Written by: Deborah Post
For several years and at various institutions where I have taught Business Organizations I have asked my students to read the business section of the New York Times every day. Once a week I administer a quiz on the stories that appeared that week. To be honest, I have had to make some adjustments because of the querulous nature of current students. I narrowed the assignment to the three stories featured in the online version of the New York Times. Not every student has to read the paper every day as the quiz is administered to groups, not the entire class. They can divide the responsibility for reading the news among the members of the groups or they can play the odds and hope that when I roll the die, their group will not be the one selected to take the quiz that week. The quiz is administered in game show fashion and I use a power point with some visual clue for each question.
The benefit of this assignment is that offers students an opportunity, if they chose to take it, to educate themselves about the kinds of problems/issues that confront those who are in business and the lawyers who represent them or work in agencies that regulate commercial and corporate activities. The other benefit, which is not obvious to students as much as it is to me, is that this practice allows us to patterns as they emerge. In the 1980s the legal issues that emerged had to do with acquisitions, contested takeovers, and, ultimately, the risk associated with the use of junk bonds in leveraged buy-outs. In the early 1990s it seemed that every week there was a story about downsizing and corporate restructuring. I watched with my students as the bubble burst, the Pacific Rim Miracle faded like a mirage and massive financial fraud on the part of corporate executives in companies like Enron and WorldCom were exposed. Nothing compared, though, to the implosion of the financial institutions, catastrophic loss in wealth and massive unemployment that my students watched in the Fall of 2008.
Looking back on this experience in the aftermath of the economic collapse two years ago, and particularly in light of the current debates about government intervention and oversight, I have concluded that the search for answers is not broad enough, that the experts trying to fix our economy are looking at the facts close at hand, not the evolution over time of current financial and economic structures. Distance – social and temporal – adds something to the analysis. The fact is that the United States took a wrong turn decades ago and the systemic and structural changes made in the 70s and 80s are not easily undone.
Back in the late 70s, when advocates for reform began to beat the drums of doom — announcing the imminent demise of the social security system — the IRS adopted the provisions which allowed the middle class to move their savings into the stock market. Civil servants, union members, and teachers, saw pension benefits reconfigured in a way that did not include a promise of an annuity, but an opportunity to accumulate wealth by purchasing stocks, bonds and other investment vehicles. At about the same time, monetary policy was remade in a way that made ordinary savings unattractive.
Why invest in a CD with a 6 % return when investments in the market offer a return in double digits – as high at one point as 25%?
There was a point at which I began to question the wisdom of this diversion of savings. I thought the constant infusion of cash distorted the market. It meant that stocks and other securities were overvalued. How could the stock market reflect real value when every week pension funds had to purchase millions of dollars of securities? My worst fears were validated weeks after the financial meltdown in 2008 when I heard a story on npr which was called, appropriately enough, The Giant Pool of Money. Too much money spurred the development of esoteric investment vehicles. Smart people, quants, came up with sophisticated mathematical models for securitized debt like mortgage backed securities. see http://www.nytimes.com/2009/03/10/science/10qside.html?emc=eta1 Unfortunately these models must not have included a variable representing human frailty – inertia, incompetence, sloth or greed — and soon we were knee deep in hustlers recruiting buyers for an inflated housing market and insurance companies selling credit default swaps, arbitrageurs shorting investment firms like Lehman Brothers and the debt of sovereign nations like Greece.
Blame for the current economic crisis has been assigned to a culture of risk taking but the attempts to change that culture have been directed almost exclusively to federal laws that regulate the practices of banks and financiers. State law has played a not insignificant part in the creation of this culture of irresponsibility. People are more inclined to take risks when there are no consequences and the proliferation of limited liability vehicles which could be combined in ways that made immunized managers from liability for gross errors in judgment short of bad faith or actual fraud.
The late 70s saw a proliferation of state statutes offering entrepreneurs limited liability. I recently heard Professor Charles Goodhart discuss the problem of the excessive salaries and bonuses in companies that received a bail out from the government. His remarks were limited to the “casino end” of the banking industry, the investment banking firms, but he noted that payment structures which were problematic because while they might have been appropriate when these firms were general partnerships, when losses as well as profits were shared, they made no sense when the form of entity was a limited liability company. http://www.bbc.co.uk/iplayer/episode/p008s7mz/Business_Daily_Banks_Beaches_and_Brazilians/ see also Charles A. E. Goodhart, The financial crisis and the structure of contracts, Dec. 17, 2009 http://www.voxeu.org/index.php?q=node/4396
Last year I asked my students to consider how state law might be amended to address the problem or recklessness which had been identified by the President as one of the causes of the economic crisis. No one even mentioned the relationship between the obsessive or excessive commitment to limited liability. They did mention, however, the doctrine of piercing the corporate veil which is, unfortunately, sparingly applied particularly in the case of public corporations and parent/subsidiary relationships. Unless an owner knows in his bones that a decision can cost him everything, the prospect of a huge profit is not just attractive, it is irresistible.
The piercing doctrine is one example of the way judges played a role in creating the culture of recklessness but it is not the only contribution they have made. From where I sit in the academy I believe too little has been said about the jurisprudence that made a virtue of risk. Ideology drives analysis and far too many judges were persuaded that economic growth would be fostered if commercial interests were deregulated by courts as well as legislatures. Deregulation could be accomplished by reconsidering contract doctrines or engaging in a form of statutory interpretation that looked for efficient – that is non-interventionist – legal rules or doctrines. The propensity to take risk was encouraged, even applauded, by judges who thought the repeat players in the market should not be constrained by the costs of litigation. Innovation and risk were conflated, as though prudence and innovation were incompatible. Even more disturbing was the reallocation of risk – a process that shifted risk in disturbing ways. One example might be the admonition of Judge Ralph K. Winter in Joy. V. North, 692 F.2d 880 (2d Cir., 1982), discussing derivative suits and the ability of a special litigation committee of the board of directors to dismiss such suits. He chided shareholders:
…it is very much in the interest of shareholders that the law not create incentives for overly cautious corporate decisions. Some opportunities offer great profits at the risk of very substantial losses, while the alternatives offer less risk of loss but also less potential profit. Shareholders can reduce the volatility of risk by diversifying their holdings. In the case of the diversified shareholder, the seemingly more risky alternatives may well be the best choice since great losses in some stocks will over time be offset by even greater gains in others. Given mutual funds and similar forms of diversified investment, courts need not bend over backwards to give special protection to shareholders who refuse to reduce the volatility of risk by not diversifying. A rule which penalizes the choice of seemingly riskier alternatives thus may not be in the interest of shareholders generally.
Id. at 886.
I have always thought that responsibility for bad choices should be shared by those in whom we repose both power and trust with an expectation that they will exercise sound judgment. The idea that the duty of care should be abrogated and replaced by an ethic of self reliance and duty to diversify reverberates through other contract and corporate doctrines as well.
The question we need to ask ourselves as members of the legal community and as educators of the next generation of lawyers and legislators is what we can do to help our students understand the role law played in the current crisis and how to think about possible solutions.