Why Investment Bankers Should Have (Some) Personal Liability

Posted by Scott Hirst, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Thursday January 28, 2010 at 9:10 am
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Editor’s Note: This post comes to us from Claire Hill and Richard Painter. Claire Hill is the Solly Robins Distinguished Research Fellow and Professor of Law at the University of Minnesota Law School; Richard Painter is the S. Walter Richey Professor of Corporate Law at the University of Minnesota Law School. The post relates to a recent paper by Professors Hill and Painter, which is available here.

Commentators on this blog and elsewhere have discussed solutions to problems that caused the most recent financial crisis. A pervasive theme has been the excessive appetite for risk in the banking industry and the impact of compensation on attitudes toward risk.

Some commentators have proposed making stock-based compensation more “long term” by requiring bankers to retain stock holdings in their employers. Others such as Lucian Bebchuk and Holger Spamann have recommended that bankers’ compensation be tied to the fortunes of creditors, not just shareholders. (Learn more about their views here.) Many of these proposals would be an improvement upon the status quo.

We are concerned, however, that these proposals – and others currently being considered in Congress – do not go far enough in linking the financial interest of bankers with the financial health of their banks. Bankers may lose upside profits if their banks do not do well, but they do not share the downside impact that their own risk taking has on broad segments of society – creditors, customers, employees and ultimately, taxpayers.

Cognitive psychology offers some insights as to why a banker might cause a bank to take excessive risks even if he has a significant equity stake in the bank—so long as his worst case scenario leaves him sufficiently well-off. Various terms and frameworks in psychology are available to describe the effects at issue: these include ‘prospect theory’ and, more specifically, the ‘house money effect.’ A prior gain, such as an equity stake awarded as compensation, may be experienced as ‘house money;’ people may be far more willing to make a risky bet with house money than they would with what they might regard as ‘their own money.’ More orthodox dynamics may also be at issue, such as declining marginal utility of money. Beyond a certain point, money for the sake of its purchasing power may not matter much. Bankers may thus not have been highly motivated to avoid huge losses: despite those losses, many of them are left over with more money than they can reasonably spend on themselves and their families. The possibility of a loss of $950 million of a $ 1 billion portfolio, having $50 million left over, may matter less than the possibility of a loss of all but $1 million of just about any large portfolio.

We have written a short paper for a symposium on the work of Adolf Berle in which we advocate reintroducing some measure of personal liability for bankers, as was the case in Berle’s day, and indeed up through the 1980′s. We describe in our paper the broad outlines of a proposal to impose some measure of personal liability for a bank’s debts on the most highly paid bankers. The proposal would revive two mechanisms that imposed personal liability in an earlier era: general partnership, which was common for investment banks prior to the 1980s, and assessable stock, which was relatively common in corporations including some commercial banks through the 1930s.

It is difficult to imagine the investment banking business returning to the partnerships of old. General partnership – with the illiquidity and liability it imposes on general partners and the constraints it imposes on a bank’s ability to raise capital – probably will not be considered a viable option. It is also difficult to imagine corporations in the financial services industry issuing assessable stock to all of their shareholders or regulators seeking to require them to do so.

Our objective is to design another way to impose some of the risks of unlimited liability on the most highly compensated managers and other decision makers at investment banks and other financial services and trading firms. We seek to do so without requiring the firm itself to switch to general partnership form or to make any other change in its organizational or capital structure. We discuss below two alternatives, each one based on historical precedent.

The first approach is a mandatory partnership/joint venture agreement between certain “covered companies” in the financial services industry (banks, broker-dealers, larger hedge funds and some others) and certain “covered employees” earning over $3 million per year in compensation. These employees would enjoy their large pay packages, but also the exposure to unlimited liability that hung over the heads of investment bankers who were in fact partners not so long ago. A covered employee would only be personally liable for amounts his or her company could not pay to its creditors, and the covered employee would be allowed to set aside up to $1 million of personal assets that would be immune from reach by company creditors (in this respect our proposal is considerably more generous than traditional partnership law). The covered employee also would not be liable to pay company creditors out of income earned from other sources after the company’s insolvency (a personal bankruptcy filing thus would not be necessary to protect future income or inheritance).

The second approach is requiring that these same “covered companies” pay any employee compensation over $1 million in assessable stock. The stock would be nontransferable and could only be exchanged for nonassessable stock one year after the employee left the company. In the event of firm insolvency, the stock would be assessable in an amount equal to its book value at the time of issuance (this amount would likely be considerably higher than the book value at the time of insolvency). The assessment would be a personal debt of the record holder of the stock. For example, an employee who was paid $5 million in cash and $15 million in assessable stock over five years or a total of $20 million in compensation would be liable for up to $15 million on the stock if the company became insolvent. Once again, we would allow the stockholder to set aside up to $1 million in personal assets that would be immune from the assessment, and personal income earned and assets acquired after the assessment would not be subject to attachment to pay the assessment.

We believe that imposing genuine downside risk through these or other vehicles for personal liability is the best way to make bankers approach risk in a manner consistent with their broader social responsibilities. Our objective with this paper is to begin a conversation about how this might be done; we invite comments from our readers about which proposals are most likely to work.

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  2. I’m sorry I don’t have a comment about which proposal will work, but I do agree with you that the downside risk needs to be taken into account. Who wouldn’t take big risk if their was a huge upside reward with a limited downside backlash.

    Comment by Travis — February 3, 2010 @ 8:56 pm

  3. I think the first approach is most likely to work. I am doing a research project on this topic for my Finance Law class and I have a few talking points. If my investment banker to whom I gave substantial amounts of money for him to invest lost 95% of its value, I would expect that he be held completely liable. Safeguarding $1 million is a lot in my mind. Why do you have to be so generous? Make it $100,000. Many American families live just fine on less than that. I think they would make better decisions if they knew that there “all in” bets could not just sting them, it could rip their faces off. Second, rather than create a line where beyond it lies liability but under it lies nothing, have a progressive liability percentage. For instance, if someone makes $300,000 they are liable up to 5% of the investment; $750,000 is 10%, $3 million is 20%. Or if you want to make it a dollar amount, let it be progressive as well. Either way, if I was an investment banker, I would do all that I could to stay under that line to avoid liability. Once you hit that six digit compensation line, the risk should start to be on your shoulders. Lastly, I do agree that money made elsewhere should be protected. I don’t think it’s fair that you can get sued for losing money at a bank, and lose your inheritance or your wife’s side business or personal investments.

    Comment by William — February 6, 2010 @ 3:09 pm

  4. To add to my prevous comment, If we were only taking away stock that the employee had, it wouldn’t hit home as hard as real asset value. Having stock feels more like fake value, as opposed to cash or land value you aquired through purchase of income made with these investments. Taking away stock is like “oh well, I don’t have that option anymore.” Taking away land or cash in your bank accounts is like “oh crap, now i’m in trouble my money is gone.”

    Comment by William — February 6, 2010 @ 3:30 pm

  5. [...] adds lengthy comments.  Here is a very relevant paper by Claire Hill and Richard Painter, and a blog post by them.  Here is Suzanne McGee.  Here are some debates on non-limited liability in economic history, [...]

    Pingback by Wealth externalities and limited liability in banking — Marginal Revolution — February 13, 2012 @ 7:32 am

  6. I think that investment banks should shoulder the risk of their decisions. The moral hazard generated by the rush to take on greater risks was fueled by trying to outdo the competitor across the hall and accelerated by herds of traders who didn’t want to be left out of the feeding trough. If bankers, or traders, are not held accountable for decisions made on high-risk investments and not sound fundamentals or looking out for the best interests of their client’s money, then they should not be allowed to benefit while their clients lose. More, they should be prosecuted if that is the case.

    Comment by Billy W. — April 14, 2012 @ 1:38 am

  7. Thanks for your post. In my opinion the investors *should* know what they’re getting into before they invest, but the bankers should also do their best to try and offer some amount of protection to them. Heed the warnings and do your homework!

    Comment by Mason — December 10, 2012 @ 4:20 pm

 

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