually no elite accountability – no “poster child” in prison

Triumphalism vs. Gresham’s

Fraud epidemic facts

FBI warned of it in 2004

Corp’s aided it: continued to gut underwriting, controls & spread

MBA’s priority: stop reg., not fraud

FBI took advice from the perps

Nonprime fraud incidence: >40%

80% of frauds induced by lender

Invest. banks: 34 referrals (03-07)

Every day: new scandals

Madoff’s “giant Ponzi scheme”

Results: “Too good to be true”

Madoff morals: give $300 M in bonuses at end to ensure clients suffer total loss

Steven Gordon pleads guilty to crude mortgage fraud. AUSA: "You would think there would be more due diligence."

Governance implicationsNo one did any underwriting – at

>7 levels at multiple firms

Controls suborned deliberately to hide the massive fraud

Has to be done systematically, can’t be hidden from BOD

Requires firing, intimidating or suborning your personnel

Expertise = never using expertise

Looting the firm w/o going to jail

Bad loans, huge leverage & rapid growth optimize accounting fraud & maximize comp.

CEO can’t send a memo. urging that strategy

But he can send that message: through comp.

Gresham’s dynamic sends it to rival firms, extending bubbles

Ask the experts how it’s done

Don't just say: "If you hit this revenue number, your bonus is going to be this." It sets up an incentive that's overwhelming. You wave enough money in front of people, and good people will do bad things.

Franklin Raines: CEO, Fannie Mae 

Do as I say, not as I do

“By now every one of you must have 6.46 [EPS] branded in your brains. You must be able to say it in your sleep, you must be able to recite it forwards and backwards, you must have a raging fire in your belly that burns away all doubts, you must live, breath and dream 6.46, you must be obsessed on 6.46…. After all, thanks to Frank, we all have a lot of money riding on it…. We must do this with a fiery determination, not on some days, not on most days but day in and day out, give it your best, not 50%, not 75%, not 100%, but 150%.”

The anti-canary

“Remember, Frank has given us an opportunity to earn not just our salaries, benefits, raises, ESPP, but substantially over and above if we make 6.46. So it is our moral obligation to give well above our 100% and if we do this, we would have made tangible contributions to Frank’s goals.” (Mr. Rajappa, head of Fannie’s internal audit.)

Rival concepts of the problem

Law & economics: government and overly cautious CEOs

Governance scholars: weak governance and excessive risk

Contradictory. U.S. policy an incoherent blend of both

Neither addressed the acute problem explained above

Law & econ. praxis caused the crisis, governance didn’t

stop it Governance scholars’ good ideas

missed the acute problem

Law & econ. praxis optimized the “criminogenic environment”

Neither identified the real problem

Risk isn’t the issue or the problem

Fraudulent CEOs (1) make sure BODs don’t govern & (2) hate good government ideas

Law & economics: praxis

1. Deregulation & desupervision

2. Performance pay to align CEO/shareholder interests

3. Private market discipline & reputation trump incentives

4. Reduce fiduciary duties; criminal/civil liability

“Control fraud” is the problem

1. The person that controls the firm uses it as a “weapon”

2. Apparent legitimacy & power

3. Accounting is a financial firm’s “weapon of choice”

4. Causes more financial losses than all other forms of property crime combined

Only the CEO can:

1. Suborn “controls” into allies

2. Convert firm assets to own use via normal corp. means

3. Optimize the firm for fraud

4. Change the external environment to aid fraud

Optimizing Accounting Fraud

1. Assets w/o clear mkt. values

2. Risk is not the key

3. Loan to the worst borrowers

4. Bad underwriting is good

5. Cover up defaults & book new income via refinancing

6. Grow rapidly & lever – Ponzi

7. Trivial loss reserves

Control fraud epidemics

1. Occur when there is a strongly “criminogenic environment”

2. Extend & hyper-inflate bubbles

3. Create Gresham’s dynamic due to modern compensation

4. Overwhelm law enforcement

5. Suborn & degrade controls

6. Deceit erodes trust: can cause systemic risk: mkts. fail

Recent epidemics1. S&Ls: fraud “invariably” at the

“typical large failure”

2. Treadway found control fraud in 80% of SEC cases

3. Russian privatization

4. E. Europe “tunneling”

5. Enron, WorldCom, et al.

6. Washington consensus: L. Am.

7. Non-prime mortgage fraud

Why is it getting worse?

1. Hindsight is rarely “20:20”

2. Conservative resistance is understandable

3. Control fraud epidemics are a fundamental, existential threat to everything they hold dear

4. Denial and reinterpretation: the government as villain

The challenge to conservatives

1. Epidemics falsify the core theories of modern finance

2. Epidemics make econometric studies perverse

3. Conservative praxis optimizes criminogenic environments

4. Regulation becomes essential to block Gresham’s dynamic

5. Their patrons & heroes: frauds

The challenge to theory

1. Finance rests on efficient mkts. & efficient contracts

2. Easterbrook & Fischel: don’t even need rules vs. fraud

3. Core of corporate law theory

4. Fraud epidemics are impossible: falsify theories

5. If it’s bad criminology, it’s bad economics

Perverse econometric studies

1. The worst practices optimize accounting fraud

2. Econometrics uses earnings or share price = “performance”

3. Accounting fraud produces record earnings & share prices

4. Econometrics, during an epidemic, must laud the worst practices that produce disaster

Farblondget

1. Greenspan & Fischel re Keating’s Lincoln Savings

2. Benston lauds financial cyanide: 0 for 32

3. Enron & Fastow’s awards

4. Praise for CEO super comp.

5. Greenspan & neo-classical economic praise for exploding rate ARMs

Praxis1. Deregulation decriminalizes control

fraud and creates opaque, or worse, falsely transparent markets

2. Comp. suborns controls, intensifies CEOs’ conflicts and optimizes the conversion of corporate funds

3. Private players don’t discipline control fraud – they aid it

4. Weaker sanctions & fiduciary duties encourage control fraud

Denial (and worse)1. Fischel’s text on his theories ignores

their failures when he used them

2. Asserts critics of one control fraud (Milken) were anti-Semites and communists & lauds “Keating Five” pressuring regulators on behalf of the worst S&L fraud as a “model”

3. Mankiw (1993): “it would be irrational for operators of the savings and loans not to loot.”

Can’t govern a control fraud

Because the ideas are useful control frauds won’t use them

Formal compliance is an illusion

Their “tone at the top” – enriching those creating the most fake income – aids fraud

Remove corrupt CEOs from office

Use prisons to govern them