Corporate Governance

Thain, Fiduciary Duties, and the Problem of an Effective Regulator

By J. Robert Brown

The latest on Merrill Lynch is that Andrew Cuomo is barrelling ahead in his investigation of the unexpectedly large losses in December and the payment of employee bonuses.  As part of the investigation, he has already sent a subpoena to John Thain, the former CEO.  As Cuomo has stated:

• Today, as part of our ongoing inquiry into executive compensation issues at institutions who have received TARP funds, my Office issued subpoenas seeking the testimony of former Merrill Lynch CEO John Thain, as well as the testimony of Bank of America Chief Administrative Officer J. Steele Alphin. These subpoenas are part of an ongoing inquiry into billions of dollars in bonuses paid by Merrill Lynch late last year just days before Merrill was taken over by Bank of America. The fact that Merrill Lynch appears to have moved up the timetable to pay bonuses before its merger with Bank of America is troubling to say the least and warrants further investigation.

His focus is on the bonuses and, according to the WSJ, Cuomo is looking into what Thain told the directors at Merrill about the losses.  As the article noted:

• According to the person familiar with the situation, Mr. Cuomo also wants to know if Merrill's board knew about the deepening losses last month, which resulted in a net loss of $15.31 billion in the fourth quarter. That information may have led Merrill's compensation committee to readjust the bonus payouts, the person familiar with the probe said.

He is also, apparently, looking into whether shareholders were mislead by the disclosures. 

There are several observations that need to be made this investigation.  First, to the extent that there is some concern about false disclosure, it seems that the State of New York (as happened many times under Eliot Spitzer) is doing the job for the Securities and Exchange Commission (albeit that there could be an investigation that has not yet leaked to the public).  Perhaps the resources devoted to the health problems of Steve Jobs would be better spent on looking into this issue.

Second, and more profoundly, there is a fundamental issue about the role of the board in this escapade.  Did the board know of the losses when it approved the compensation?  What exactly did the board know?  Even if Thain did not provide all of the necessary information, was there a system of controls in place that should have required it? 

All of these issues are state law issues that turn on the application of fiduciary duties.  Fiduciary duties in turn depend upon the interpretation of the Delaware courts.  And the courts have largely eliminated any avenue for exploring these issues.  The Attorney General of Delaware has and will remain silent on these issues.  Private plaintiffs can bring a law suit but will confront the excessive limitations on the suits imposed by the Delaware courts. 

In other words, the issue between Thain and the Merrill board by and large raise issues of fiduciary obligations.  But rather than have the state that sets the standards determine whether a violation has occurred, shareholders and the market have to rely on the aggressive stance of the attorney general of New York.  And while Spitzer and Cuomo have been willing to take on this responsibility on a case by case basis, the approach is not systematic and depends upon the personality of the NY attorney general.  Were Cuomo not involved in this case, the issues between Thain and the board would likely never be exposed and shareholders would likely never know whether the board or Thain is responsible for the bonus decisions.

A governance system that relies on the attorney general of a different state to explore fiduciary duties is inefficient, incomplete, and demonstrates the weakness in having the standards determined by Delaware.

Full post as published by The Race to the Bottom on January 30, 2009 (boomark / email).