Nocera on the uncorporation and the financial crisis

Larry Ribstein —  16 December 2010

The Glom’s having a book club on McLean & Nocera’s All the Devils Are Here. I haven’t read the book (it takes a lot to get me to read a book by business journalists).  But I have read David Zaring’s interview with his “favorite Times columnist.  One of the questions and answers naturally piqued my interest:

Q:  Business law scholars think a great deal about how the corporate form can facilitate good business decisions.  But financial institutions tend to use corporate governance best practices (no poisons pills, dual class stock structures, plenty of outside, if not always qualified, directors), and yet have extremely high levels of insider compensation, regularly exercise poor risk management, and so on.  You’ve looked at the way the banks were run during the crisis; how did you think their corporate organization affected their performance, if at all? 

A.  It is important to remember that most Wall Street firms were partnerships before they became corporations.  When they took investment risk, they did it with the partners’ money; when they reaped rewards, it was the partners who put those rewards in their pockets.  Once the partnerships became publicly traded corporations, they were suddenly freed from the fear that losses would come out of their own pockets–it was now shareholders’ money they were putting at risk.  Yet their view of compensation never changed: the vast majority of the gains they made went not to the shareholders, but to themselves.  Most Wall Street firms put aside more than 50 of revenues–not profits, but revenues–for compensation, an astounding figure.  That is why there was so little brake on the riskiness, and even the foolishness, of the risk-taking:  all the incentives went in the opposite direction.  Having a corporate structure, in no small measure, created those warped incentives.

Obviously I agree that corporations were a cause, and the uncorporation is a possible solution.  I noted this more than two years ago discussing a post by Charles Calomiris making points identical to those of Nocera.  Since then, the point has been made by so many others that it is now commonplace: 

  • Michael Lewis (“No investment bank owned by its employees would have levered itself 35 to 1 or bought and held $50 billion in mezzanine C.D.O.’s. I doubt any partnership would have sought to game the rating agencies or leap into bed with loan sharks or even allow mezzanine C.D.O.’s to be sold to its customers. The hoped-for short-term gain would not have justified the long-term hit.”)
  • James K. Glassman & William T. Nolan, Wall St. J., Feb. 25, 2009, at A15
  • Steve Davidoff  (the firm that best avoided the problems with subprime, Goldman, “retained the most partnership-like attributes” of all the investment banking firms, but that “all partnerships were not created equal”)
  • Caroline Salas & Pierre Paulden
  • Richard Posner, A Failure of Capitalism, 99-100 (2009) (hedge funds didn’t do as badly as large publicly held financial firms partly because they were “less plagued by conflicts between owners and managers” and that “the incentive to take risks that is created by executive overcompensation in publicly held companies has been a factor in the financial crisis”).
  • Alan Blinder (hedge funds have less leverage than investment and commercial banks because their senior partners “almost always have significant shares of their own personal wealth tied up in the funds”)

I noted in my 2008 post that

[t]his story directly supports what I have been saying about the advantages of what I call partnership, or “uncorporate,” governance structures that involve not only high-powered owner-like compensation, as Calomires stresses, but also distributions to owners and limited term of the fund, both of which tend to expose managers to capital market discipline.

* * * [T]hese devices can be superior to the sort of monitoring structures that publicly held corporations and other firms governed on the corporate model typically rely on. So we see that all of the so-called independent directors in the world and the other trappings that are considered so essential to the modern corporation did not stop a huge segment of the investment industry from deliberately ignoring reality, and causing vast dislocations as a result. Yet despite this, as I show in my article, there is still a bias against uncorporate structures in large firms.

I later wrote in my Rise of the Uncorporation (footnotes omitted):

[I]t is not clear that investment firms need to turn back the clock to the partnership era. Managers’ personal liability may deter beneficial risk-taking because there is a lot of uncertainty that even the most intense monitoring cannot eliminate. Modern uncorporate business forms may be a better approach because they combine limited liability with partnership-like mechanisms for addressing agency costs.

In my article, Uncorporation’s Domain, I noted that the uncorporate/hedge fund structure is appropriate for investment banking:

The modern uncorporation could offer a useful compromise for investment banks.  These firms might become more like hedge funds, which survived the meltdown relatively well. * * *

The biggest problem posed by uncorporate investment banking is that it could exacerbate concerns about market risk.  Owner demands for cash might force distressed firms to sell assets in illiquid markets at “fire sale” prices.  In the recent financial crisis, rapidly deteriorating asset values led to fears of investor runs on financial firms.  Toppling financial firms reduce overall market liquidity and thereby can threaten the whole economy.  Thus, rather than permitting the spread of the uncorporation into investment banking, regulators seem poised to apply increased regulation of the financial sector to uncorporations.  Indeed, the U.S. House of Representatives passed a major financial reform bill that would, among other things, impose registration and systemic risk regulation on hedge funds, while European regulators appear to be moving toward even tighter controls. 

It is important to keep in mind, however, that these market risks materialized in a financial industry dominated by corporations.  Uncorporate governance could weed out the weakest firms before disaster strikes, thereby reducing the risk of a market-wide crisis of confidence.  Uncorporations also can avoid some of the problems posed by bankruptcy of financial institutions. An uncorporation that cannot continue making distributions to its owners is in a different position from a firm that cannot continue paying its creditors in that it can deal with the potential shortfall by ex ante contract, possibly avoiding the need for a hasty ex post restructuring in bankruptcy.  This Article’s analysis suggests that regulators should consider the basic governance differences between uncorporations and corporations when deciding which financial institutions are appropriate for systemic risk regulation.

Of course we now know that didn’t happen — Dodd-Frank Section 403 responded to the financial crisis in part by shackling hedge funds with new registration and information requirements despite the now commonplace wisdom that hedge funds were a solution to rather than a cause of the financial crisis.

Final note:  I like the idea of academic bloggers interviewing journalists.  Great illustration of what I saw a few years ago as the potential relationship between blogging intellectuals and the mainstream press — and a way to get a better press corps.  But hey, Dave, how about some follow-up questions?

Larry Ribstein

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Professor of Law, University of Illinois College of Law

One response to Nocera on the uncorporation and the financial crisis

  1. 

    Yes, yes – follow ups would be good. Just trying out the form, so it was made simple and emailey. But the point is taken!