“A trustee is held to something stricter than the morals of the market place.”
Judge Benjamin Cardozo
There are individuals who walk the earth who possess a preternatural gift for the perception of value. My Great Aunt Corinne, a self-made millionaire, who started reading the Wall Street Journal at the tender age of nine years, was a person of this sort. Her story is not family myth because she told it to me herself: the story of a young black girl growing up on a Mississippi cotton farm who would sneak to the local country store to read the white store owner’s copy of the Wall Street Journal. During those days of segregation, when separate was considered equal, and black people inferior, the store owner would hide her in the back with the supplies while she read to her heart’s content.
I sat at her knee and raptly listened to her story, as a brand new graduate of Harvard Law School, a person she considered to have stepped gingerly into her league. She explained that quite early in her investment activities she had stopped using a broker. Right around the time color television was invented. She explained that she dropped her broker at that time because he tried to convince her that color TV was a fad, which would soon pass. And she described him derisively as “the biggest fool” and maintained her insightful investment. I still get a huge thrill of just thinking about this story of the young, under-educated black woman telling the smug Wall Street broker that he was a fool and firing him.
But what this story also taught me was that she was so special. Even though she deigned to allow me into her realm, I knew that what she possessed was a gift that I did not share. I was a graduate of Harvard Law, for sure, but I did not see value in the profound manner that she casually demonstrated. She tried to get me to do a “simple investment” in Bicentennial coins to get my feet wet. I scoffed at that. “Aunt Corrine,” I said. “Bicentennial coins? Please! If I had the money to invest I surely would not invest it in something as ridiculous as Bicentennial coins.” I hurt her feelings. I thought this suggestion was absurd until a few years later she proudly informed me that she had just sold half of her 500 sets and paid for the entire original investment. I was astonished at her constant and deep insight into value. I finally realized that she saw value everywhere, like a good person sees love everywhere.
I tell this story because I firmly believe, almost twenty-five years later and years after her death, that she was not alone in the possession of this gift. She was a type. Some years later she called me up and asked me about a gentleman she had some contact with named Michael Milken. She was all excited about investing in this new venture he created, which eventually became known as “junk bonds,” but that at this early stage appeared to be an extremely lucrative high yield bond. She was ready to take the plunge and invest substantial sums into these instruments. She knew the details of the deal and asked me for my legal advice. Now I was just a baby lawyer and I did not think I had the sophistication to advise my sage-like aunt on the nature of these high level investments. But as she explained the whole transaction to me I became very concerned. My learning of “Corporate Finance” class came back to me. “This stuff can’t be legal,” I told my aunt. “Sounds like to me he’s on both sides of the transaction and hasn’t disclosed it.” I advised against investing in any scheme of the sort that would, at minimum, violate what I had learned about Security and Exchange Commission regulations on disclosure. She wasn’t pleased with this advice. After all, she was trying to lead me in the right direction with regard to investments and she was certain she had a hot item. Our conversation ended somewhat abruptly.
Then in 1989 he was indicted on 98 counts of racketeering and securities fraud after an insider trading investigation. On April 24, 1990, he entered a guilty plea to lesser offenses of securities and reporting violations, got a sentence of ten years in prison, was permanently barred from the securities industry, but only served two years because he “cooperated” in testifying against his former colleagues. My aunt called me when she saw the headlines. “I wanted to thank you,” she said to me. “Because of your advice I did not join in this investment…you saved me some real heartache.” I smiled. It was gratifying to be of some use to this genius and I felt that despite my lack of her gift I did have real value. And I was just three years out of law school.
Today, the observation is just this: when will we start to learn? Critics of Milken called him the “Junk Bond King.” But he has his admirers like George Gilder who in his book Telecosm says:
“Milken was a key source of the organizational changes that have impelled economic growth over the last twenty years. Most striking was the productivity surge in capital, as Milken…and others took the vast sums of trapped in old-line businesses and put them back into the markets.”
When I read that quote I thought about my dead aunt. Clearly, the quote is about the ability to perceive value and then capitalize on it. But my relationship with my aunt taught me that despite the fact that this ability is an example of sheer genius, apparently, it is not automatically accompanied by an equal moral, ethical or legal gift. As such, it can be misguided, misinformed and even abused. So when will we learn this fact and start to live accordingly?
In the case of Meinhard v. Salmon Justice Benjamin Cardozo, then Chief Judge of the New York Court of Appeals, discusses the fiduciary duty of loyalty that a trustee owes his joint venture partners. He describes it as follows:
“A trustee is held to something stricter than the morals of the marketplace. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior. As to this there has developed a tradition that is unbending and inveterate. Uncompromising rigidity has been the attitude of courts of equity when petitioned to undermine the rule of undivided loyalty by the “disintegrating erosion” of particular exceptions. Only thus has the level of conduct for fiduciaries been kept at a level higher than that trodden by the crowd. It will not consciously be lowered by any judgment of this court.”
This oft-quoted case sets a high standard for contract fiduciaries: honesty, honor, and undivided loyalty. Most often, trustees are creatures of statute or contract. But courts of law, exercising their equitable powers, can also impose what is known as a constructive trust. A constructive trust is imposed as a remedy when one person has deprived another of his or her rights in situations where there has been an improper exercise of rights over property, unjust enrichment or interference. In such instances, the abusing party has the fiduciary duty of a trustee imposed on their activity so that the benefit of the improper exercise of rights can be brought to adhere in the proper individual. Simply put, a constructive trust can be employed to right a wrong. Individuals can have fiduciary duties imposed on them because of their conduct and for no other reason.
Now Meinhard v. Salmon addresses the role of a fiduciary duty in the context of a joint venture contract. But, in terms of business conduct, isn’t it true of the past and also of the present that the conduct of our lions of finance is everyday creating situations where trustee-like, fiduciary duties should be imposed? When “genius’ level investors leverage, and as such then control, huge swaths of our economy to the extent that when it all goes bad the public concludes that we cannot afford to let them fail, hasn’t the time come to recognize that these are actually fiduciary acts in fact? And then don’t these facts, as with the constructive trust, then require an appropriate remedy?
This type of control is currently exercised by the participants of what economist Paul Krugman calls “the shadow banking system.” Some call them investment banks. Some of the members describe themselves as “hedge-funds.” But whatever the description, as Krugman says, any institution that “promises ready access to cash for those placing money in its care,” is a bank: even if they invest “most of that money in assets that can’t be liquidated on a moment’s notice.”[i]
I provide this definition because the main feature of the “shadow banking system” is that this system consists of a group of institutions that act like banks but are not regulated or protected like the “banks” most Americans are familiar with and utilize. When most Americans think of a bank they understand that to mean functions like: checking accounts, savings accounts, car loans and maybe a mortgage loan. We understand that the federal government protects our deposits in these entities with an insurance program called the FDIC.
The shadow banks are not so protected or regulated. They deal in arcane investment vehicles called: derivatives (like credit default swaps, asset default swaps, equity-volatility swaps), securitized mortgages, and bond arbitrage, to name a few. They have names like Bear Stearns, Lehman Brothers, Salomon Smith Barney, Berkshire Hathaway, Goldman Sachs, J.P. Morgan, Merrill Lynch, Travelers Insurance, Citicorp, AIG and a long dead entity called Long-Term Capital Management. This is not an exhaustive list. Many more corporations participate in the system by entering into investment contracts with these firms and are formally referred to as “counter-parties.”
In the book When Genius Failed author Roger Lowenstein described the rise and fall of the hedge fund Long-Term Capital Management (LTCM) a firm that recruited two Nobel Prize winners Robert Merton and Myron Scholes as partners. At its high point LTCM, located in Greenwich, Connecticut, “boasted 134 billion in assets. In just over four years, an investment in the fund had quadrupled…the value of a single dollar invested at the start had risen to $2.85—a phenomenal 185 percent profit in barely fifty months.”[ii]
But when LTCM fell, due to its portfolio of high-risk investments, it fell big time. The genius partners’ mathematical formulas indicated “it was unlikely to lose more than $35 million on any single day,” but in 1998 when the fall began they “dropped $553 million—15 percent of its capital—on one Friday in August. It had started the year with $4.67 billion” in capital “and suddenly it was down to $2.9 billion.”[iii] Lowenstein further states:
“Three quarters of all hedge funds lost money in August, and Long-Term did the worst of any of them. In one dreadful month, Merriwether’s gang lost $1.9 billion, or 45 percent of its capital, leaving it with only $2.28 billion…The fund had $125 billion in assets—98 percent of its prior total and an extraordinary fifty-five times its now shrunken equity—in addition to the massive leverage in its derivative bets, such as equity volatility and swap spreads. This leverage was simply untenable. If its assets continued to fall, its losses would eat through that $2.28 billion sliver of equity in an eye blink.[iv]”
During this time firms tried to assess their exposure in terms of a potential default. Lowenstein writes that:
“Even J.P. Morgan, which was offering capital to Greenwich with one hand, was sifting through its exposure to Long-Term to prepare for a possible default on the other. “It was going to be ugly,” a Morgan executive confided. Bankruptcy does not prevent derivative parties from seizing collateral. If Long-Term filed, it could expect to find its fax machine humming with claims from each of its fifty or so counter-parties. In fact, if Long-Term defaulted on any of its seven thousand derivative contracts, it would trigger a default in every one of the others, which covered some $1.4 trillion in notational value.[v]”
Think about it. A firm with $2.28 billion in actual capital was leveraging $1.4 trillion of economic activity in our system and that was in 1998. Now matters are much worse.
In fact, in June 2008, Timothy Geithner, then serving as president of the New York Federal Reserve Bank described the problem as follows:
“The structure of the financial system changed fundamentally during the boom, with dramatic growth in the share of assets outside the traditional banking system. This non-bank financial system grew to be very large, particularly in money and funding markets. In early 2007, asset-backed commercial paper conduits, in structured investment vehicles, in auction-rate preferred securities, tender option bonds and variable demand rate notes, had a combined asset size of roughly $2.2 trillion. Assets financed overnight in triparty repo grew to $2.5 trillion. Assets held in hedge funds grew to roughly $1.8 trillion. The combined balance sheets of the then five major investment banks totaled $4 trillion.
In comparison, the total assets of the top five bank holding companies in the United States at that point were just over $6 trillion, and total assets of the entire banking system were about $10 trillion. [vi]”
But time marches on, and by 2008 the Brookings Institute indicated in a study that American homeowners, consumers and corporations owed roughly $25 trillion during 2008. This total broke down as follows: American Banks $8 trillion in traditional mortgage loans; Bondholders and other traditional lenders $7 trillion; and in the parallel or shadow banking system $10 trillion. The $10 trillion figure represents forty percent of this financed economic activity. And in 2008 it was this shadow banking system that failed—created by our economic geniuses.
Paul Krugman says the trigger for the collapse of the shadow banking system was the end of the housing bubble and that “$7 trillion will have been losses to homeowners and only about $1 trillion in losses to investors.” The problem is that “losses to investors” means the shadow banking system. It is a problem because these investments were highly leveraged. This means that unlike regular banks no cash reserves were in place to protect against loss. Instead, the investment contracts contained clauses that required an injection of cash if certain trigger events occurred like: significant losses, default on contract payments, or a declaration of bankruptcy.
If a trigger event occurred the target would have to deposit additional collateral under a formula contained in the contract. As we saw with LTCM this sort of contract clause could result in a “liquidity trap” where all of its contracts were placed in default. In such a circumstance, the firm would not have enough capital on hand to pay a demand for increased collateral. When its clients begin to make these demands in concert, it becomes just like the “panic” or run on banks experienced in this country in the Great Depression. It was not supposed to be able to happen because of our federal government banking protections. But because the shadow banking system is outside that protection this sort of bank run was possible. And this is exactly what happened in 2008.
Krugman explains that “the failure of hedge funds associated with a French bank is generally considered to have marked the beginning of the crisis…”[vii] But most Americans had the issues brought to their attention September 15, 2008 when Lehman Brothers went bankrupt. Federal government officials thought the system could absorb the failure of this firm but they overlooked the significance of the counter-parties. Again Krugman writes: “within days it was clear that this had been a disastrous move: confidence plunged further, asset prices fell off another cliff, and the few remaining working channels of credit dried up.”[viii]
Protection of the system from the reverberations of the failure of the firm and its subsequent impact on its “counter-parties” was the reason why the government intervened to bailout AIG. AIG went from $60 billion in assets in 1998 to $204 billion in assets year-end 2007. And its leverage ratio was 11 to 1.[ix] By 2008, AIG had $52 billion in capital equity and $860 billion in assets. As with LTCM there was simply no way $52 billion could cover any significant run on its assets. This is why AIG was “too big to fail.”
In fact, the bailout of AIG began with government loans of $122 billion, to cover the demand for increased collateral by its counter-parties. But the figure continued to climb to $180 billion by March 2, 2009. Clearly, $52 billion could not cover such a sum and it is unclear whether the real exposure has ever been presented to the American public. For if LTCM with 2.2 billion in equity leveraged $1.4 trillion in economic activity, how much of the $10 trillion did AIG leverage? It is an interesting question.
But one fact is not in doubt. With the collapse of the shadow banking system 40% of the credit capacity of our financial system was effectively nullified and this is why we are still in a credit crisis today. Krugman explains that as a result of the collapse of the shadow banking system “old-fashioned” bank lending actually expanded. “But the expansion of old-fashioned bank lending came nowhere near to making up for the collapse in shadow banking.”[x]
The control of such huge segments of our economy, in my view, should henceforth be considered a public trust and those who manage this trust should be defined and treated as fiduciaries. Black’s Law Dictionary describes a fiduciary relationship as “one founded on trust or confidence reposed by one person in the integrity and fidelity of another.” Simply put, fiduciaries must exhibit the highest form of disclosure, openness, trust, fidelity, and confidence. They are expected to act in the best interest of their clients at all times. As agents of a public trust, this means that a fiduciary would have to act in the best interest of the public at all times. They would have to protect all of us and not prey on us or otherwise cheat and take advantage of us.
I believe that individuals or firms that control such huge segments of our economy should be held to the highest fiduciary standards as a matter of law and we should pass such laws as quickly as possible.
But even if we do not possess the political will to adopt laws imposing these duties on such operatives, they themselves should hold to these ethical and moral standards as the ideal to be pursued for their type because of who and what they are as individual personalities. This is genius in operation and even if we pass such laws who can say whether or not another brilliant person or group will come along and see a loophole that can be exploited to all of our detriment?
This is why I propose this new ideal. I assert this because of one essential moral point: each and every individual must make the moral decision in their life whether to act for their own narrow self interests or act for the interests of all others. Clearly, and at this point can it really be disputed, that when such genius acts for its own narrow self interests these actions eventually bring the utmost in destruction down on themselves and the entire system. Recent economic history is merely a repetition of cycles of this sort of destructive activity bringing us repeatedly but predictably, over and over, to the brink of annihilation.
I write this to beg and implore individuals of genius to add to your lives the pursuit of this fiduciary ideal. We of lesser gifts would be silly to try and impose on you the limitations of not being driven by the profit motive or not compensating your self with a requisite percentage of the earned riches. But add this ideal to these drives. Earn profit and wealth, not just for your own self but also for the good of the whole. Impose on yourselves the discipline of systemic improvement and preservation. Strive for this as devotedly as you strive for wealth. Frown on any of your brothers or sisters who do not pursue this lofty and noble goal. Adopt not just “honesty alone, but the punctilio of an honor the most sensitive” as your standard of behavior. Do this as a sacred task. Be the blessing to your fellow human beings that your gift of value-insight and wealth making implies. Walk the earth as lords of commerce and bring all of humanity into a new golden age.
[i] Paul Krugman, Return of Depression Economics at 156. Henceforth RDE.
[ii] Roger Lowenstein,When Genius Failed at p.131.
[iii] Id., at 147.
[iv] Id., at 159.
[v] Id., at 180.
[vi] RDE 170-171.
[vii] Id., at 177.
[viii] Id., at 178.
[ix] AIG’s Failure is so much bigger than Enron by Andrew Sullivan CFA September 17, 2008
[x] RDE at 172.