Lucy Kellaway is correct.

In today's Financial Times piece:

If one employee offends against a bank’s vision and values, it is [his or her] fault. If 5,300 do, it is the bank’s. Wells Fargo has proved that its culture is a hopeless safeguard to anything. The people who have really transgressed are not the rank and file, but the top managers who set up the wrong incentives and who looked the other way as customers were stitched up.

It really IS about the incentives.

The Dewey indictments and cognitive biases (updated).

This morning's NYT brings the story of the criminal indictments of some of the people at Dewey & LeBeouf (here).  If the emails referenced in the story are real, then the downfall of Dewey is even more Enronesque than I'd originally thought.  Here's an example:

In another exchange in June 2009, Mr. Sanders and Mr. Canellas joke about the law firm’s outside auditor, who was fired by his company for reasons unrelated to his auditing assignments. Mr. Sanders remarks to Mr. Canellas, “Can you find another clueless auditor for next year?” Mr. Canellas responded: “That’s the plan. Worked perfect this year.”

Today's WSJ brings more news of the emails (here):  

According to the complaint, Mr. Sanders emailed Dewey's then chief operating officer on Dec. 4, 2008, expressing concern about the firm's cash-flow problems. "I don't want to cook the books anymore," Mr. Sanders allegedly wrote in the message. "We need to stop doing that."

Why lawyers (and, for that matter, law professors) persist in emailing proof of unsavory words or deeds is a matter involving social science as much as it involves issues of character.  Why might partners at a law firm (1) decide to doctor the books or (2) ignore some clear signs of economic distress?  

I don't know the people who were indicted.  But I do know that there are a variety of cognitive biases that can cause very smart people to talk themselves into very dumb decisions.  The partners who may have been involved in a fraud and its cover up could have talked themselves into their actions because of a misguided belief that they were protecting the firm (cognitive dissonance).  The partners who could have put 2 + 2 together to ask some sharp questions of the law firm management ("why are we paying all of this money to get these laterals, and how can we afford this?") could have been waylaid by both social pressure and the diffusion of responsibility phenomenon.*  My point is that we need to watch cases like Dewey to study not the venality of people but the way in which cognitive biases affect their actions.


UPDATE (3/10/14):  Bernie Burk has a great post over at The Faculty Lounge about the indictments (here).
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* I discuss Enron and Dewey in a forthcoming article, Nancy B. Rapoport, “Nudging” Better Lawyer Behavior: Using Default Rules and Incentives to Change Behavior in Law Firms, 4 St. Mary’s J. L. Ethics & Malpractice ___ (forthcoming 2014).

Who can't love an op-ed piece about corporate greed that refers to Nozick?

See the Financial Times piece by John Kay here.

Enron in retrospective.

BBC Radio 5 Live's Wake Up To Money asked me a bit about Enron, 10 years later (interview starts around minute 27:30), or click here.

My Dad and my buddy Gus Schill pointed me to the Houston Chronicle's Enron retrospective:  see here, here, and Fuel Fix's compilation, here.  Some of my takes are here, here (Colin Marks and I wrote this one), here, and here.  And the books that Bala Dharan, Jeff (yep, my Jeff) Van Niel, and I did:  here and here.

Short version of my take on things, 10 years later?  Two things:  those who do not learn from history are doomed to repeat it, and humans don't seem to be able to learn from history, at least where their own cognition is concerned.

It's all about the incentives.

See this morning's New York Times story in the Dealbook section (here).  The easy part is realizing that incentives will almost always dictate behavior.  The hard part is figuring out how to put the right incentives in place.  That's why I liked Steven Davidoff's story so much.

Beware the unintended consequences of bad incentives.

What do these stories have in common?  From the Wall Street Journal (written by Liz Rappaport and Michael Rapoport--distant relations at best), "Ernst Accused of Lehman Whitewash" (here); from the New York Times and David Streitfeld, "Homes at Risk, and No Help From Lawyers" (here); and from John Stossel, "Uncle Sam Will Help You Buy an Alpaca" (here).

Each of these stories has the same subtext:  people behave according to the incentives that reward them.

If it is true that Ernst facilitated the bad accounting at Lehman (let's wait and see, but I wouldn't be particularly surprised), my guess is that the facilitation was due to the twin incentives of (1) rewards for pleasing clients (remember Enron?) and (2) no rewards for calling shenanigans on accounting tricks that--at the very least--violate the spirit of accounting rules, if not the technical wording of those rules.  (For the basic advice to avoid all actions that can be explained by, "Well, technically, it's ok," see the paper that Colin Marks and I wrote for the Fordham Law Review, "The Corporate Lawyer's Role in a Contemporary Democracy," which you can download here.)

Want to prohibit fraudsters from preying on distressed homeowners?  California tried, by enacting a law that prohibits lawyers from being paid for doing loan modifications until the modifications are approved.  Good for California for trying to squeeze out those businesses that took the modification money and ran, before getting their clients the modifications.  But give California a big "oops" for not exempting legitimate lawyers who just can't afford to float the entire fees for a process that might take years to complete (and which could be discharged in bankruptcy if, after the modification, the client still needs to restructure debt).

And those alpaca subsidies?  Tax credits can be great ways to shape behavior but, well, they shape behavior.  All regulation shapes behavior--again, by providing incentives or disincentives.  Much of regulation is important:  criminal penalties, pollution standards, food and drug standards, etc.  But lawmakers need to understand that regulation can create unintended behavior as well and to think hard about what might go wrong with a poorly written or ill-conceived regulation.  For example, rage at the bizarrely high pay for poor-performing executives and the revolving door for inattentive board members has created a backlash of irritation at all high salaries.  (Well, maybe not the high salaries of athletes, but the high salaries of non-athlete businesspeople.)  Redistribution of wealth from all high-earners to more low-earners wouldn't be the correct response to that rage.  (I still remember enjoying Robert Nozick's Anarchy, State and Utopia, which is actually available--yay!--here.)  Again, cutting too wide a swath will create more off-target incentives.

People are hard-wired to behave in certain ways.  If we're going to create incentives for behavior--and we will always create some incentives--we need to try to think those incentives all the way through.

Focus, shareholders. FOCUS.

Yesterday's New York Times story on directors who presided over corporate failures being snapped up as directors by other companies (see here) did exactly what the authors (Susanne Craig and Peter Lattman) intended.  It frustrated the heck out of me. 

Yes, we should kick out C-level officers who plunder companies.  That's a no-brainer.  But we should also hold directors accountable when they should have known that something was going dreadfully wrong on their watch.   (Remember Andy Fastow's personal profit on deals with--well, against--Enron?  That was board-approved.)

Shareholders need to pay attention to who's running their company and who's monitoring those who are running their company.  And if the directors aren't doing what they should to watch over the CEOs, CFOs, and the like, shareholders should replace them.

See? Clients want to push for fees calculated other than by the billable hour.

See here.  (Hat tip to my buddy Walter Effross.)  Law firms are thinking about how to stay profitable while figuring out new ways to value their services (good), but they may not have realized how much the legal landscape has changed (bad).

We're talking about a paradigm shift.  Lawyers are supposed to make a decent living, but if they're hoping for perpetual multimillion-dollar draws, they have (as Mom used to say) "another think coming."

Elizabeth Warren on Wall Street's Race to the Bottom

Read Prof. Warren's wonderful op-ed in today's Wall Street Journal here.  BRAVA!

Great questions to ask the bankers

See Andrew Ross Sorkin's New York Times column, What the Financial Crisis Commission Should Ask, here.

And now, some common sense from one of my heroes

This op-ed today (here) from Clark Kent Ervin.

Here's what we're not realizing: there probably were some procedures in place for homeland security folks to use to keep Umar Farouk Abdulmutallab from getting on that plane to Detroit. I don't know if the procedures were the best ones we could have developed, but I'm going to guess that if (1) someone's own parents call and say, "watch out for our son," and (2) that son is already on a watch list, and (3) he checks in for a flight with no luggage and pays cash for his ticket, there were probably some procedures that could've kept Abdulmutallab off that plane. So what happened?

Procedures don't matter one whit if the incentives for following them (or the incentives for violating them) don't work. Whether it's travel security or corporate governance, all of the regulations in the world are worth less than the paper they're printed on if the people who have to execute them, day-to-day, have no accountability for performing them correctly.

That's why--and no, this is not a non-sequitur--I'm so pleased that Morgan Stanley's going to include clawbacks in the salary provisions for its top executives (see here). Clawbacks = accountability, at least if they're carefully applied.

So all of those idiotic new rules for airline travel, which aren't even designed cleverly enough to catch Abdulmutallab's plot,* mean exactly zero, compared to the incentives for the people creating no-fly lists, the people issuing or revoking visas, and the people working at TSA. Figure out the right incentives, while paying attention to the way that people make basic cognitive mistakes, and you might get some results. It's the people, not the regulations, that matter most.

*Let's see . . . . Nothing on our laps for the last hour of a flight, because terrorists never ignite bombs earlier? Check. No accessing carry-ons for the last hour, because terrorists never plan ahead? Check. No asking the type of security questions that, say, the Israelis ask before someone's cleared to fly? Check. Paying zero attention to behavior and plenty of attention to silly rules? Check. Yep. We're safe now.

Don't miss Jon Macey's marvelous op-ed in today's WSJ today

See here. He's right, as usual.

I don't think garden-variety caps on executive compensation are the way to go--but I don't care if there's a rush to the exits, either.

Joe Nocera's column in this morning's New York Times (here) once again gets it right: it's not about the caps, it's about the boards of directors deciding about compensation packages in the first place. If shareholders are unhappy with who's getting paid what, the fix is with getting rid of the folks believing the hype about who has to get paid the gargantuan bucks.

Look, I'm a firm believer in capitalism. I don't believe that the free market system works perfectly--obviously, we don't have anything near perfect information--but I have no problem with people making money, even scads of money. But boards of directors who let people get scads of money for failing abysmally, year after year, just aren't doing their jobs. Rewards aren't aligned with risks, and that's why so many boneheaded risks are being taken. It's all upside and no downside, because the risks are being paid for with other people's money.

Want the C-level officers to take more reasonable risks? Then create incentives for them to have more skin in the game? (Of course, that's what stock options were supposed to be about, but those options didn't quite work out the way we hoped.)

Boards are being told by compensation gurus that the best people won't work for less than huge salaries, all of which have to be earned up-front, or close to it, or these best folks will bolt for better jobs. Fine. Let them bolt. Heck, hold those doors open for them so that they won't bruise themselves during their dash for better, more lucrative work.

In a wonderful case, reported by WSJ Blog's Peg Brickley here, Bankruptcy Judge Jeff Bohm said "no mas" to ludicrous requests for compensation:

Oblivious to recent congressional and public criticism over executives of publicly-held corporations who are paid monumental salaries and bonuses despite running their companies into the ground, two investment banking firms now come into this Court requesting that they be employed under similarly outrageous terms. They do so because two committees in this Chapter 11 case have filed applications to employ these investment banking firms to perform valuation services even though two other independent firms have already performed similar valuations. These investment bankers, who wish to have their fees and expenses paid out of the debtor's estate, have sworn under oath that they will render services only if they immediately receive a nonrefundable fee aggregating $1.0 million. This Court declines the opportunity to endorse such arrogance. The purse is too perverse.

In observing that the two investment banking firms' proposed compensation was significantly higher than the compensation that an already-retained firm was charging in the same case, the bankruptcy judge also pointed out that

one other investment banking firm--i.e. Parkman Whaling--has already been retained to provide similar valuation services in the case at bar without demanding such a high premium; Parkman Whaling has received $75,000.00 per month, which is substantially lower than the fees demanded by Houlihan Lokey and Tudor Pickering. It is entirely legitimate to ask why Houlihan Lokey and Tudor Pickering are unwilling to work under the same or similar terms as Parkman Whaling. Neither Houlihan Lokey nor Tudor Pickering adduced sufficient testimony at the July 15, 2009 hearing to convince this Court that they should be treated so differently--indeed, so much more favorably--than Parkman Whaling. Stated differently, Parkman Whaling is as capable and competent an organization as Houlihan Lokey and Tudor Pickering, and to approve the far more exorbitant terms demanded by Houlihan Lokey and Tudor Pickering would suggest that these two firms somehow provide services that are superior in quality than those provided by Parkman Whaling. There is nothing in the record to suggest that this is true.

The court then highlighted its shock at the tone-deafness of some of the specific compensation requests:

Nevertheless, the Court feels compelled to discuss the initial provision in the proposed terms requiring a daily witness fee of $25,000.00 because the very fact that Tudor Pickering made such an audacious request underscores how oblivious the investment banking community--or, at least this one investment banking firm--is to the extremely hard economic times in which the country in general, and this Debtor in particular, find themselves. This Court believes that a discussion of the $25,000.00 daily witness fee request is appropriate to telegraph to the business bankruptcy bar and the investment banking community how unseemly this request really is.

One of the best parts of the case is the footnote immediately following this part of the court's opinion:

For example, the men and women of our nation's armed forces, who risk their lives to preserve and protect the abundant freedoms of this country, earn an annual salary that barely exceeds Tudor Pickering's proposed $25,000.00-per-day appearance fee. See United States Army Public Website, Benefits--Total Compensation, http://www.goarmy.com/benefits/total_compensation.jsp (listing the average annual salary for a military police sergeant as $26,967.00). Moreover, there are numerous other occupations whose members are in daily physical danger and who provide absolutely necessary services for our society but yet are paid an annual salary approximating the requested daily fee of the Tudor Pickering witness. For example, a nursing-aide at a public hospital, can expect to earn less annually than what Tudor Pickering is requesting for each day it appears for a hearing. See United States Department of Labor, Bureau of Labor Statistics Website, Occupational Employment and Wages, May 2008, Nursing Aides, Orderlies, and Attendants, http://www.bls. gov/oes/current/oes311012.htm (listing the average annual salary for a nursing-aid as $24,620.00). Finally, public school teachers who are educating future generations can expect to earn barely more in one year than Tudor Pickering seeks to be paid for each day that it appears for a hearing. The per annum salaries of the military personnel, nursing-aides, and public school teachers, compared with the requested daily fee of $25,000.00, speaks volumes about the level of hubris among some members of the investment banking community.

(Citation omitted.) In concluding its opinion, the court refused to fall for the adage that the requested compensation had to be paid or the case would lose the opportunity to get the best and brightest minds:

The exorbitant fees requested by Houlihan Lokey and Tudor Pickering are similar to the "appearance fees" which certain of the world's top athletes--for example, Tiger Woods--are able to command. However, unlike Tiger Woods, whose presence does guarantee a financial benefit at any event where he appears, neither of these two investment banking firms introduced any testimony or exhibits guaranteeing some benefit to the estate in this case. They expect to be paid an appearance fee for simply showing up--not only do they not guarantee success; they do not even guarantee they will work a minimum number of hours in order to try to achieve success. This Court will therefore not approve the payment of their requested "appearance fees." Tudor Pickering is not Tiger Woods. Nor is Houlihan Lokey.

In In re Mirant Corp., 354 B.R. 113 (Bankr. N.D. Tex. 2006), the Honorable D. Michael Lynn made some very telling comments about the integrity of the process with respect to financial advisors demanding guaranteed compensation under [sec] 328:

The court erred seriously in entering orders which left it so little discretion in assessing the work of the financial advisors. Though the court was given to understand Debtors and the Committees could not obtain competent financial advisors without assurance that there would be substantial "success" bonuses, whether or not each advisor could show it had earned such a fee, the court has since learned that some financial advisors, at least, will accept more conventional arrangements in terms of compensation. In the future, the court hopes and expects that parties in large chapter 11 cases in this and other districts will seek out financial advisors that are willing to have their work judged on a basis similar to the rules applied to other professionals.

In re Mirant, 354 B.R. at 128 (emphasis added). In effect, Judge Lynn has recommended that parties in large Chapter 11 cases should call the bluff of investment bankers who make Shermanesque statements that they will only provide services pursuant to a huge, guaranteed fee approved under [sec.] 328. Judge Lynn is urging parties to respond to these investment bankers by telling them that if they will not work under the more conventional arrangements pursuant to [sec.] 330, or at least pursuant to reasonable fee arrangements under [sec.] 328, then the parties will find one or more of their competitors who will. Implicit in Judge Lynn's remarks is that if the parties themselves give in to these investment bankers, then the bankruptcy courts themselves must call the bluff of these financial advisors and challenge them to accept reasonable fee arrangements.This Court shares Judge Lynn's concerns about the integrity of the process and also accepts his remarks and advice. Given the state of the record in this case, this Court will not approve the proposed enormous fees for Houlihan Lokey or Tudor Pickering, but rather chooses to call their bluff. Every other key professional in this case--including the investment banking firm of Parkman Whaling--has agreed to reasonable fee arrangements that are governed by, among other orders, the Procedure for Professionals Order, the Cash Collateral Order, and the Budget. Given the state of the record, there is no good reason why Houlihan Lokey and Tudor Pickering should be exempt from these same reasonable compensation arrangements. This Court does not want to make the error (about which Judge Lynn cautions in Mirant) of approving the Applications and later learning that some other financial advisors would have accepted much more reasonable compensation arrangements, which include agreeing to oversight by this Court. Indeed, given that Parkman Whaling, an investment banking firm every bit as competent and qualified as Houlihan Lokey and Tudor Pickering, was willing to work for a reasonable fee, this Court's approval of the compensation schemes proposed by Houlihan Lokey and Tudor Pickering would not only be an error; it would be a gross error.

(Footnotes and citations omitted). Judge Bohm added that "Judge Lynn's willingness to concede his mistake [in Mirant] in order to educate others and improve the bankruptcy system underscores his own high integrity and brilliance."

My point? A judge in Houston, Texas understands the difference between good compensation for good work and unreasonable compensation for very little work. And he's not the only judge with, well, judgment. I'd expect boards of directors to be able to distinguish gold from dross as well. If they can't, then let's vote them out and vote in others who can distinguish the two, and who have the courage to do so.

See? It is possible to rethink executive compensation without having the government do it.

Take a look at this article in today's New York Times (here).