Solutions Other Than Prohibiting Principal Investing By Commercial and Investment Banks

In my last post, I advocated prohibiting investment and commercial banks from investing their own capital for gain. But there is another possible solution: these firms should cease being publicly traded companies and return to being general partnerships.

Before going into why this would create the right incentives, I will briefly explain the relevant differences between general partnerships and public corporations. General Partnerships are agreements between two or more people to jointly own a business. In terms of liability, general partners are normally liable for all actions they undertake individually as a partners, for the actions of all partners, and liable for the actions of the partnership’s employees. For example, if one partner, acting as a partner, engages in tortuous conduct, all partners can be held liable for the actions of that one partner. Moreover, in states with joint and several liability, the injured party can usually sue any of the partners, not just the partner who caused the injury and collect the entire amount of the damages inflicted. With respect to debt, partners are liable individually for all the debt of the partnership regardless of which partner incurred it. For example, if a partner, acting as a partner, borrows $100 mm to buy a piece of real estate for the partnership, even if the rest of the partners do not know about it and ends of up defaulting on the loan, all of the partners are liable for the debt. Making matters worse for general partners, in most states, the lender can go after any of the partners individually and make them responsible for repaying the entire debt. Furthermore, the lender (as well as the injured party mentioned above) can go after the personal assets of the general partners, even ones who did not incur the debt or cause the injury.

Corporations limit the liability of employees and owners. In terms of being liable for the debt and torts of the corporation, the most shareholders can lose is the amount they paid for their shares. For example, if the corporation defaults on its debt, lenders generally can only look to the corporation’s assets to cover the debt. Therefore, if the CEO agrees that the corporation will take out debt, the CEO and CFO would not be personally liable if the corporation defaults. Furthermore, except in very limited circumstances, lenders cannot go after the personal assets of the shareholders to repay the debt of the corporation.

Prior to the 1970s and 1980s all investment banks were organized as general partnerships. Partners in the investment banks had much of their wealth tied up in these partnerships because they had to pay in capital when they were elevated to partner and had much of their compensation put back into the partnership. Moreover, it was very difficult for partners to sell their partnership stakes. Unlike shareholders in public companies, partners could not nor were they permitted to sell their shares to outsiders or anyone else until they retired. This model (Unlimited Personal Liability + Wealth Tied Up in illiquid Partnership stakes) caused the partners to closely monitor the partnerships activities and make sure that it was not taking too much risk with its operations and investments. If they did not, they could be financially ruined.

Fast-forward to 2008, all of the investment banking partnerships had been converted to corporations. This meant that Dick Fuld, CEO of Lehman Brothers, Jimmy Cayne of Bear Stearns, and Stanley O’Neil of Merrill Lynch could only lose the value of the shares they held in their companies. They would not be held responsible if their firms defaulted on the billions of dollars in loans the firms had taken out. Limited liability allows firm officers to take on much more risk and debt than general partners. The worst that can happen to them, assuming no criminal fraud, is that they lose their job and their stock. Even if shareholders sue for negligence, most of these firms have waived liability for ordinary negligence for their directors and officers. Even if they have not waived the liability or if the law does not permit it, most of the corporations have purchased D&O insurance, which would indemnify the officers and directors. This means that the officers and directors generally are not held personally liable no matter how stupid their investments turn out to be (except in rare circumstances).

Furthermore, senior execs at these firms are now paid in cash and stock. The stock portion, which increases as a % of total compensation as they become more senior, can be liquidated any time after it becomes unrestricted, usually 1-5 years after it is received. Unlike the banks’ former general partners who could not liquidate their partnership interests until they retired and protect themselves from the firm failing, corporate execs can sell their stock anytime after it becomes unrestricted. This means that if a senior exec has sold most of his stock, he or she has less of an incentive to make sure that the firm does not fail. Had Lehman Brothers still had been a partnership, as it was before the 1980s, Dick Fuld and other senior officers would have more closely monitored the amount of risk Lehman took on. If they did not, they would be liable for the debt incurred and their wealth would have been wiped out. Instead, Fuld and others are not liable for the debt and they were able to sell a significant amount of stock over the years. In defense of Fuld (slightly), he still had tens of millions of shares of Lehman stock when it went bankrupt. At one point in 2007, it was valued at over $1 bn. Now that stock is worthless.

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