1. Gresham’s Law. Centuries ago, Gresham observed that bad money drives out good. He was commenting on currency debasement, but his principle applies to many other human endeavors. For instance, banks that aggressively exploited regulatory capital rules had lower capital costs, and could, and did, use their lower capital costs to drive out competitors who were not as aggressive. Bad banks drove out the good. This perverse result is more common than most would think; regulations designed to thwart bad conduct end up encouraging it. This seems to be an unavoidable failing of any top-down, one-size-fits-all regulatory structure.

     2. Prince’s Law. Just before the bubble burst, former Citigroup CEO Charles Prince memorably observed, “As long as the music playing, you’ve got to get up and dance. We’re still dancing.” Prince was widely criticized for saying this, but I wonder how many of his critics could have, in the midst of one of the greatest credit expansions in history, shut down lending, closed departments, fired employees and put a “gone fishin’” sign on the window. Inertia is one of the most powerful forces in the universe, stoppable only by an equal and opposite force. Too often the equal and opposite force that stops the dancing also crushes the dancers.

     3. Summers’ Law. Larry Summers once wrote a paper criticizing the efficient market hypothesis. Its first lines were: “THERE ARE IDIOTS. Look around.” I start by looking in the mirror. When we try to fix past problems with new regulatory structures that depend, at their center, on the wisdom of regulators, I have to wonder why we think this time it will be different. We seem to think there “were” idiots, when in fact there “are” idiots, something we will prove again, and again, as much to our regret we learn, and re-learn the essential truth in Summers’ Law.

Sure, we may be losing the OCC, OTS and PWG, but with the addition of the CFPA, FCCC, FSOC, NBS and ONI the acronym count will just keep growing.

You can’t tell these all cap players without a scorecard, so to help guide you through the alphabet soup I’ve prepared this Financial Reform Glossary. It deciphers over 75 of the acronyms and other cryptic terms used in the white paper. I hope it injects a little transparency into this process.

Financial Reform Glossary

I get the sense that a lot of us have in mind a Platonic ideal form of corporate governance against which we measure individual companies, sorting those deviating the least from the ideal into the “good” category and those deviating the most into the “bad” category.

But is there one Platonic ideal form of governance for all companies?

I think most would agree that the ideal governance for private companies is not the same as the ideal governance for public companies. That one’s easy.

Many would agree that the ideal governance at a distressed or failing company differs from other companies, as distressed and failing companies are usually being run for the benefit of, and/or under contractual restrictions imposed by, their creditors.

I expect that most would agree that the ideal governance for a public company controlled by a large shareholder differs from the ideal governance for a company with more widely dispersed voting power, if for no other reason than the ownership/management agency problem is less acute (or, if you prefer, different) at a controlled company.

Many companies are run for the long-term, but not all. Those that are being run for a quick sale, such as PE- or VC-backed portfolio companies, probably have a different ideal governance.

I would suggest that the ideal governance at companies in mature industries differs from the ideal governance at companies in immature industries, if for no other reason than management entrenchment is most likely to be a concern when the company itself is entrenched.

Similarly, I have a sense that slow-and-steady companies with strong economics may be better served by a democratic style of governance while volatile companies with high risk/reward opportunities may be better served by an autocratic dictatorship style of governance. In the latter case we may need the strong leadership of a visionary CEO to lead us into the promised land, while in the former case we’ve already arrived and just want to be sure the CEO doesn’t screw it up. The Great Man/Great Ham divide, if you prefer.

So, when we say a company’s governance is good or bad, we should also have to say which of the many Platonic ideal forms of governance we are measuring the company against.

Next month we will take up a broad package of corporate disclosure improvements, all designed to provide shareholders with important information about their company’s key policies, procedures and practices, including compensation policies and incentive arrangements…. Also, shareholders should understand how compensation structures and practices drive an executive’s risk-taking. The Commission will be considering whether greater disclosure is needed about how a company — and the company’s board in particular — manages risks, both generally and in the context of compensation. The Commission will also consider whether greater disclosure is needed about a company’s overall compensation approach, beyond decisions with respect only to the highest paid officers….

Initial thoughts:

   1. Will anyone read these disclosures (other than the corporate lawyers who have to draft them)? I can’t imagine an investor making a buy or sell decision based a company’s “overall compensation approach” for lower-level employees. While the SEC’s last attempt at a Katie Couric rule was deeply flawed, and rightly axed, its main appeal was that it would satisfy our prurient desire to see what Katie Couric makes. Here the SEC would strip out the fun part and leave us with the same pointless disclosure.

   2. This disclosure seems tailor-made for our recently-failed financial companies, where compensation is the largest single expense and employees were encouraged to bet trillions of borrowed dollars on impulsive hopes and prayers. The problem is these companies have already failed. And the few that haven’t have surely gotten the message by now that a heads-you-win, tails-we-lose compensation philosophy isn’t going to cut it these days. But in an uncertain world, nothing feels better than fighting the last war.

   3. The magnitude of the recent destruction of our financial system seems to have blinded some of us to the reality that most of our companies aren’t thinly-disguised casinos. Compensation and risk are not that closely related at these companies because these companies don’t pay their employees enough to make a difference. And those employees don’t ever bet trillions of borrowed dollars on impulsive hopes and prayers. Those companies worry about unsexy stuff like raw material pricing, distribution deals, technology licensing and the like. To understand risk at these companies, read their MD&A’s instead of their CD&A’s.

   4. Is there any problem that can’t be solved by more disclosure? But as our documents get thicker, I’m wondering whether we’re at the point yet where there’s a declining marginal utility for each additional disclosure. Investors can only absorb so much before they toss the document aside and return to day-trading index funds. Perhaps the answer is to require the SEC to subtract a disclosure requirement for each new one it adds.

During Cox’s tenure, penalties imposed on companies fell 84 percent, from $1.59 billion in 2005 to $256 million in 2008.

Speaks for itself, doesn’t it? The Washington Post seems to think so, printing the above sentence without further explanation.

But I wonder.

Was the level of culpable conduct similar in 2005 and 2008? If so, the drop in fines may be interesting. If not, the drop in fines is not interesting.

Which was a more “normal” year for fines: 2005 or 2008? 2005 was the year the SEC booked $765 million in fines in connection with Adelphia – two of its largest fines ever – so perhaps the 2005 total is a bit of an outlier. Or is a year without an Adelphia the outlier?

Did the number of enforcement actions also drop? According to a recent GAO report, 272 formal orders of investigation were initiated in 2005. Although this dropped to 233 in 2008, the 14% difference does not come close to explaining the 84% drop in fines.

What probably does explain the drop in fines, and what is mentioned only in passing in the Post article, is the enforcement policy the SEC formalized in 2006 of not double-penalizing shareholders. The policy recognizes that when a company’s action is wrong because it harms the company’s shareholders, there is little point in penalizing the company with fines because those fines just penalize the shareholders. It makes more sense to penalize the individuals involved and/or require corrective procedures at the company to prevent future harm to shareholders.

But then penalizing individuals and implementing corrective actions won’t boost fine totals, disappointing those keeping score by that metric.

The trend has already been to move away from staggered boards: Shearman & Sterling’s 2008 corporate governance survey showed that only 27 of the 100 largest U.S. public companies had classified boards.

When a company eliminates its staggered board, one consequence is that it reduces the effectiveness of its poison pill. This is because pills give power to the board, but this power only lasts until the board is replaced. At a company with a classified board, replacing the board requires at least two annual meetings – an eternity in M&A land – but at a company without a classified board this can happen at the next annual meeting.

So, if a classified board gives a pill its teeth, a pill without a classified board is defanged.

Not surprisingly, with fewer classified boards, we’re also seeing fewer pills. Shearman & Sterling’s survey found that the trend away from poison pills is even more pronounced than the trend away from classified boards, with only 12 of the 100 largest public companies having pills in 2008.

Some of these companies may have pulled their pills thinking that if they ever got put in play, they could always adopt a new pill. But if that company also declassified its board, its “morning after pill” would be of limited use. The company would have to reclassify its board in order to give its pill teeth, something that would require shareholder approval or, if Schumer’s bill passes, be illegal.

Some have detected a recent resurgence in the popularity of poison pills, but this trend would presumably be squashed by a ban on classified boards.

So when thinking through the classified board ban, we also need to consider that it’s an antidote to poison pills. To some this is a feature, to others a bug.

After reviewing Matthew Butterick’s wonderful Typography for Lawyers website, which shows just how easy it is to make our words look great, I found myself wishing our agreements looked better and wondering why they didn’t.

Why do so many corporate lawyers still use typewriter fonts? Why do the rest of us settle for Times New Roman? Why do we fully justify everything? Does any word really need to be bold, italic and underlined? And what’s with all those bold all-caps paragraphs?

In short, why do our agreements look like crap?

Butterick is a litigator, and his website is oriented towards litigators, so to explain the persistent crappiness of corporate documents I had to look inward. It wasn’t a pretty sight. Here are a few explanations:

   1.  Weakest link formatting. Unlike litigators, our documents are collaborative, each side adding its own edits along the way. As a result, our typography ends up being determined by the weakest link in the working group. If you serve up a first draft with good formatting, someone down the line will surely muck it up. Who has time fix it? And if someone serves up a first draft with bad formatting, those of us with a little design sense will ignore it, preferring to spend our deal capital fighting over more substantive issues. So, in the end, after going back and forth a few times, our documents tend to acquire a lowest-common denominator look.

   2.  The joy of impenetrability. Good typography makes a document easier to read, but sometimes we don’t want to make our documents easier to read. Litigators need a judge to read their brief and find it so convincing he rules in their favor. We just need someone to sign. So if an agreement is a chore to read, maybe, we think, the other side will just skip to the end and sign. Or if they insist on plowing through the whole thing, maybe their eyes will glaze over and their addled brain will miss some issues. Now I doubt bad typography has ever actually helped anyone this way – if anything, it’s only made others suspicious and facilitated later misunderstandings – but this sort of wishful thinking may explain why we put our most important paragraphs in all-caps bold-face type, thereby making them nearly impossible to read.

   3.  Blame it on EDGAR.  Many of us spent our formative years mired in EDGAR documents. Long after the rest of world moved to fancier formatting, EDGAR still hewed to its retro ASCII lineage, serving as perhaps the last bastion of the typewriter font. This arrested the typographical development of an entire generation of corporate lawyers, and we are living with the consequences.

   4.  White shirts, grey suits. Look around any gathering of corporate lawyers, and what you do see? A sea of white shirts and dark gray suits. If your idea of flash is a pinstripe, or a yellow tie, I can’t see your documents moving beyond the boring familiarity of Times New Roman. 

Notwithstanding the foregoing, I still wish our documents were easier on the eye, and I think we could all benefit from Mr. Butterick’s typography tutelage. His advice is concise, comprehensive and fun to read (“Don’t use Bookman unless you want your brief to look like it was printed during the Ford administration. If fonts were clothing, this would be the corduroy suit.”), so please, for all our sakes, give him a read.

to enact compensation policies that are linked to the long-term profitability of their institutions, … and most importantly, to prioritize the long-term health of their firms and their shareholders….

This focus on the long-term is common and uncontroversial. Even Marty Lipton, who with two co-authors recently wrote a memo that disagrees strenuously with pretty much everything in Senator Schumer’s bill, emphatically agrees with Senator Schumer on the importance of the long-term:

Short-termism is a disease that infects American business and distorts management and boardroom judgment.

Senator Schumer’s bill blames management and boards for this short-termism, while Lipton blames shareholders for it, but each agrees that the short-term is the wrong term.

I don’t agree. Sure, sometimes the short-term is the wrong time-frame, but other times the short-term is exactly the right time-frame. It all depends on the context.

For an investor, a long-term buy-and-hold strategy makes a lot of sense while markets are rising, but it looks a lot less attractive in declining markets. A lot of investors today now wish they’d been infected with a severe case of short-termitis last fall.

Similarly, a company may rationally believe that pursuing a ten year plan will maximize its value, but if someone then comes along and makes a better offer, all of a sudden that same company may rationally prefer a short-term strategy.

So why does long-term get all the glory?

I expect Senator Schumer’s real concern is preventing game-playing in executive compensation, with executives taking bonuses based on short-term results and leaving shareholders with long-term losses. This game can only be played when a company’s compensation incentives do not further its goals. A well-designed compensation system prevents this game-playing by ensuring that management’s incentives are aligned with the company’s goals, whether they be long-term goals or short-term goals (or, at many companies, a combination of both).

And I expect Lipton’s real concern is to protect managers from shareholders. Lipton generalizes that shareholders are short-term in their outlook and that management is long-term (their jobs need preserving, after all), so his demonization of the short-term is neither surprising nor, unless you are a manager in need of Lipton’s entrenchment services, persuasive.

Yellow Kid Weil was a con man, famous for saying he promised something for nothing and delivered nothing for something. As detailed in his fascinating book Con Man: The Autobiography, around 1900 Weil and a partner took out a series of ads in newspapers across the country that simply said: “A Little Story of a Big Success – How $100 Makes $1,000.”

To the many that responded, Weil sent a brochure explaining that because he and his partner owned many race horses, they had an insider’s betting edge:

The brochure further explained how we, as the owners of the most consistent winners, were in better position than anybody else to know just when these horses would win and what the odds would be. We proposed that the investor send us a hundred dollars to open an account. We would place bets for him on sure winners, using all or any part of his money.…

In those days $100 was a lot of money and we hardly expected to find so many who had that much with which to speculate. But soon our mail was overwhelming. Remittances for $100 poured in. We had to take more space and enlarge our quarters.

Dangling the promise of inside tips to take betting money was a standard con at the time, one that Weil himself seems to have done quite a bit. This con was different. What set it apart from the rest was what he did with all the money that rolled in:

Here is the way we worked. We would put Mr. Smith (who had an account of $100 with us) down on a ten dollar bet on a horse that had won. As soon as we knew the horse had won, we mailed the report to Mr. Smith….

We kept Mr. Smith’s account for a month. At the end of the month, we sent him a remittance for $125, with this explanation:

“We are returning your original investment plus the earnings. We regret that the volume of our business makes it impossible to handle such small accounts.”

We did the same thing to every account. Our letters only whetted the investor’s appetite. If he had more money, he immediately wrote in to ask how much he would have to invest to have us handle his account. We replied that we could handle nothing under $500. The response to this was so great that we soon raised the minimum to $1,000. We had a few inquiries about taking larger investments — $5,000 or more.…

Actually what we were doing was paying dividends on old accounts from the monies we received from new accounts — borrowing from Peter to pay Paul.

Weil claims this con netted an annual income of $480,000 before its inevitable crash.

Years ago when I first read Yellow Kid my two recurring thoughts were (1) he’s exaggerating (he is a con man, after all), and (2) if he isn’t exaggerating, people in the old days were much more naive than people today.

Reading Yellow Kid now, I have to admit my initial assessments were most likely unfair to Yellow Kid and to people in the old days.

a panegyric welcoming … the new director of the Institute; long sections of annual reports of the Institute; polemical memoranda concerning such matters as the scope of compulsory insurance for building trades, the fixing of insurance premiums, and the inclusion of private automobiles in the category of enterprises that require insurance; his well-known paper on preventing accidents in the use of wood-planing machinery; memoranda in a couple of interminable contested cases; the jubilee report for the twenty-fifth anniversary of the Institute; and appeals for the creation of a public psychiatric hospital in wartime Bohemia and aid to disabled veterans.

I’m a fan of Kafka’s fiction, and I’m a corporate lawyer, but even I can’t muster up any enthusiasm for reading his office papers. Not even his “well-known paper on preventing accidents in the use of wood-planing machinery.” It all seems deadly dull.

Then again, I am the guy who thought the world would be interested in the use of “as amended” in statutory citations and the proper pronunciation of “comptroller,” so who am I to turn up my nose?