Jonathan Ernst/ReutersSecurities and Exchange Commission’s headquarters in Washington.Claire A. Hill is a professor and James L. Krusemark Chair in Law at the University of Minnesota Law School and heads its Institute for Law and Rationality. Richard W. Painter is the S. Walter Richey Professor of Corporate Law at the University of Minnesota Law School and was a witness at the House Financial Services Committee hearing that is mentioned below.
A federal judge rejected a proposed settlement last year between Citigroup and the Securities and Exchange Commission. The S.E.C. had alleged that Citi had defrauded investors by selling them collateralized debt obligations that included assets the bank handpicked and then bet against. In rejecting the settlement, the judge, Jed S. Rakoff of the Federal District Court in Manhattan, cited in particular a lack of admission of guilt by Citigroup, even as it agreed to pay $285 million and promised not to violate securities laws in the future. The S.E.C. and Citi appealed the rejection; an appeals court sided with them, and stayed Judge Rakoff’s order.
Whether or not Citi’s behavior was illegal, it is clearly behavior that should be discouraged. But how should this best be accomplished? A recent hearing of the House Financial Services Committee focused on the role of settlements and particularly, whether the S.E.C. and other regulators should insist on an admission of wrongdoing in their settlements. Most witnesses testified that settlements should not require such admissions. Defendants would almost always refuse to settle on such terms, in part because an admission of a violation invites an onslaught of private securities suits seeking enormous damages. Regulators would be forced to litigate far more cases, often against adversaries with far greater resources.
Requiring settlements to include an admission of guilt is not the best way to proceed. A more effective approach would be to make senior, highly compensated officers of the bank pay some portion of the fine.
The Congressional hearing addressed the fact that a penalty assessed against an entity is effectively paid by its shareholders. The shareholders neither caused the behavior that led to the fine nor were they responsible for preventing it. By contrast, the Citigroup officers who were responsible do not bear a significant portion of the penalty, except to the extent they are shareholders or their bonuses are tied to earnings, now reduced by the penalty. They thus have little incentive to change their behavior.
To change that incentive, all of a bank’s most highly compensated officers — those making more than $1 million a year — should be personally and collectively liable for paying a significant portion (perhaps 50 percent) of S.E.C. fines levied against their bank, a liability that could not be waived by the commission. Officers should be liable for an amount in proportion to the size of their compensation that year.
We need to prevent banks from avoiding settlements in order to dodge this personal liability. Indeed, independent directors should supervise the negotiations of, and approve the terms and entry into, settlements. Independence should be judged not just by looking at familial and business relationships, but also by looking at the real-world ties between board members and officers. Moreover, if the case was litigated rather than settled, the officers should be personally and collectively responsible for a portion of the bank’s legal bills incurred in the litigation. And banks should be prohibited from reimbursing officers for the amounts the officers paid in connection with any settlement or litigation, and from increasing their pay for the two years thereafter.
The idea of personal liability for bank executives is not as novel as it might seem. Before the 1980s, many investment banks were organized as general partnerships, with each partner’s capital tied up in the partnership and each partner personally liable for debts the partnership incurred. Any loss to the partnership – including a fine imposed by a regulator – was borne by the entire partnership in proportion to each partner’s share in the firm.
When there was a loss, the most highly paid and most powerful partners suffered the most. There were no outside shareholders to absorb fines and other costs of the partners’ wrongdoing. The partners enjoyed the fruits of their labors, but they also paid for their mistakes.
In the period between enactment of the federal securities laws in the 1930s and the 1980s, when many of the investment banking partnerships became public companies with shareholders, wrongdoing in the industry was probably less frequent and certainly of smaller magnitude than it is today. The partnership model of investment banking thus helped prevent excessive economic and legal risk-taking —risk-taking that led to the Great Recession.
While it is not realistic to require investment banks to become general partnerships, bankers should be subject to some personal liability, as they would have been had they been partners. We have already suggested imposing on the most highly paid investment bankers some measure of personal liability for the debts of their firms in the case of insolvency – although stopping short of full joint and several liability. We suggest making these same bankers pay a portion of any fine imposed on their bank for alleged misconduct, whether or not the bank admits to wrongdoing.
Some might object that imposing personal liability for a firm’s debts would curtail risk-taking. Indeed it would, but this is an advantage of personal liability, not an objection. We need less risk-taking in investment banking these days, not more, whether the risks at issue are legal, those involving the solvency of financial institutions or, as is often the case, both. Bankers will continue to take big risks as long as the benefit they get from doing so is far higher than the costs they may incur. We need to increase the personal costs to bankers of unreasonable risk-taking; personal liability is the way to do it.
Regulatory solutions too often focus on institutions. Regulators, and the private sector, should be thinking more about individuals. Senior bankers make a great deal of money; they can do a great deal of good, but their actions also can cause enormous harm. We need to focus our attention on how to make bankers be more mindful of the consequences of their actions.