CEOs: The Favorite Child?

posted by Michelle Harner

Something about Tiger Woods’ press conference last Friday was very familiar. I felt as though I had heard those words before. “I knew my actions were wrong. . . . But I convinced myself that normal rules didn’t apply. I felt I was entitled.” (See here for this quote and an interesting comparison of the Woods and Toyota situations.) I then heard an interview yesterday with author and psychologist Ellen Weber Libby, who is promoting her new book, The Favorite Child (video description of book here). After listening to Libby’s interview, I realized that the hubris evident in Woods’ statement is similar to that we often hear in the comments, or see in the conduct, of corporate managers. Consider Ken Lay’s statement regarding the Enron scandal: “I take full responsibility for what happened at Enron. But saying that, I know in my mind that I did nothing criminal.”  (See also description of allegations in complaint against Bank of America here.)

Libby explains the “favorite child” scenario as one where a child makes her parents feel good and in exchange the child receives special privileges. Libby herself used Tiger Woods as an example in the interview and uses her brother-in-law, Scooter Libby, as an example in the book. Although treating a child as a favorite can promote positive characteristics, such as self-confidence, it also can impair a child’s ability to recognize the consequences of her actions, according to Libby. I cannot help but notice similarities between these natural family tendencies and those we observe in the corporate “family” context. (Notably, the overconfidence and failure to appreciate consequences sometimes apparent in the corporate context might be a combination of the two; a corporate manager raised as a favorite child in her natural family and then further enabled by her corporate family. Indeed, personality traits such as narcissism are identified by some commentators as indicative of an overconfidence bias in corporate managers.  See here and here for discussion of overconfidence in the current and past economic downturns.)

The analogy is not perfect, but I think it fosters valuable analysis. Corporate boards may overlook or be more lenient with respect to scrutinizing the conduct of corporate managers when times are good and the managers’ performance is making the board feel good about the company. The same arguably can be said about oversight from shareholders, regulators and the markets. But this leniency obviously is troublesome when exceptional corporate performance is based on inappropriate risk-taking or illegal conduct. So the challenge then becomes how to motivate appropriate oversight and encourage a healthy dose of skepticism into corporate governance. I touched on this issue in a prior post, and I come back to it here because I think it is an extremely challenging task. Creating a legal rule is not difficult, but designing a rule to change human behavior in an effective manner and without unwanted side effects is. And then you have to consider how best to implement that rule—e.g., legislation, best practices, etc. This difficulty may explain our long history of corporate scandals (for just a portion of this history, see here and here), but it should not discourage us from continuing to try.

  February 27, 2010 at 9:24 am  Tags: Corporate Law, Current Events  Posted in: Corporate Law, Current Events   Print This Post   3 Comments

Regulating Innovation

posted by Michelle Harner

I was honored last week to attend the Fourth Annual Law & Entrepreneurship Retreat, hosted by Gordon Smith at the BYU Law School. It was a wonderful collection of legal scholars who focus aspects of their teaching and scholarship on legal issues affecting entrepreneurs and innovation. Several of the papers and much of the general discussion considered innovation, particularly whether we can or should attempt to regulate innovation and related risks. The economic crisis provided the general context for this discussion; should we restrict or monitor innovation in the financial industry and, if so, how can we perform those tasks effectively?

I was struck by several things during the conference, including the universal and recurring nature of the innovation conundrum. I realized as we were debating solutions to abuses of credit derivatives that the proposed subject of regulation was novel, but the problem was not. We struggled with governing “the marriage of steam power and iron rail” in the late 1800s (see sample of related text here); it is a habitual problem in the biotech, energy, intellectual property and other fields (see here, here and here); and the problem is not confined to the United States (see here).

The recurring Hobson’s choice lies in the nature of innovation itself—to innovate is to create something new or different. As one commentator observes, “Genuine novelty knows no rules. We cannot reduce to routine what we do not know. Yet of course we cannot resist trying.” (See here at 1.) And innovation is often a very good thing (see here). So the challenge is to mitigate the negative side effects of innovation without stifling it altogether. (For a discussion of the regulation choices and challenges in the financial product context, see here, here and here.) Certainly easier said than done.

  February 21, 2010 at 11:11 am  Tags: Corporate Law, Current Events  Posted in: Uncategorized   Print This Post   6 Comments

Tale of Two CEOs

posted by Michelle Harner

As I mentioned in a previous post, Bank of America and some of its current and former executives, including its former CEO Ken Lewis, are facing tough times. The executives were named as defendants in a scathing complaint filed last week by New York Attorney General, Andrew Cuomo, relating to Bank of America’s 2008 acquisition of Merrill Lynch. And yesterday, Judge Rakoff suggested that he might not approve Bank of America’s latest $150 million deal with the SEC to settle allegations of fraud and misconduct in connection with the Merrill Lynch acquisition. Judge Rakoff expressed his views that the settlement was too small, lacked focus on the individual executives and did provide sufficient oversight of Bank of America’s proposed corporate governance changes.

In contrast to these trying times for Bank of America and its executives, one former Bank of America/Merrill Lynch executive is getting a second chance. John Thain, the former CEO of Merrill Lynch who orchestrated the Bank of America deal and then redecorated his office for a reported $1.2 million, was named as the new CEO of small business lender, CIT. Admittedly, CIT could use a talented turnaround artist at its helm; having just emerged from bankruptcy, CIT has a long way to go. And the markets seem to think Thain is the guy. Time will tell whether Thain can achieve for CIT what he did for NYSE and Merrill Lynch. In the interim, Thain’s new opportunity must add insult to injury on the heels of Bank of America’s and its executives’ latest legal challenges, which stem in part from bonuses that Thain approved for Merrill Lynch employees immediately before the Bank of America acquisition.

  February 9, 2010 at 7:50 am  Tags: Corporate Law, Current Events  Posted in: Uncategorized   Print This Post   No Comments

Corporate Versus Individual Accountability

posted by Michelle Harner

The recent announcements that the SEC reached a new $150 million settlement with Bank of America (see here) and that the New York Attorney General commenced civil litigation against certain current and former Bank of America executives (see here) are an interesting study in corporate versus individual accountability for corporate misconduct. The SEC did not pursue any actions against the individual executives at Bank of America (see here); rather, the SEC’s action and resulting settlement focus on the corporate entity. The Attorney General’s action, on the other hand, focuses on alleged individual misconduct.

The different approaches may be due in part to different legal standards of liability. In general, the SEC must establish intentional misconduct on the part of individuals in this context (see also here); the applicable New York law does not include this type of scienter requirement. (A cynic also might say that the difference relates to public opinion and Andrew Cuomo’s potential campaign for the governor’s office.) Nevertheless, the New York Attorney General’s approach appears to address more directly the concerns expressed by Judge Rakoff when he rejected the SEC’s original $33 million settlement with Bank of America (see also here).

The different approaches also raise an important question regarding whether corporate or individual liability is a more appropriate or effective remedy and deterrent for corporate misconduct. How far do we want to extend the legal fiction of the corporation? How in either situation do we avoid the corporation and its shareholders paying for individual misconduct that harms the corporation and its shareholders (e.g., indemnification)? How do we distinguish between good faith, honest mistakes and reckless, cavalier misconduct? And how do we level appropriate sanctions against individual wrongdoers without deterring other qualified individuals from serving on corporate boards?

These are difficult questions that courts, legislatures and commentators try to balance and address. I am not convinced that we have reached an appropriate equilibrium, and perhaps we never will. But I think we could benefit from acknowledging that corporate misconduct is caused by individuals and that some individual accountability is necessary to deter future misconduct. Notably, that remedy does not need to be a monetary penalty. In fact, public reprimands and temporary and permanent bars could be even more effective because those remedies impact reputation and arguably make it more difficult for the individual to commit similar wrongs in the future. (For a discussion of bars and the SEC’s and courts’ use of them, see here and here.) They also may ameliorate the concern that holding an individual liable for the amount of losses typically associated with corporate misconduct is too punitive. (For other means to address this concern, see here.) As we continue to reflect on and try to learn from the economic crisis of the past few years, I hope we consider alternatives to link more directly corporate misconduct and corporate accountability.

  February 5, 2010 at 8:09 am  Tags: Corporate Law, Current Events  Posted in: Uncategorized   Print This Post   6 Comments

Making Money in a Down Economy

posted by Michelle Harner

For the past few years, many businesses have struggled to meet payroll and keep the doors open. But such challenges are not bad news for everyone. At least one group of investors (a/k/a distressed debt investors) has found a way to capitalize on the financial troubles of businesses. In fact, recent reports (see here and here) suggest significant above-market returns for hedge funds that utilize a distressed debt investment strategy (e.g., Avenue Capital Group, Third Avenue Funds, Third Point Funds).

A distressed debt investor basically buys the debt of a troubled company and then flips the debt for a quick profit or seeks returns through a longer investment horizon. Investors that fall in the latter category may simply wait for the debt to be refinanced or cashed out, or they may seek to utilize the leverage associated with the debt instrument upon a default or potential default by the company. In fact, “activist” distressed debt investors may use their distressed debt holdings to influence management decisions (think of Carl Icahn’s letter to CIT bondholders) or gain control of the company through a debt-for-equity exchange or credit bid at an asset sale (think of Carl Icahn’s recent acquisition of Tropicana Entertainment and bid for Trump Entertainment).

The existence of an activist investor in a company’s debt holdings can swiftly change the dynamics of the company’s restructuring negotiations. These investors typically want to achieve their objective at the lowest cost (thereby maximizing their upside), which often conflicts with the objectives of other stakeholders. Conflict can lead to delay, expense, litigation and even liquidation. Many companies, such as Adelphia, Aleris, Foamex, Fairpoint, Lyondell and Tropicana Entertainment, have experienced this type of conflict firsthand.

That being said, hedge funds and private equity firms that typically invest in distressed debt may be a good (or the only) source of funding for troubled companies. And their investment objective (maximizing their upside) is understandable given their obligations to their own fund investors and, let’s be honest, the typical fund fee structure.  So the question then becomes who is or should be protecting the interests of other stakeholders to mitigate conflict and obtain a fair deal for the company? Is management, particularly in a distressed situation, up to the task? Even if it is, management typically does not learn about the presence of a distressed debt investor in the company’s capital structure until it is too late. Notably, this issue is beyond the scope of the proposed Hedge Fund Transparency Act of 2009 and the Financial Regulatory Reform: A New Foundation proposal submitted by the Group of 30. Moreover, proposed revisions to Bankruptcy Rule 2019 (requiring some disclosure of holdings) may help some companies and other stakeholders in the bankruptcy context, but again the information may come too late and only for bankrupt companies. And whether you focus on disclosure, representation or accountability in considering the creditor control issue, you certainly need to target more players than just hedge funds and private equity firms.

  January 27, 2010 at 2:08 pm  Tags: Bankruptcy, Corporate Law, Current Events  Posted in: Uncategorized   Print This Post   No Comments

The “It Will Never Happen to Me” Mentality

posted by Michelle Harner

We started our spring semester today at Maryland, and I am teaching one of my favorite courses, Legal Profession. Having faced ethical dilemmas in practice (and unfortunately seen very talented lawyers disciplined, disbarred and jailed), I believe that this course is extremely valuable. I suspect, however, that most of our students disagree with me, which is why they typically wait until the last semester of law school to take this required course. In fact, the very first time I taught Legal Profession, I asked my class of 75 3Ls to raise their hands if they would “elect” to take Legal Profession if it was not required for graduation. Only one student raised her hand; I promptly commented that she was perhaps the smartest woman in the room. Since that first year, more students have raised their hands, but I attribute at least part of that increase to a note in prior students’ outlines to “raise hand when Prof. Harner asks . . . .”

Why the resistance to learning, understanding and appreciating the ethical rules governing lawyers’ conduct? Some students have the ill-conceived notion that the study of ethics is boring. (I actually happen to think the topic, particularly the hard questions in the grey areas, is really interesting, controversial and timely; ever watch an episode of Boston Legal?) But for many students, at least based on my conversations, their lack of enthusiasm for the course stems from the simple belief that they are moral individuals who would never act unethically. It is the old “it will never happen to me” mentality.

Unfortunately, I think individuals, including lawyers and business executives, fall prey to this mentality far too frequently. (For an interesting discussion of similar psychological traps, see here and here.) For example, a lawyer may be a moral individual but the pressure of the practice—client demands, senior partner demands, billables, family obligations, etc.—and even good old human greed can blur the line between right and wrong. Likewise, not all executives who get caught up in corporate scandals or pursue excessive risk are bad people; rather, these individuals often get trapped by the same pressures as lawyers. And the consequences can be devastating for the individual and those around her.

I do not know how we correct this mentality or if we can change this aspect of human nature. For my part, I try sensitize my students to the issue and help them decide what kind of person and lawyer they want to be before they enter the profession. I think the use of peer reporting and whistleblower provisions may help curb some of these human tendencies (in the lawyer context, consider Model Rules of Professional Conduct 8.3 and 1.13), but we need to stay focused on the human side of the problem as we continue to draft and amend rules and regulations to govern lawyers, business executives and others. (This side of the corporate risk management problem was thoughtfully raised in a comment to one of my prior posts. See here.) It is a difficult issue, but one worth tackling.

  January 19, 2010 at 9:15 am  Tags: Corporate Law, Legal Ethics  Posted in: Corporate Law, Legal Ethics   Print This Post   2 Comments