Eyes On Wall Street : Executive Compensation Lawyers & Attorneys : Labaton Sucharow Law Firm : Class Action Litigation, Shareholder Rights

The G-20 has finally weighed in on the issue of executive compensation. Why should investors care what global financial policy leaders think about performance-related bonuses? Because reforms aimed at ending the financial incentive for executives to bet the house on risky securities will only work if they are adopted uniformly.

There is little mystery about the role that fat-cat compensation packages played in last year’s financial crisis. Top management of investment banks enjoyed bonus packages that rewarded short term bets that could be disastrous for investors, while eliminating any downside risk to executives themselves. It should surprise no one that the result was a vast appetite for dangerous investments that would prove to have tragic long term consequences for investors and taxpayers.

In the Leaders' Statement from the September 24 – 25, 2009 Summit in Pittsburgh, G-20 leaders urged that reforming compensation packages is essential to any effort to increase financial stability. The leaders stated that reforms should ensure that compensation is aligned with long-term value creation for investors, rather than excessive risk-taking. They suggested that this could be accomplished by requiring that a large proportion of performance-related compensation be deferred and be tied to long-term performance. Moreover, they argued that such provisions should have teeth, in the form of claw-back provisions permitting companies to reclaim compensation from executives whose decisions land investors in hot water.

Of course, general statements of policy will be useless unless member countries enact rules enforcing restrictions on pay. A September 5, 2009 address to world leaders by Treasury Secretary Tim Geithner outlines the steps that are being taken in the U.S. to change executive pay structures. Geithner noted that the House has already passed proposals designed to tie compensation to long term performance, and stated that the Federal Reserve would be charged with enforcing the proposed new standards.

It remains to be seen whether any legislative effort to reform compensation can survive powerful lobbying efforts by management interests, but international cooperation on the issue is an encouraging sign.

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Eyes welcomes Professor Frank Partnoy of the University of California San Diego, author of The Match King (PublicAffairs April 2009). The Match King is a tautly paced and erudite account of the life and times of Ivar Kreuger, one of the twentieth century's greatest financial innovators—and one of its most notorious scam artists. Partnoy talks to Eyes about lessons investors could learn from Kreuger, and the similarities and profound differences between Kreuger and Bernie Madoff.

Eyes:  Why do investors need to know about Kreuger, a man who died nearly eighty years ago?

Partnoy:  One of the lessons all of us take away from this financial crisis is that we need to remember history.   So many of the financial innovations that recently brought down the banks and AIG are echoed in Kreuger’s story. He was a creator of complex off-balance sheet transactions, he used special purpose entities, he incorporated subsidiaries in regulatory havens. And he manipulated financial statements so that investors wouldn’t understand the truth about what was happening in the bowels of his companies. I think the tragedy is that we should have known about and understood Ivar Kreuger’s story several years ago. 

Eyes:  In your book you give an account of Kreuger’s key role as an innovator of financial products, and you have a great quote from Keynes, who called Kreuger “the greatest constructive business intelligence” of his age. With that in mind, is it fair to compare Kreuger to Bernie Madoff?

Partnoy:  In many ways I think it’s unfair to Kreuger. He, for much longer than Madoff, sustained legitimate businesses. The core of his operations was a compelling idea – the lending of money raised in America to struggling post-World War I European governments in exchange for a match monopoly. He put together these three actors – American investors, European governments, and match producers – in a way that generated gains for all three groups. And he sustained those businesses for many, many years.

Eyes:  Despite their reputations as criminal geniuses, one of the things that is striking about both Kreuger and Madoff is that the frauds they perpetrated were in some ways very crude. How did they go undetected for so long?

Partnoy:  One of the most perplexing aspects of confidence games is that it’s so hard for the people involved in them to see what is happening. Both schemes basically involved paying out very steady, low double-digit payments to people over time, even when markets were volatile. And once people know that there’s a track record of steady, 10 percent payments, they run screaming to get in. One of the lessons of Ivar Kreuger and of Bernie Madoff is that investors should run when they see steady reported returns from a fund. That's a sign not of a well-run business but of danger lurking in the shadows. 

One of the lessons of Ivar Kreuger and of Bernie Madoff is that investors should run when they see steady reported returns from a fund. That’s a sign not of a well-run business but of danger lurking in the shadows.

Eyes:  Looking back both at the 1920s and at the decade preceding our current crisis, how large a role do you think market booms played in the success of Kreuger and Madoff’s schemes? 

Partnoy:  The booms are important because they run parallel with investor psychology. As stocks rise, as companies develop new business models, as financial innovations spread, markets become ripe for financial fraud. Years of stock gains are like the fertilizer that enables fraudulent schemes to flourish and grow. Such gains prime the pump for fraud because they make it easier for companies to come along and tell a believable story about how they can deliver outsized returns. 

Eyes:  If there’s one silver lining to be found when massive frauds are finally exposed, it’s that briefly there is an appetite for reform. And one of the interesting points that you make in your book is that the Securities Act of 1933 and the Securities Exchange Act of 1934 were directly inspired by Kreuger’s fraud . How likely is it, do you think, that Bernie Madoff will inspire similar kinds of reform?

Partnoy:  I’m not especially optimistic. We didn’t get reform immediately after the 1929 crash. We only got reform after the public became very upset about the frauds of Ivar Kreuger and Samuel Insull, and after the federal investigative commission under Ferdinand Pecora started to publicly flog bankers and bring them to their knees. Whether or not we ultimately get reform will turn on whether we experience more scandal and on whether there is someone like Pecora who can galvanize public opinion. It might be the case that Thomas Greene is able to do that with the current version of the financial crisis inquiry commission, but we’ll have to wait and see.

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In the autopsy of last year’s financial meltdown, one of the principal culprits to have emerged is the extraordinarily lax oversight that the boards of some public corporations have exercised over management. On September 17, 2009, Mary Schapiro, the new Chairman of the Securities Exchange Commission, gave a speech, "Address to Transatlantic Corporate Governance Dialogue--2009 Conference," announcing the SEC’s plan to ensure that this practice would come to an end.

Schapiro lambasted boards of directors for failing to reign in management decisions about risk, and suggested that many boards appear to have misunderstand the gravity of risks taken. The new Chairman stated that “[s]enior management took higher returns at face value without questioning why such higher returns were possible for supposedly safe investments and strategies.”

The new Chairman suggests that regulators should ensure that investors in publicly held companies have the opportunity to remove directors who turn a blind eye to irresponsible management. She outlined a proposal by the SEC to remove obstacles to shareholders' ability to nominate candidates for the boards of directors of the companies that they own.

Under the proposed rules, shareholders who otherwise are provided the opportunity to nominate directors at a shareholder meeting would be — subject to certain eligibility and procedural requirements — able to have their nominees included in the company proxy that is sent to all voters.

You can expect a fight. This comment letter (PDF)  in support of the proposal was filed by Labaton Sucharow and other firms representing institutional investors.

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Of all the major players in the mortgage-backed asset debacle of the last two years, credit rating agencies have proven to be the great white whale for injured investors: an attractive target, but difficult to catch. This may be about to change.

The ire directed at the agencies is easy to understand. Only months before the spectacular collapses of Lehman Brothers and AIG, credit rating agencies gave these companies investment grades of A or higher. In email comments uncovered in a recent SEC investigation, one rating analyst suggested that, at her firm, a deal “could be structured by cows and we would rate it.”

Historically, the First Amendment was one of the greatest impediments to suits against the ratings agencies. Ratings agencies argued that a rating is an “opinion” that is entirely protected, or is an assertion about a matter of public interest that is protected by the “actual malice” standard set forth in New York Times Co. v. Sullivan, 376 U.S. 254, 279-83 (1964).

There was a time when such arguments might have made sense. Originally, rating agencies were paid by subscribers to rate most or all of a particular kind of securities for the benefit of the public. However, by the 1970s, they had transitioned to a model where the agencies were paid by the companies whose products they rated, creating insoluble conflicts of interest.

Courts are increasingly unwilling to interpret the First Amendment as giving carte blanche to the agencies.  The U.S. District Court for the Southern District of Ohio recently refused to extend the First Amendment defense to a rating agency because its ratings were not published for the benefit of the investing public at large, but rather were distributed only to a select class of institutional investors.  In re National Century Financial Enterprises Inc., Inv. Litigation, 580 F. Supp.2d 630, 640 (S.D. Ohio 2008).

Such decisions should give investors some cause for hope that credit ratings agencies may yet be held responsible for their role in the market crisis.

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