Punishing Shareholders? Nonsense

Whenever a company’s executives get caught doing something stupid/illegal, and are forced to pony up a hefty fine, a hue and cry go up: You are only punishing the shareholders.

Well, yes, you are. That is, in fact, the purpose of these fines: To punish the companies engaging in violations of SEC laws, and to serve as an example to other firms — including their shareholders.

The latest example of this is Andrew Ross Sorkin’s NYT column, Punishing Citi, or Its Shareholders? (good column, bad headline).

To be blunt, the SEC really doesn’t care about Citi’s executives, shareholders, or even its particular legal transgressions. Rather, it is about deterrence. The idea is to prevent the other million senior executives at the other 8,000 publicly traded companies from engaging in other SEC violations. Perhaps, it might even dissuade some investors from putting money into companies run by shady operators.

Call it a “teachable moment.”

The shareholders who own Citi? Well, they also own other firms — typically through mutual funds, 401ks, or even through their own ESOP plans. Publicly punishing a company caught violating rules may cost the investor some money in one investment, but it serves as a deterrent for the executives running the companies in the rest of his portfolio. The goal is to have a market of law abiding companies; some participants must be punished to impact the behavior of the rest of the market.

Judge Jed S. Rakoff of Federal District Court in Manhattan in the Bank of America case misunderstood this. He DKed a proposed $33 million fraud settlement over the BoA Merrill Lynch acquisition, because “it proposes that the shareholders who were the victims of the bank’s alleged misconduct now pay the penalty for that misconduct.

Like bondholders who lend money to insolvent firms that go belly up, Shareholders who invest in firms that engage in bad behavior should feel the sting of their bad choice. That is the first reason why there are penalties for this.

But, its not just BofA’s shareholders who are hurt by its senior management’s fraud. THE ENTIRE MARKETPLACE is damaged by management that engages in fraud. If we were to take the judge’s logic to its inevitable conclusion, then no company should ever be punished for its management’s behavior, because (say it with me) you are only punishing the shareholders.

That makes no sense whatsoever.

Now, ideally, we should punish specific executives personally for their misbehavior. We have seen that happen occasionally when someone crosses the line, and had to pay disgorgement, penalties, etc. And I wish that happened more often, rather than less. The problem is these are the same execs who are agreeing to the settlement, versus going to court, costing S/Hs even more, and perhaps losing even bigger (think Goldman Sachs settling for $550M instead of $20m six months earlier).

In promulgating the new financial regulation rules, we can hope the SEC follows the example set by Sarbanes Oxley, and hold more executives more liable for their behavior. Short of that, expect to see more shareholders pay the consequences of bad behavior by the people who run the companies they invest in.

Perhaps knowing this will dissuade fund managers from buying shares in companies run by ethically challenged managers. That would be the biggest deterrent of all . . .


Punishing Citi, or Its Shareholders?
NYT, August 2, 2010

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