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Final paper for Banking and Financial Institutions Law class. Topic: stakeholder fiduciary duties
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Table of Contents
INTRODUCTION .................................................................................................................................. 3
PART I – THE SIGNAL IN THE NOISE & THE DANGERS OF MISTAKING THE
LATTER FOR THE FORMER ........................................................................................................... 3
A. The “Signal” and the “Noise” ................................................................................................. 4
B. Finding the Signal in the Noise ................................................................................................ 6
Part II – The Antifragile Mindset .......................................................................................................... 9
A. Antifragility explained ................................................................................................................ 9 B. Using antifragility with respect to financial institutions ................................................... 12
PART III – THE ISSUES WITH CURRENT PRACTICES AFFECTING BANKING AND POLICY PRESCRIPTIONS TO ADDRESS THEM ......................................................... 13
A. The causes of the problem(s) within the banking industry .............................................. 13 B. How these issues are affecting the banking industry ........................................................ 16
C. What has been done to address these issues ....................................................................... 18
D. Why these approaches have failed ......................................................................................... 19
E. A new approach to the problem .............................................................................................. 23
F. Unintended consequences of adopting this new approach .............................................. 26
CONCLUSION ...................................................................................................................................... 27
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INTRODUCTION
The 2008 financial crisis highlighted an enormous problem with the way the United States does
business. Namely, it exposed flaws and bad assumptions in the business practices of the largest
financial institutions the world has ever seen in the form of the idea that perpetual growth is a desirable
goal and should be pursued above all other considerations. Although it is impossible to tell what
motivates board directors in individual decision-making, there are a number of laws which currently
not only do little to curb irresponsible practices; but many actually even encourage said irresponsible
behavior. As such, there are no laws in U.S. which set out a fiduciary duty to stakeholders. However,
when considering all of the effects a business has on society, the notion of requiring such a fiduciary
duty begins to seem less and less far-fetched.
Part I of this paper provides a brief overview of Nate Silver’s book, The Signal and the Noise, and
demonstrates how to apply the principles of analyzing predictive models to the financial industry. Part
II of this paper then addresses the issue of how to identify practices that are more beneficial to others
before describing potential applications in banking. Finally, Part III of this paper will conclude by
using the lessons from Parts I & II in examining the current financial situation, what has been done
to address it, why it has not worked, and alternative policy prescriptions to address the issues currently
being faced.
PART I – THE SIGNAL IN THE NOISE & THE DANGERS OF MISTAKING THE
LATTER FOR THE FORMER
“It’s exactly when we think we have overcome the flaws in our judgment that something as powerful as the
American economy can be brought to a screeching halt.”
~Nate Silver, The Signal and the Noise
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A. The “Signal” and the “Noise”
When it comes to many of the decisions being made in the financial market – especially
investments – many of these decisions are based on predictive models derived from statistics and
financial principles.1 In his book, The Signal and the Noise – Why So Many Predictions Fail, But Some Don’t,
author Nate Silver makes the case that while many forecasters attempt to make precise predictive
models for investors to follow, the precision of these models does not necessarily guarantee their
accuracy with respect to real-world effects.2 Mr. Silver describes this distinction through using shooting
a gun at a target: you can have a tight shot grouping that is precise; but if you do not hit the bulls-eye,
then your shots still lacked accuracy and missed the mark. The reasoning for these mistakes, Silver
posits, is due to an overflow of information – or “noise” – which enables forecasting experts to
represent with an illusion of confidence that something is certain (accurate) through the presentation
of neat and clean (precise) data.3
Instead, he argues that the most preferable model for predictions is one that is both accurate and
precise.4 Finding data which is both accurate and precise can be difficult, but not impossible. Perhaps
the easiest way to identify information that can be considered the “signal” over the “noise” requires
first an understanding of what exactly is noise. As Silver points out, life is a complex, unpredictable
system and anything that occurs in life is subject to unforeseen consequences suddenly changing
everything.5 The biggest flaw, he points out, is that our predictions often fail when we venture “out
of sample” from what they are designed to predict. For instance, up until the ambush at Pearl Harbor,
the fact that the United States was rarely attacked was taken as an indicator that an attack on the U.S.
1 Silver, Nate. The Signal and the Noise – Why So Many Predictions Fail, but Some Don’t, pages 19-25, The Penguin Press (2012). 2 Id. at 21. 3 Id. at 33. 4 Id. at 46. 5 Id. 419-420.
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was unlikely. Leaders were familiar with this empirical observation, yet regarded it as a concrete law
that will continue to be played out without taking the reality of Japan’s war-time situation and Hawaii’s
location in the Pacific Ocean into account. Therefore, when the U.S. was eventually attacked at Pearl
Harbor, it was ill-prepared due to this widespread assumption and the results were disastrous.6
Similarly, Silver cites the Housing Crisis of 2008 involving the massive over-leveraging by the
financial industry in the mortgage backed securities market.7 Mortgage backed securities were
purported to be safe investments because it created a pool of mortgages that was so large, that the
effective default risk rate was mathematically less than a percentage point in some instances.8 Financial
institutions began to increase operations more and more in this industry as the perceived growth in
the housing industry continued for several decades. Some companies, like Lehman Brothers, were
leveraged up to $1 in capital for every $33 in financial instruments it held (mostly mortgage backed
securities). Before the Crisis, this was viewed as sound investing as these MBS’s had received triple-A
ratings from the rating agency Standard and Poor’s. However, as Silver points out, if Lehman Brothers
experienced just a 3-4 percent decline in its portfolio, then it could potentially face bankruptcy.9
Lehman Brothers’s excessive leveraging in the mortgage backed securities market indicates that its
managers assumed the market would always be there because it had (recently) historically operated
very profitably in this way and these investments had received an almost-perfect rating. But, when the
weakness of the MBS system revealed itself and the bubble finally burst in 2008, this assumption cost
Lehman, causing the investment firm to be brought to its knees and eventually fold.
6 Id. 7 Id. 33-36 8 Id. 9 Id. at 35. (Silver details at-length in his book the exact technical details as to why this rating was mathematically flawed. The short answer is that the ratings did not account for the effect defaults from higher-risk mortgages would have on other MBS’s in these security pools and their default rates.)
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In short, the noise is that data which is irrelevant to making an accurate and precise prediction. As
shown above, this data is usually based on empirical evidence and has a measure of certainty to it that
makes it an attractive option to rely on. However, it must be understood that this data is generally
based on the faulty assumption that what is true now will continue to be true in the future. As such,
the “signal” is that kind and quality of data which offers predictions that reflect the natural
uncertainties of life.10
B. Finding the Signal in the Noise
In order to achieve accurate and precise predictions, Mr. Silver argues that a certain mindset is
necessary to avoid the pitfalls of mistaking one for the other and instead looking for both. First, he
highlights society’s flawed over-reliance on “expert” predictions through the research of Dr. Philip
Tetlock, a professor of psychology and political science at the University of Pennsylvania, for his work
on the accuracy of expert predictions in everything spanning geo-political affairs, the Japanese real-
estate bubble, and almost every other major event spanning the 1980s-1990s. When his research
concluded, Dr. Tetlock’s conclusion was damning against such expert predictions: on the whole they
tended to be no better than random chance.11
However, while the experts’ performance was poor in the aggregate, Tetlock also found that some
had done better than others and the relationship between accuracy of predictions had a negative
correlation with the amount of exposure the expert received from the media.12 Silver reports that
Tetlock’s work in psychology led him to have a natural curiosity as to the cognitive differences in the
more-accurate experts. What Tetlock was able to achieve was to classify the experts on a spectrum
between what he called “foxes” and “hedgehogs.” Those who were most accurate were described as
10 Id. at 46. 11 Id. at 52. 12 Id. at 53.
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“foxes” for their ability to be scrappy and take a plethora of little ideas from a multitude of approaches
to solve a problem and shift approaches when new information presents itself. Conversely,
“hedgehogs” were the least accurate and consisted of type “A” personalities who believed in big ideas
that govern every single interaction in the world and will generally reject any information counter to
these views – and they also garnered the most headlines.
Nate Silver adopts the fox approach in his forecasting and has subsequently achieved much
acclaim for the accuracy in his predictions.13 He narrows this approach down to three principles and
some additional considerations in order to readily identify the signal in the noise. The first principle
requires that one think probabilistically when making predictions.14 This means that all predictions
must include a range of possibilities and should, at all costs, avoid seeking a concrete and definite
outcome. The second principle is a reminder that today’s forecast is the first forecast of many.15 As
silver puts it, “[a]nother misconception is that a good prediction shouldn’t change.”16 This is incorrect,
as changing circumstances will necessarily change the validity of a prediction and one should therefore
not hesitate to revise predictions based on changing circumstances. Finally, the third principle Silver
identifies is to look for consensus in predictions, as they tend to be between 15-20 percent more
accurate than individual predictions.17 However, Silver is quick to point out that this does not
necessarily mean that the group consensus is necessarily accurate and the point is to apply multiple
perspectives to the same problem instead of treating any one piece of evidence as if it were the Holy
Grail.
13 Id. 59-60. 14 Id. at 61. 15 Id. at 65. 16 Id. 17 Id. at 66.
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In line with Silver’s third principle, the first consideration in applying his approach is to be wary
of magic-bullet forecasts – especially those that purport to use simplicity to predict complex systems,
like the finance industry.18 They are often inaccurate and only serve to play to sensationalist media that
sells headlines, while neglecting the fundamental principles of uncertainty and randomness. Finally,
Silver advises to weigh qualitative information in its broader context.19 This means that not only should
predictions be considered in the sphere of the current data directly affecting them, but also the other
related data which can affect the prediction. For instance, one should not rely exclusively on the
growth projections for the housing market as an accurate predictor of the future, but also that other
data should be considered, such as the relative amount of debt one incurs to get said housing, the type
of mortgage used, and whether or not this information is also outpacing average income for these
individuals.
Ultimately, The Signal and the Noise offers a solid foundation by which to evaluate predictions that
helps root out the unsupported assumptions predictions in the financial industry (and really all events
in life) are based on. In the case of the financial industry, there are numerous assumptions about the
efficacy of growth only, shareholder value-maximizing approaches which have been systematically
building up a bubble-burst cycle on a scale that is becoming unsustainable for society. However, before
these issues are addressed, it would first be helpful to examine exactly what systems in nature tend to
yield the best overall results.
18 Id. at 67. 19 Id. at 68.
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PART II – THE ANTIFRAGILE MINDSET
“Wind extinguishes a candle and energizes fire. Likewise, with randomness, uncertainty, chaos: you want to
use them, not hide from them. You want to be the fire and wish for the wind.”
~Nassim Taleb, Antifragile
A. Antifragility explained
In his book, Antifragile – Things That Gain from Disorder, author Nassim Taleb describes how
most everything in life can be described as fitting into three categories: (1) those things that are fragile;
(2) things which are resilient/robust; and (3) the often overlooked things that typically gain strength
or improve when subject to stress.20 Each category has its own distinct characteristics, and changing
circumstances can affect whether or not something fits into a particular category. The reference point
by which Taleb measures whether something is fragile, resilient, or antifragile depends on its ability to
survive and respond to stressors.
1. Those things that are fragile
Imagine a small glass statue of a giraffe. While it is likely beautiful and expertly made to fit that
particular purpose, it would not last long if subjected to a blow from a hammer. This is an example of
extreme fragility: although the glass giraffe is fit for a particular purpose in looking night, the slightest
trauma will shatter it. In Antifragile, Taleb uses a package marked as “fragile” as an example to
demonstrate the full-range of consequences if unforeseen trauma hits the package: at best, the package
will be unharmed, and at worst it will be completely ruined. However, it is more likely than not that
the package will incur some sort of damage due to its fragility.21
20 Taleb, Nassim N. Antifragile – Things That Gain From Disorder, pages 33-35, Random House New York (2012). 21 Id. at 33.
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With regard to what Nassim Taleb describes as the “Modernity” mindset,22 he posits that we as a
society have become absolutely obsessed with increasing the predictability of events and completely
eliminating the natural stressors in artificial processes which might cause us trauma to society, such as
attempting to completely eliminate economic busts. Taleb asserts that the systematic removal of these
checks on growth has actually served the opposite goal of making society stronger because it enables
behavior which would otherwise be eliminated or improved upon early on through normal downturns
in growth to grow to such a size that when a big unanticipated “Black Swan” event occurs, it brings
the entire system crashing down around it.23 He describes this effect by stating that it essentially is a
“whale attempting to fly like an eagle.”24
2. Things which are resilient/robust
With regard to resilient/robust systems, Taleb again turns to his package analogy and describes
such systems as things which are inherently fragile by themselves, but when combined with the right
insulation or in sufficient quantity which can, at worst, resist trauma and come out relatively unharmed,
and at best remain unharmed.25 However, these systems never truly adjust to trauma by and large
because of their size, and in fact become fragile again when a Black Swan event comes along that
completely changes the circumstances which supported the robust system in the first place. For
example, if one were to only lift weights so that one particular muscle group were targeted, it may be
great for that individual set of muscles and they will grow quite large from the work – but when some
other activity is required that engages other muscle groups, the built-up muscle is so strong that it can
often injure the unworked and atrophied muscles.
22 Id. at 81. 23 Id. at 116. 24 Id. 25 Id. at 33.
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As hinted at above, the Taleb believes that the modern mindset of insulating institutions from
harm through enabling unbridled growth and then protecting these institutions against harm has
created a system that is resilient, but ultimately will become fragile because it does not suffer from the
small stressors to force adjustments to changing circumstances.26 He argues that it is our attempts to
predict small trauma in society and systematically eliminate it, in effect suffers from the same problem
as only working out one area of muscles: everything else that supports it will atrophy and become
susceptible to the slightest unanticipated trauma.27
3. Things that typically gain strength or improve when subject to stress
Finally, Taleb describes a third, often-overlooked system which is neither fragile, nor robust, but
rather gains strength, and at worst is unharmed, when subjected to stressors.28 Antifragile systems are
modeled after life and are complex by their very nature. The system is robust enough to not be
completely eliminated by normal stressors, but also built in such a way that the system will improve
from the trauma through allowing small changes that can then make the overall system strong enough
to withstand the occasional Black Swan event.29
Again, utilizing the muscle analogy, Taleb finds that when worked out properly, muscles (and
other biological processes) are the perfect examples of antifragility. Small tears gained through working
out cause the muscle to grow bigger, and by working out all of the muscle groups, the overall system
becomes much stronger because it overshoots in response to the trauma and is then able to resist
greater trauma then it was just subjected to.30 Taleb uses this example to point out one of the stark
contrasts between human behaviors in artificial economic systems vs. antifragile biology: humans tend
26 Id. at 112. 27 Id. at 115. 28 Id. at 32. 29 30 Id. at 44.
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to measure trauma based on the worst in memory, implicitly assuming that is as bad as things can get
and attempt to fix the issue using the bare minimum necessary based on this measurement, whereas
nature by default always responds as if things will get worse and overcompensates.31
B. Using antifragility in financial institutions
In developing an antifragile system, it is important to note that it requires developing a certain
comfort with uncertainty – especially that of the boom-bust cycle. It is through these uncertainties
that unanticipated results manifest and cause us to innovate in new directions in response. However,
as Taleb notes, it is crucial to avoid placing on that system so much insulation from harm that things
which are actually quite fragile end up dominating the landscape.32 Conversely, Taleb also advocates
that simply allowing the trauma to happen laissez faire is also not preferable because the whole goal of
becoming antifragile is being robust enough to not crumble under some pressure, while being nimble
enough to adjust to the lessons learned from the stressor.33
When it comes to financial institutions, Taleb points out two main causes that reduce antifragility
and increase fragility: excessive indebtedness and over-intervention. The first notion, excessive
indebtedness reduces antifragility because it causes growth which is not sustainable in the long-run.
For instance, using mortgage backed securities and other financial innovations based on debt to
increase a bank’s portfolio in much the same manner that Lehman Brothers engaged in. While it may
cause astounding growth in the short-term, the growth is founded on as-of-yet non-existent assets via
debt, and it ultimately will reach a logical conclusion of being unsustainable if over-leveraging occurs.
Engaging in excessive indebtedness in turn leads to over-intervention once the flaws in the system
fully expose themselves. For instance, when the financial crisis of 2008 hit, the immediate knee-jerk
31 Id. 32 Id 286-287. 33 Id. 119-120.
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reaction was to prevent any financial institution deemed systemically crucial from failing, and the U.S.
government spent trillions attempting to avoid defaults from the largest financial institutions, which
had little effect in fixing the problem and only increased the taxpayer debt load further.34
PART III – THE ISSUES WITH CURRENT PRACTICES AFFECTING BANKING AND
POLICY PRESCRIPTIONS TO ADDRESS THEM
A. The cause(s) of the problems in the banking industry
As Taleb points out in Antifragile, one of our quintessential problems inherent in the way large
financial institutions (and virtually all other human-created systems) operate today is that we have
created robust systems which have become massively fragile because they are based on a bad
assumption: that growth is or should be the only goal, and that growth is always possible. But who
controls this goal? What individual or group of individuals controls the direction of a financial
institution? This entity is the Board of Directors. They decide policy and direct a CEO, CFO, COO,
and the like to act on those policies.
With the directors determining the overall direction the institution takes, the question then is what
controls the Board’s decision making? While it would be impossible to peer into the heads of every
Board member and see their exact thoughts, and such individual motivations would surely vary from
person to person, there are concrete standards which set out the “rules of the game” so to speak, that
all companies must play by. When it comes to director decision making, there are laws and case
decisions in various jurisdictions that offer guidance to directors on the courses of action they may
take.
34 Id. at 115.
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All board members of incorporated financial institutions owe a fiduciary duty of care and duty of
loyalty – which also includes a duty of good faith – to their corporations.35 Furthermore, in addition
to fiduciary duties to the corporation itself, board members owe the same fiduciary duties to
shareholders of the corporation.36 These duties also extend to corporate managers who are directed
by the board of directors.37
The duty of care requires directors to make business decisions based on all available and material
information, and to act in a deliberate informed manner.38 This means that the board must first act in
good faith for the company’s best interests. Furthermore, they must believe that the actions promote
the best interest of the company based on a reasonable investigation of the options available.39
Similarly, the duty of loyalty mandates that the board of directors owe an affirmative duty to
protect the interests of the corporation, and also to refrain from conduct which would injure the
corporation and its shareholders.40 Essentially, this duty calls for a conflict-free allegiance to the
corporation’s best interests and to put them above self-interest in all related conduct. As such, the
duty of good faith, a subset of the duty of loyalty, specifically calls for directors to refrain from self-
dealing through using one’s position as a director for personal profit at the expense of the company.41
Again, the corporate director and manager owe these duties to both the corporation and to
shareholders. In North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, the
35 In re Walt Disney Co. Deriv. Litig., 907 A.2D 693, 753-57 (Del. Ch. 2005) (identifying corporate fiduciary duties, including possibility of duty of good faith), aff’d, 906 A.2D 693 (Del. 2006) (upholding the decision of the lower court creating the duty of good faith). 36 Kenneth M. Rosen, Meador Lecture Series 2005-2006: Fiduciaries, 58 Ala. L. Rev., 1041 (2007). 37 Michael Follett, “Note: Gantler V. Stephens: Big Epiphany or Big Failure? A look at the current state of officers’ fiduciary duties and advice for potential protection,” 35 Del. J. Corp. L., 563 (2010). 38 Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984). 39 Id. 40 Ivanhoe Partners v. Newmont Mining Corp., 535 A.2d 1334, 1345 (Del. 1987). 41 Volkmer, Ronald R. 1992. "Breach of Fiduicary Duty for Self-Dealing." Estate Planning 19 (September–October).
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Delaware Supreme Court described the duties of directors to shareholders: “It is well established that
the directors owe their fiduciary obligations to the corporation and its shareholders.”42 However, what
happens when these two fiduciary duties are at odds with each other? Although none of the following
cases contain examples of financial institutions, they tend to be the most frequently cited authorities
when describing a director’s fiduciary duties in various contexts.
In Dodge v. Ford Motor Co., the Michigan Supreme Court held that a business corporation is
organized primarily for the stockholders, as opposed to the community or its employees.43 The
discretion of directors is to be exercised in the choice of means to attain that end, and does not extend
to the reduction of profits or the non-distribution of profits among stockholders in order to benefit
the public, making the profits of the stockholders incidental thereto.44
Similarly, in Revlon, Inc. v. MacAndrews & Forbes Holding, Inc.45, the Delaware Supreme Court held
that when a takeover is inevitable, the directors’ principal duty is to achieve the best price for the
shareholder. In Revlon, the directors acting as representatives of Revlon, Inc., appealed a decision by
the lower court to enjoin an option granted by Revlon to Forstmann Little & Co. This offer was
created to avoid a takeover by Pantry Pride, Inc., who were effectively frozen out of bidding for
control of the company because of their desire to liquidate the company when Revlon went to
Forstmann, added $10 to Pantry Pride’s offer, and sold the company without any other bidder being
given the opportunity for further bidding.46
Finally, to highlight the odds corporate board members face when deciding between fiduciary
duties that become at odds with each other, one needs to look no further than the buyout of Ben &
42 North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 930 A.2d 92, 99 (Del. 2007). 43 Dodge v. Ford Motor Co, 204 Mich. 459, 170 N.W. 668 (Mich. 1919). 44 Id. at 500. 45 Revlon, Inc. v. MacAndrews & Forbes Holding, Inc., 506 A.2d 173 (Del. 1986). 46 Id. at 179.
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Jerry’s takeover by Unilever in 2000.47 Although the case never went to court, Ben & Jerry were faced
with the decision of a buyer that was offering less money for the company – but would preserve the
socially responsible mission of the company – than the multinational conglomerate Unilever. During
the buyout period, Ben & Jerry were fearful that Unilever would pervert the foundational purpose of
Ben & Jerry’s Ice Cream, but were unable to ultimately sell to other buyers that shared their social
responsibility values due in large part to threats for legal action from shareholders on the grounds that
Ben & Jerry were not maximizing shareholder value.48
These examples are only a small portion of the systemic problems with the fiduciary system
afflicting not only the banking industry, but also the entire corporate industry. The law tends to cause
directors to act in a manner that is geared toward maximizing shareholder value because this fiduciary
duty has been insulated from attack through precedent which encourages a gross violation of accurate
predictions: it assumes that because growth has traditionally been one of the most successful principles
goal in starting a business, that it will always be the most important consideration for a company. It is
decidedly fragile, instead of antifragile, because maximizing shareholder value leaves little room for
adjustment on the direction the company should take when confronting changing circumstances.
B. How these issues are affecting the banking industry
As noted above, having the maximization of shareholder value being the end-all-be-all goal for
financial institutions is a bad notion because it does not allow for flexibility in director decision-
making. This is particularly problematic in an industry like the financial sector, which is already
engaged in the business of making money. When circumstances like de-regulating limitations on the
47 Hays, Constance L. “Ben and Jerry’s Takeover is Seen Close,” The New York Times (April 12, 2000) <http://www.nytimes.com/2000/04/12/business/ben-jerry-s-takeover-is-seen-close.html> accessed May 13, 2013. 48 Dembosky, April, “Protecting Companies that Mix Profitability, Values” NPR (March 9, 2010) <http://www.npr.org/templates/story/story.php?storyId=124468487> accessed May 13, 2013.
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lending and investment activities that financial institutions can engage in, such as the passage of the
Garn-St. Germain Act, it sets off a feedback loop of bad economic practices that eventually become
catastrophic in their effects.
These catastrophic events originate in the overall general freedom bankers are granted in periods
of de-regulation and new financial innovations are created which are not necessarily controlled by
existing law and are within what Margaret Blair defines as the shadow banking industry.49 For instance,
innovations like mutual funds, mortgage backed securities, credit default swaps, and collateralized debt
obligations all have roots in shadow banking and are characterized by a lack of disclosure about the
true nature of the assets being traded, low reserve requirements, and incredibly high risk-reward.50
Furthermore, since bankers are able to use these financial instruments and their lack of regulation to
essentially jump from one risky investment to another, with little – if any – legal worry, there have
been no real disincentives for bankers to continue engaging in such risky behavior. In fact, Margaret
Blair advocates the exact opposite is true and that this conduct is in fact encouraged by the lack of
accountability.51
However, despite these inherent issues that can cause extreme fragility, when trouble came in
2008, those who caused the mess did not feel the effect of their practices because many had seen
trouble coming and gotten out or relied on U.S. government protection through bailouts.52 In the
event that an incredibly large bank like Bank of America were to fail, then there would likely be
considerable depositor panic and even the FDIC might not be equipped to handle the size of the
sudden sheer size of demand for depositor funds. Likewise, as being witnessed in Cyprus and Greece,
49 Blair, Margaret, “Financial Innovation and the Distribution of Wealth and Income” Vanderbilit University Law School Public Law & Legal Theory Work Paper Number 10-32, Law & Economics Working Paper Number 10-12, pages 11-12 (August 10, 2010). 50 Id. at 21-25. 51 Id. at 35. 52 Id. at 35.
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depositor “haircuts” are now being employed instead of making bankers pay for their recklessness,
thus staving off the inevitable consequences for those causing the trauma for a little bit longer.53
Banks are presently knee-deep in conduct which is fragile and not sustainable. The conduct
assumes there will always be someone else to take another loan and that growth is potentially infinite.
However, what this practice really does is create an endless bubble-burst cycle, as more and more debt
is acquired that in turn limits the flexibility of the mega-banks by causing them to grow to
uncontrollable sizes. With only a duty to the bank itself and its shareholders, directors of financial
institutions are left with little incentive to care about what happens to everyone else in an economy
due to this entrenched status.
C. What has been done to address these issues
Numerous reform efforts have recently been enacted or are being proposed to attempt to curb
the recklessness of the banks. For Example, the Dodd-Frank Act of 2010 which – among other things
– called for agency oversight changes, investment advisor registration requirements, and creates
Federal Reserve supervision of certain non-bank financial institutions, is one such example of
sweeping reform that aimed to try and address all of the problems cropping up in the financial sector
through a massive overhaul of the system.54 However, this kind legislation has done little so far to
curb the risky practices bankers are engaging in and none of the current reforms even begin to touch
the problems relating to accountability for bankers and the incentives to keep behaving irresponsibly.
The reactive legislation is nothing new. In 2002, the Sarbanes-Oxley Act was passed in attempt to
curb corporate accounting scandals like the Enron and Tyco cases which involved these respective
corporations falsely reporting growth statistics in order to be more attractive to investors. The SOX
53 Meek, James, “The Depositor Haircut” London Review of Books, Vol. 35 No. 9, pages 11-15 (May 9, 2013). 54 "Dodd–Frank SEC Registration – An Overview". Allan J. P. Rooney, P.C., December 14, 2010.
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Act requires more disclosure and internal controls to fight risky business practices. While some critics
praise the effect the SOX Act has had on corporate disclosure,55 there are still many critics who cite
this act specifically as one of the single biggest hindrances to new IPOs in the U.S. today.56
The agencies tasked with enforcing the specific regulations concerning financial industries also are
actively investigating for violations in the banking and lending industry. For instance, the SEC is
actively identifying banks which acted in violation of securities laws and in most cases is settling the
disputes out of court.57 So far, these settlements have been for a small amount compared to the harm
caused. For example, in the above cited case, the SEC settled with JP Morgan Chase and Credit Suisse
Group for $400 million over an accusation that the firms jointly misled investors for more than $1
billion in securities backed by subprime home loans.58
Overall, what appears to have happened in response to the recent financial crisis can be summed
up in two words: “not much.” New laws have been passed and agencies are settling claims, but the
reckless practices over over-leveraging continue to move from bubble to bubble.59 It appears safe to
say that in today’s political climate, real change through traditional avenues has become impracticable.
D. Why these approaches have failed
Although the above cited fiduciary laws and accompanying cases seem like sound judicial prudence
because even the judges/justices whom decided them thought they were addressing every possible
important consideration that would be necessary for corporations. After all, there are numerous
55 "Administrative Proceeding: Value Line, Inc., Value Line Securities, Inc., Jean Bernhard Buttner, and David Henigson" (PDF). Retrieved 2010-08-27. 56 Regulation and Bonding: The Sarbanes-Oxley Act and the Flow of International Listings, Journal of Accounting Research, (May 2008). 57 Berthelsen, Christian, Eaglesham, Jean, & Jones, Christian, “SEC, Two Banks Settle Over Loans” The Wall Street Journal (November 16, 2012) <http://online.wsj.com/article/SB10001424127887324735104578123242727307524.html> accessed May 13, 2013. 58 Id. 59 Cohn, Scott “Surging Student-Loan Debt is Crushing the System” CNBC News, (March 27, 2013) <http://www.cnbc.com/id/100598257> accessed May 13, 2013.
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federal agencies which can in theory control reckless conduct by companies if anything gets out of
hand. Likewise, it was frequently presumed throughout American legal history that there were always
remedies available to injured parties through lawsuits. These legislative and judicial rules for doing
business are, in effect, an embodiment of the quintessential flaw in reasoning Nate Silver points out
in the Signal and the Noise: because something has historically been available means it will be available
tomorrow. This behavior is also decidedly not antifragile because it limits the kind of responses and
protections against widespread abuse through making shareholder value maximizing the end goal for
most banks.
However, what happens when the two main forces for curbing reckless conduct themselves
become a part of the reckless conduct?60 What about when every measure taken to reactively “patch
up” reckless conduct eventually gets overcome by those engaging in such conduct because those
engaging in said conduct are able to take these shortcuts to growth to overcome any resistance before
it becomes an issue? How are these kinds of problems addressed?
The issue of why these prescriptions to our economic problems have not worked can be addressed
if the root symptom causing the reckless is examined. Simply put, these “solutions” just are not
attacking the problem and are instead only addressing the symptoms of the problem. The Sarbanes-
Oxley Act did nothing to curb the incentives corporations had for cooking the books. Likewise, the
Dodd-Frank Act merely reshuffled the deck on a massive scale for the same system that is already in
place. Finally, the agencies charged with enforcing these laws are currently occupied by the same
industry heads they seek to regulate and are, in effect, complicit with the unsustainable conduct.61
60 "Robert Khuzami Named SEC Director of Enforcement" U.S. Securities and Exchange Commission Press Release (February 19, 2009) Retrieved January 9, 2011. 61 Suzanne Barlyn, "DJ Compliance Watch: SEC Plan To Catch Big Fish Questioned" Dow Jones Newswire (May 16, 2011). Retrieved May 23, 2011
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As hinted at above, simply put, the statutes and case law governing bank conduct by and through
its directors are short-sighted because they are all based on one simple assumption: that growth is
always good, and because profits maximize growth, that the name of the game should be to maximize
profits. Now this is not technically true in the absolute legal context. However, whenever a bank
becomes publicly traded (i.e., a corporate-style bank), it becomes subject to buyouts.
Although a publicly traded bank may start out engaging only in conduct which would be safer,
rather than simply focusing on maximizing shareholder profits, it will ultimately be overcome by a
larger bank that does focus on maximizing wealth, and is therefore able to leverage at least a hostile
buyout – if not an outright agreed upon buyout – or simply outcompete the bank.62 Stockholders,
concerned with maximizing profit, flock to the bank which appears more profitable in the short run,
and the bank engaging in more sustainable conduct is forced to adopt similar reckless behavior just to
survive. Additionally, banks which are not public, smaller, and more sustainable tend to not be able to
compete against large banks on equal footing because society has – for at least the last thirty or so
years – been absolutely obsessed with maximizing wealth in all respects of life.63
While these kinds of practices for publicly traded banks may work in the short run; producing
record profits and accounting for a large proportion of an economy,64 they are all still based on the
false assumption that reckless investment banking is the preferable option because it ensures the
largest profits in the short run, while at the same time (presumably) other opportunities will crop up
down the road that allow them to continue this practice in another manner ad infinitum.
62 Associated Press, “Citigroup buying Wachovia banking operations” NBC News U.S. Business (September 29, 2008) <http://www.nbcnews.com/id/26933280/ns/business-us_business/t/citigroup-buying-wachovia-banking-operations/#.UZDQg7XvuCg> accessed May 13, 2013. 63 Niskanen, William A.. "Reaganomics". The Concise Encyclopedia of Economics. Retrieved 2007-05-22. 64 Eaves, Peter “Rising Bank Profits Tempt a Push for Tougher Rules” The New York Times (April 17, 2013)
<http://dealbook.nytimes.com/2013/04/17/rising-bank-profits-tempt-a-push-for-tougher-rules/> accessed May
13, 2013.
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Congressional legislative remedies such as the recent to-big-to-fail legislation has not only done
little to alleviate the financial crisis, it also has encouraged the continuance of said behavior through
failing to punish those who engage in reckless banking practices.65 Furthermore, there is virtually
limitless funding to campaigns from lobbying groups, making it impossible for all but the most-
wealthy of contributors to have their voices heard. As such, the practice of using virtually unlimited
funds in lobbying activity has enabled large banks and other corporations to control the direction of
Congress and has led to essentially a firewall of the kind of “noise” described in Nate Silver’s book in
the form of a cacophony of influence (read: money) in preventing any and all meaningful legislative
action against these respective industries.66
Moreover, the agencies which are tasked with policing this risky behavior have become entrenched
with high-profile representatives from the banking industry that then use their newfound seats of
power to do very little to curb the risky behavior based on this false assumption, and in turn often
return to even better positions for assisting the industry once they have worked in the agencies for a
while.67 The effect of this kind of agency capture can be readily observed with the settlements currently
being reached between the SEC and mega-banks which literally write off billions in damages for
pennies on the dollar.68
Finally, judicial remedies, are easily overcome for several reasons. First, the cost of litigating against
mega-banks is so expensive that few plaintiffs – if any – could ever hope to successfully survive a
claim against them. Furthermore, even if one possessed such financing in bringing a claim, there are
65 Senator Bernie Sanders, “Too Big to Jail?” The Huffington Post (March 28, 2013) <http://www.huffingtonpost.com/rep-bernie-sanders/too-big-to-jail_b_2973641.html> accessed May 13, 2013. 66 “Banker Group Plans to Fund Super-PACs to Kill Dodd-Frank” Money News (September 5, 2012) <http://www.moneynews.com/FinanceNews/bankers-aba-super-pac-dodd-frank/2012/09/05/id/450906> accessed May 13, 2013. 67 Kara Scannell, "Davis Polk Recruits Ex-SEC Aide" The Wall Street Journal (April 13, 2009) Retrieved February 26, 2011; "Deutsche Bank Hires Former S.E.C. Official" The New York Times (October 2, 2001). Retrieved March 4, 2011. 68 Protess, Ben “Hedge Fund Manager and S.E.C. Reach Deal” The New York Times (May 9, 2013) <http://dealbook.nytimes.com/2013/05/09/philip-falcone-said-to-settle-with-s-e-c/> accessed May 13, 2013.
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also still numerous obstacles which must be overcome. For instance, once one moves to trial, there
would likely be a lack of evidence against the directors violating their fiduciary duties to the
corporation because of the inherent control they have over the physical evidence a company can
produce (and can very easily cover up massive fraud or at least make it next to impossible to sort out).
Furthermore, with record-profits for shareholders, there is considerable evidence that the bank is
fulfilling its fiduciary duty on this regard.
When coupled with decisions such as Dodge and Revlon, there would likely be considerable judicial
deference to the banks not engaging in any violations. Such decisions were couched in the same
reasoning Nate Silver cites as the cause for most statistical failure: they adopt R.A. Fisher’s approach
which assumes human beings are objective, rational actors, over the tried and tested Bayes Theorem
– which posits that humans are biased, self-interested actors.69 These courts essentially assumed that,
objectively speaking, pursuing growth was always good and should be a business’s primary goal.
To summarize the entirety of the problem now being faced: legislative ineffectiveness, agency
capture, and no one being held accountable for these practices are all direct results of the popular –
and legally encouraged – notions that growth is always good; that directors should only be concerned
with maximizing shareholder value. There is little, if any mention of sustainable business practices in
any laws anywhere. However, it is a lack of behaving sustainably which created this problem to begin
with.
E. A new approach to the problem
Taking into account that the legislative branch and agencies are effectively ineffective at stopping
the financial industry from continuing to spiral out of control on top of the case law in place affirming
69 “The Signal and the Noise” supra at 247.
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the kind of conduct which helped get the U.S. where it is now, there appears to be little that can be
done to fix the problems in the short-term. Ideally, as noted in the Antifragile analysis above, the best
course of action would be to break up these institutions and put caps on the size companies can reach
while simultaneously encouraging behavior that promotes antifragility rather than fragility through
excessive over-leveraging. But this outcome is likely not possible in the current political climate.
However, there are some other changes which if implemented, just might have an effect on the way
business is done in unexpected ways.
One such potential change would be the creation of a fiduciary duty to stakeholders for corporate
directors. Establishing such a duty can potentially have the effect of changing the guiding light which
directs board members and help encourage more business leaders to behave in more
sustainable/responsible manners. The reasoning this change might have a chance at working is
because it shifts focus away from the need to maximize shareholder value and instead towards the
overall effect the company has on its environment. This proposal can take shape in a couple different
forms. First, because stakeholders necessarily include anyone who has a stake in the corporation,
simply placing a fiduciary duty to stakeholders as an umbrella term to define anyone or anything
affected by the corporation (including the bank itself, shareholders, and those whose lives the
company’s actions effect). Conversely, a duty to stakeholders can take shape as a compliment to the
current fiduciary duties. This will at least give stakeholders a say in the conduct of the bank and can
potentially give an additional reason for directors to depart from some practices that only serve to
increase wealth.
The creation of a new fiduciary duty to stakeholders for corporate directors is nothing new.70 Up
until the late 1990s, the notion of an additional fiduciary duty to stakeholders was popular among
70 Allan Kaufman, “Managers’ Double Fiduciary Duty,” Business Ethics Quarterly 12:189-214
(2002), 189.
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businesses outside of the financial sector. However, pressure from the financial sector eventually led
to this idea by and large being abandoned. Today, there are new entities taking up the cause for
fiduciary duties to stakeholders. For instance, B Corporations are businesses which are certified as
meeting rigorous standards of social and environmental performance, accountability, and
transparency.71 They aim to strike a balance between making a profit and being good for the
community. While some critics may or may not have criticisms of such business practices, B Corps
are growing at a considerable rate and are far better than traditional companies at engaging in
sustainable practices.72 In its third year of reporting with similar results, the case that sustainable,
socially accountable enterprises are not possible is beginning to evaporate.
While it can be argued that creating this duty to stakeholders runs afoul of one of Nate Silver’s
principle warnings of being wary of magic bullet predictions, this policy proposal is not intended to
be a magic bullet prescription. It is, instead, an attempt to set the rules of the game up so that directors
have an excuse to do the right thing while simultaneously providing an opportunity for renewed legal
consideration on foundational business issues which only worked in a time when sustainability was
not as much of an issue. In short, it enables the U.S. society to be more antifragile because accounting
for stakeholders naturally includes accounting the environment and community that a business is
based in. Therefore, when natural periodic trauma comes along, the business will be in a better position
to truly address the situation instead of panicking and putting itself in an endless cycle of clawing for
more and more growth mandated by failed standards.
71 “What is a B Corp?” B Corporation corporate webpage <http://www.bcorporation.net/what-are-b-corps>
accessed May 13, 2013. 72 2012 Annual B Corp Index, B Labs,
<http://www.bcorporation.net/sites/all/themes/adaptivetheme/bcorp/pdfs/bcorp_index.pdf> accessed May 13,
2013.
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Creating a stakeholder fiduciary duty makes sense because banks and other large corporations
affect more than just their workers and shareholders; they effect entire communities. Although their
primary founding purpose might be to make money, that does not necessarily mean they have to be
held to that standard and only that standard. In fact, the needs of society and nature seem to mandate
specifically against these kinds of practices being the model focus.
F. Unintended consequences of adopting this new approach
Although there are many advantages to creating a fiduciary duty to stakeholders, there still exist
very real considerations which must be taken into account. For instance, this proposal is not a cure-
all for the problems being faced by the system. Although it would be a good start and hopefully would
put things back on track to being more sustainable, it could in theory also create risks where there is
over-emphasis on stakeholder well-being and the overall ability of the bank/corporation to be
profitable suffers to the point that the business could no longer sustain itself financially. Likewise,
these duties might do little – if anything – to help address the problems currently being faced. Without
adequate enforcement of this duty, it will just be another meaningless law in the sea of laws aimed to
address banking misconduct. Finally, creating this new fiduciary duty will most assuredly upset
hundreds of years of judicial precedent and there is really no telling how that will affect future cases.
Ultimately, when it comes down to general sustainability issues that might present themselves
when it comes to a stakeholder fiduciary duty, the argument begs the question: how does that make it
any different from the current system? In fact, if the example of B-Corps is to be taken as indicative
to how this system can turn out, then the notion that this duty will be unsustainable begins to seem
unrealistic. As for enforcement, this issue will likely be closely related to how the precedent issue will
play out. Although agency capture has made it next to impossible to police financial institution
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misconduct, a shakeup that calls all the laws into question on a very basic premises can provide just
the opportunity society needs to rectify some of these long-standing issues.
CONCLUSION
The creation of a fiduciary duty to stakeholders in the corporate context appears to be a sound
policy option that has some evidence of its potential for sustainability. Although creating this duty will
not even begin to address all of the issues the United States is currently facing because of the
recklessness of the financial industry, it will provide a new avenue through which directors can base
their decisions and new legal options that will present new opportunities for agencies (or courts
bypassing these agencies if enforcement still proves to be a problem) to shake up a stagnant legal
system with regard to financial institution accountability.
This policy is also expands the necessary pool of considerations for directors, enabling them to
make better-informed decisions (and reconsider those decisions when new evidence appears) about
the institution’s direction instead of operating off of the cure-all profit over everything else approach.
It will provide antifragility because it will naturally limit the size of corporations to more sustainable
levels and the increased options open to directors enables the company to respond more dynamically
to ever-changing circumstances.