Wall Street paternalism and disconnect at it’s finest and on display. A Skadden partner writes about shareholder ignorance and displays plenty in the process.

I’ve written a series of posts on the disconnect from reality between the Wall Street fantasy land and Main Street, which has made modern day Wall Street possible. The problem is systemic in my opinion, from trade publications like the National Underwriter whose editor in chief believes spending yet more money on public relations is the answer to bad faith insurer claims handling, to their trade groups and shills like Robert Hartwig that try to convince the fleeced taxpaying public that insurers really didn’t screw people here after Katrina. As is his custom, however, it was Mr CLS who gives us almost more googling to do than time but in this instance a post of his on Yahoo Allstate provided me the catalyst to author this post which will illustrate again the disconnect of which I speak and it is there we begin:

sop, check out the “Winners” of the 4th Annual U.S. Securitization Awards…….

Don’t know what happened to the 5th Annual U.S. Securitization Awards, guess they cancelled and took “the 5th”.

The links he gave listing the winners was 404, no doubt broken on account of the financial crisis but undaunted I did a quick search and found them. This of course resulted in one of those patented Ah Ha moments for me but before I connect the paternalistic dots lets examine some of those that Wall Street honored back in April 2008 at the 4th annual U.S. Securitization Awards:

Deal of the Year: IHOP Corp./ Applebee’s International Securitization. Underwriter: Lehman Brothers

Deal of the Year – CMBS: Equity Office Properties Securitization Financing. Underwriters: Bear Stearns, Goldman Sachs and Bank of America

Deal of the Year – CDO: Genesis CLO 2007-1 and Genesis CLO 2007-2. Underwriters: Genesis 2007-1: CDO manager: Ore Hill Partners, Underwriter: Deutsche Bank. Genesis 2007-2: CDO manager: Levine Leichtman Capital Partners, Underwriter: Deutsche Bank

ABS Firm of the Year: Goldman Sachs

Outstanding Contribution Award: The American Securitization Forum / Dept. of the Treasury

As if these ironies aren’t delicious enough the final one is over the top.

Lifetime Achievement Award Recipient: C. Thomas Kunz, Retired Head of Structured Finance, Skadden, Arps, Slate, Meagher & Flom

We are well familiar with State Farm’s main US based law firm Skadden, Arps, Slate, Meagher & Flom from their great work revising the history of the Katrina litigation planting falsehoods such as the oft repeated meme that Jim Hood used his criminal investigation of State Farm to assist Dickie Scruggs in cramming the first big settlement down State Farm’s throat (with help of ignorant bloggers such as Mississippi’s own Tom Freeland  who still repeats such propaganda on occasion despite reams of contemporaneous press reports to the contrary). Our readers will also no doubt recall I once lamented the impact of layoffs at Skadden on our daily readership earlier this year.

While reading the award winners and the Skadden connection to the toxic paper industry (makes one wonder how much work the boys at Skadden did on State Farm’s Merna Re) a recent post on Greenbackd came to mind that featured the work of Skadden partner John Carney who evidently is in charge of shilling for the firm and it is to the Greenbackd post we go next:

Clusterstock has an article by John Carney, How Ignorant Are Shareholders?, in which he argues that the financial crisis has “dealt a serious blow” to the “idea that corporate governance reforms that empower shareholders to direct the activities of corporations would make companies more financially responsible.” We think John’s got it wrong, but before we begin our rant, let us just say that there is much to respect about John Carney. According to his bio, he’s got a law degree from the University of Pennsylvania, and he practiced corporate law at Skadden, Arps, Slate, Meagher & Flom and Latham & Watkins, both of which are preeminent firms. We also almost wholly agree with his positions on plenty of contentious issues, as summarized here in his bio:

He has argued that failed banks should not be bailed out, Lehman’s collapse was not a disaster, AIG should be declared bankrupt, that naked short selling is not a problem, that backdating isn’t so bad, insider trading should be legal, many corporate CEOs are underpaid, global solutions are worse than local solutions, Warren Buffett is overrated, Michael Milken is a great American, the collapse of the hedge fund was not a scandal, hedge funds are over-regulated, education is overrated by the educated, bonuses at successful Wall Street’s firms are deserved and possibly undersized, management buyouts are boons to the economy, Enron’s management was victimized by an over-zealous prosecution, Sarbanes-Oxley should be repealed, corporate compliance culture is a disaster, shareholder democracy is overrated, hostile takeovers ought to be revived, the market is permanently moving away from public ownership of equity in corporations, private partnerships are on the rise, public ignorance is encouraged and manipulated by governments and corporations, experts overrate expertise, regulatory agencies are controlled by the businesses they supposedly regulate and Wall Street is much more fun than people give it credit for.

He’s trained in the dark arts of the law and he’s practiced with the best. In other words, he should know better.

John’s premise is that financial companies that score highest on most measures of corporate governance performed poorly during the crisis. He argues that shareholders are ignorant, and giving them more say in the management of a company is like tossing the car keys to a blind man and jumping in the back seat:

In political science, the roles of irrationality and public ignorance are well understood. Studies going back decades prove that the public is not only ignorant, it is stubbornly ignorant. It remains ignorant even in the face of widely available and easily obtainable information. Voters are so ignorant that they cannot rationally choose between different programs offered by politicians. And the ignorance persists so that they cannot assign blame or credit to the parties responsible for the programs that are ignorantly selected.

If economists were to take this seriously and apply it to shareholder behavior, they might discover that the case for shareholder democracy is seriously undermined. Instead, many continue to doubt that shareholder ignorance is a serious problem. And those who acknowledge it could be a problem, often assume it can be overcome by providing shareholders with more information. This simply ignores what we’ve learned in political science about shareholder ignorance.

Now, we don’t disagree that many shareholders are ignorant. It’s well known that many don’t read disclosure documents, and many can’t read financial statements. We’ve also argued previously that even those who do read financial statements often ignore important parts of those financial statements, like the balance sheet. Our own About Greenbackd page argues that there are opportunities for investors focused on the balance sheet, because many investors are mesmerized by earnings and totally ignore assets. Where earnings understate the asset value, this creates an opportunity for investors like us. No, we don’t disagree that many shareholders are ignorant. In fact, we rely on that ignorance to make our living.

The point at which we diverge from John is his contention that this ignorance precludes a shareholder from voting. We don’t allow shareholders to vote because that is the best way to manage a company. Shareholders vote because it is their right to do so. A share is nothing more than a bundle of rights: A right to a dividend, a right to a share of the assets on a winding up, a right to a say in the affairs of the company on certain issues, a right to determine who directs the affairs of the company. They are property rights, and standing is accorded to the holder to enforce those rights. The board, and, indirectly, the officers of the corporation, serve at the pleasure of the shareholders. Often a board will seek to prevent a shareholder attempting to demonstrate this last point, for example, by implementing poison pills and other shareholder unfriendly devices, but that is nothing more than an implicit recognition by the board that it is true. Voting, then, is simply a shareholder exercising one of their property rights. If you advance your money, we think you should get all of the attendant property rights, whether you’re ignorant or not. In this society, for good or ill, the owner of property is the person who controls its destiny. We’d argue that this is generally a good thing, and almost all progress the world over stems from this simple principle. Any attempt to sever the relationship between private property and ownership strikes right at the heart of capitalism.

So why the seeming relationship between “good corporation governance” and poor returns? Who knows, really? Statistics can be massaged to say anything. If we had to guess, without reading the paper, we’d guess that it’s a problem of definition. The phrase “good corporate governance” is at best meaningless, and at worst a smoke screen to obfuscate what it really is: an attempt by management to operate on behalf of “stakeholders” (read “parties other than shareholders”), to adhere to the “triple bottom line,” “The Equator Principles,” and other similar ideas irrelevant to shareholders. It’s no wonder that the corporation performs poorly. The board’s worried about everyone other than the owners. We’d argue that those are not proper considerations for the board. What sensible suggestions fall within the remit of “good corporate governance” are necessary only because shareholders don’t have sufficient voice in the operation of the company. They are simply unnecessary, additional regulation to paper over holes left because shareheolders are disenfranchised.

What’s the alternative? Plato’s Republic shoehorned into the corporations law? Philosopher-king CEOs? Frankly, the thought makes us gag. No, the real alternative is shareholder enfranchisement. Force the stewards of capital – the boards and officers – to recognize the rights of shareholders – the rightful owners of that capital. Ensure that shareholders are properly able to deal with their property as they see fit, and to express their desires for that property to the board without restriction……

I don’t necessarily agree with either Carney or Greenbackd on those “bio” issues that T. (I’m using his first initial only) at Greenbackd cites at the beginning of his post but like T. I was very dubious of the study Carney cited to make his point. I looked a bit deeper though to find the behavioral economic motivation that would cause Mr Carney to latch onto the study and found it in another Clusterstock piece he wrote last month. Before I get to that,  I think it will helpful to spend a few minutes with the source study itself as distilled by the authors in a piece they wrote for the Harvard Law School Forum on Corporate Governance and Regulation:

An OECD report argues that “the financial crisis can be to an important extent attributed to failures and weaknesses in corporate governance arrangements”. We find no evidence supportive of such a statement in our data. There is no evidence that banks with better governance, when governance is measured with data used in the well-known Corporate Governance Quotient (CGQ score) perform better during the crisis. Strikingly, banks with more pro-shareholder boards performed worse during the crisis.

Fair enough, the OEDC report relies (as does Professor Stulz) on what these companies say are doing rather than their actual actions. To me good corporate governance is in the actions taken such as proactive shareholder communication and transparency, not the policies and procedures the enterprise claims to follow. And of course no matter how good the corporate governance system that is in place it is the business decisions made that leads to ultimate success or failure, not the processes that lead to those decisions.  Thus can we correlate anything between the corporate governance as defined by the study’s authors and how well the business is run as defined by return on investment or other objective financial measure? Professor Stulz doesn’t seem to think so.

Bank balance sheets and bank profitability in 2006 are more important determinants of bank performance during the crisis than bank governance and bank regulation. Banks that had a higher Tier 1 capital ratio in 2006 and more deposits generally performed better during the crisis. As a result, the positioning of banks as of the end of 2006 is more important than governance and/or regulation in explaining the performance of banks during the next two years. Another way to explain our results is that banks were differentially exposed to various risks by the end of 2006. Some exposures that were rewarded by the markets in 2006 turned out to be unexpectedly costly for banks the following two years. Overall, the explanatory power of regulatory variables is small compared to the explanatory power of bank-level variables.

That doesn’t stop Mr Carney (whom I earlier termed a shill) from misrepresenting the study’s conclusion in his two Clusterstock articles on the topic thus my conclusion as to his employment function with Skadden. In his earlier article “Better” Corporate Governance Made Banks Riskier Carney attempts to make the case that Nassim Taleb is all wet that how bank execs were compensated directly correlates with the subprime orgy that caused the financial crisis. In the article he reveals his self interest which any behavioral economist worth his salt will tell you is the real motivation behind these two less than intellectually rigorous articles authored by Mr Carney. In short he attempts to protect the status quo of outsized executive bonuses from the mindless securitization of crap assets shined up and termed shinola. I invite our readers to compare what Carney claims Professor Stulz’s study says against the actual study itself:

• One striking result is that banks with the highest returns in 2006 had the worst returns during the crisis. More specifically, the banks in the worst quartile of performance during the crisis had an average return of -87.44% during the crisis but an average return of 33.07% in 2006.
• In contrast, the best-performing banks during the crisis had an average return of -16.58% but they had an average return of 7.80% in 2006. This evidence suggests that the attributes that the market valued in 2006, for instance, a successful securitization line of business, exposed banks to risks that led them to perform poorly when the crisis hit. The market did not expect these attributes to be a source of weakness for banks and did not expect the banks with these attributes to perform poorly as of 2006.

This supports a couple of positions we’ve been arguing for around here for some time. First, it wasn’t bad bonus incentives that drove banks to take risky bets in asset backed securities. It was a widespread mistake about the values of those assets. And that mistake was shared by bankers as well as investors in banks.

The key here is how the term corporate governance was defined. Imagine what the returns at Countrywide would have been for instance if Angelo Mozilo has disclosed the true nature of the risks he was taking in 2006 (while selling his stock into the runup) instead of doling out below market loans to Senator Chris Dodd.

There is a reason we need to keep lawyers as far away from economic theory as possible.

The Skadden folks are all over us so if Mr Carney wants to come on here to defend himself confined strictly to this subject and not ongoing litigation I so invite him. Rest assured Mr Carney not all shareholders are the morons you no doubt fancy us (and would like us to be). In fact some of us were smarter than the executives who peddled those toxic assets as we weren’t dumbed down by the pursuit of the year end bonus. I have my old CFC Yahoo board time stamps to prove it. I wonder what Mr. Carney was writing about in the spring of 2006?

sop