In F.D.I.C.’s Proposal, Incentive for Excessive Risk Remains – NYTimes

Posted on April 13, 2011 by

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The Federal Deposit Insurance Corporation has proposed rules for clawing back compensation paid to executives of “too big to fail” financial institutions that do, in fact, fail. The rules are disappointingly weak. And because they are watered down, bank executives may again be encouraged to take excessive risks.

Why are these compensation rules important? Clawback rules are needed because the financial crisis was caused in part by insufficient penalties for financial executives’ poor performance.

Executives took excessive risk, which doomed their institutions and caused the government to spend hundreds of billions of dollars of taxpayers’ money to rescue many of them. Yet these same executives were rewarded for their failures and have retained tens of millions of dollars in pay.

James E. Cayne, the former chief executive of Bear Stearns, still lives in his $28.24 million apartment at the Plaza Hotel; Joseph J. Cassano the former chief executive of A.I.G. Financial Products, kept more than $100 million in compensation; and E. Stanley O’Neal, who was the chief executive of Merrill Lynch, retired with a pay package valued at more $300 million.

If you are a financial executive, you may want to try to play the same game in the future. Why not? You keep millions in gains, and if you mess up, the government stands behind your institution.

Ending this type of incentive system is therefore critically important to prevent the next financial crisis. Strongly penalizing executives when their institutions fail will help ensure they take care to prevent such disaster.

The Dodd-Frank Act contains provisions intended to address such distorted incentives. The law provides that when a too-big-to-fail institution is put into receivership, the F.D.I.C. can recover the last two years of compensation from any “current or former senior executive or director substantially responsible for the failed condition” of the institution.

The details of this requirement are to be spelled out by the F.D.I.C., but the agency’s proposed rules destroy the law’s letter and spirit.

The F.D.I.C. has proposed that an executive be held substantially responsible for an institution’s failure if “he or she failed to conduct his or her responsibilities with the requisite degree of skill and care required by that position.” The agency proposes that there is a presumption that executives were substantially responsible if they were the “chairman of the board of directors, chief executive officer or chief financial officer” of the failed institution.

At first blush, these would seem to be good rules. The problem is defining “requisite degree of skill and care.” Courts and other regulations often look to state law to flesh out this concept, and most big financial institutions are governed by Delaware law. In Delaware, the state courts have set a high threshold for finding that an executive failed to exercise due care. It is a definition that requires gross negligence, a legal standard that essentially requires that the executive be shown to have acted in bad faith or otherwise willfully committed a known misdeed.

The next time you see a Delaware judge, ask how many executives of bailed-out institutions have been found to have breached this duty in the wake of the financial crisis. The answer will be none.

The F.D.I.C. has thus set up a straw man, a definition that appears appropriate but will instead allow the executive to escape a clawback.

Despite its weakness, the F.D.I.C. proposal still has critics who think the wording is too strong.

The law firm Davis Polk & Wardwell, which represents many large financial institutions, promotes its client memos as “cited within the profession as the definitive treatises on their given subjects.” In a memo on the F.D.I.C. plan, Davis Polk calls it “unreasonable,” “exceedingly vague” and possibly unconstitutional. Davis Polk also criticizes the rules for failing to reference a legal definition of care like “gross negligence.”

Perhaps Davis Polk is performing a public service by pointing out deficiencies. But if you are cynical, you might say the firm is acting for its clients and trying to push the F.D.I.C. to adopt rules that are more favorable to financial executives. And if the F.D.I.C. sticks to its proposed rules, Davis Polk will be in a good position to represent these executives if their institutions fail.

Davis Polk’s comments are emblematic of an unfortunate development. The heart of the Dodd-Frank Act will be put into action through rule-making by various agencies. Few people have the motivation to keep track of the estimated 243 administrative rules required by Dodd-Frank. The financial industry and its representatives are the exception.

The result can be seen in the comments on the first iteration of the F.D.I.C.’s rules covering the procedures for resolution of too-big-to-fail institutions. Twenty-eight of 35 comment letters by my count were from the financial industry, and the F.D.I.C. met personally with Bank of America, MetLife and “financial services representatives,” which included Davis Polk. There were no meetings with public interest groups. With only one voice speaking, the rules are bound to be biased, however unintentionally, to the financial industry’s favor.

What to do?

First, systemically important financial institutions are different from other corporations. Executives and directors of these institutions probably enjoy a federal “too big to fail” subsidy. Because of this, if they engage in excessive risk-taking and fail, they should be automatically penalized whether or not their conduct met a legal standard of care like negligence.

Big financial institutions will complain that this will mean that they will be unable to recruit executives or board members. But Berkshire Hathaway seems to have no problem having Bill Gates as a director even though the company declined to obtain insurance for directors and officers, which leaves them personally liable if they are found to have breached their fiduciary duty. Moreover, compensation for financial services executives remains quite high. If executives are going to make tens of millions of dollars a year shouldn’t they be penalized if their institution fails?

Second, the “substantial responsibility” term used in the Dodd-Frank Act is not a legal standard of care, and the F.D.I.C. should say so explicitly. Congress almost certainly meant this to refer to a person who was part of the decision-making process of the institution. In this case, the board, the chief executive and chief financial officer are clearly “substantially responsible” if the institution fails, being substantially responsible for its governance. There does not need to be financial test or quantitative loss measure as the F.D.I.C. is considering.

This would be a simpler and more effective definition for the F.D.I.C. to use.

The alternative is to continue a system where executives can take excessive risks to earn outsize gains. The executives can then rely on exaggerated legal standards of care to keep their millions and avoid responsibility.

Public interest groups also need to be more engaged in the rule-making process. If these organizations don’t submit comments, why can’t the F.D.I.C. and the other rule-making agencies seek them out?

The heart of Dodd-Frank is about setting the right incentives. The cynical question is whether the F.D.I.C. is catering to the right ones.


Steven M. Davidoff, writing as The Deal Professor, is a commentator for DealBook on the world of mergers and acquisitions.

 

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Posted in: USA