Sydney M. Williams
Thought of the Day
“Dewey & LeBoeuf – A Lesson in Capitalism”May 14, 2012
Businesses sometimes go bad. Tough luck is encountered, or mistakes are made; misfortune ensues. There are countless examples every day. Most go unreported by the press. Overextending one’s self has become common. In part, that is because of the ease of filing for bankruptcy and the lack of stigmatization attached to such action. In part, it is due to a decline in moral responsibility on the part of owners and managers of enterprises. And, in part, it has to do with low interest rates and still easy access to credit. The pain of bankruptcy is felt by the owners of the enterprise and, unfortunately, shared by those who work for them. Recently the pain has too often been felt by taxpayers as well.
In large banks, those that are deemed “too big to fail” and large businesses with a unionized workforce like the auto companies, the socialization of debt obligations threatens our capitalist system; for as Carnegie Mellon Professor Allan Meltzer has written on innumerable occasions, “capitalism without failure is like religion without sin.” In 2008, preventing the failure of the banking system justified the assumption of large losses by taxpayers. However, if we continue to allow large banks, auto companies and large “essential” businesses to function free from fear of bankruptcy we will have created a monster impossible to corral. The most elemental aspect of capitalism, as Professor Meltzer taught us, is that without risk it cannot survive. Small businesses and small banks do not receive such guaranties. The lesson of 2008, as taught by Washington politicos, was get bigger and take on more risk. The partners of Dewey & LeBoeuf listened.
No matter how badly we feel for the innocent victims, it would be a mistake for taxpayers to assume the burden of their mistakes. Articles like the one on Saturday that appeared in the New York Times, are geared toward engendering sympathy for innocent victims of Dewey & LeBoeuf – retirees and lower level employees. Individually, we would like to help those people. As a society, we should not. When retirees call in asking: “How could this have happened?”, the answer is easy. The partners got greedy and ignored rules of prudent behavior. For example, partners were required to keep 36% of their compensation in the firm. But “they sometimes borrowed the money to meet the requirement.” That’s not keeping money in the firm.
I am reminded of a letter I have that my grandfather wrote to my grandmother just before they were married in 1908. He was a partner in a small bond brokerage firm in Boston and fully understood the rewards and risks of partnerships. “I went into business with less than $100 in the world. After six years, I became a partner and was given a small interest in the business. Since then my income has averaged about $3000 –as high as $6000 and as low as nothing…For several years I have helped support my aunt and my sister…Last year, on account of the panic, the firm’s profits amounted to practically nothing. So that living expenses took the two or three thousand that I had saved up to that time…These are the facts. I give them to you because you ought to know them.” Do we hear such transparency and honesty today? Partnerships are one of capitalism’s purist examples. They can be highly rewarding. But they involve confidence and trust in one’s partners. When that is lost, they can be very risky. In the case of liability, partners are held jointly and severally responsible. Nevertheless, they reap the benefits and suffer the risks. It is as it should be. Anything Washington does to moderate the risk will have detrimental consequences and will prove expensive for taxpayers.
Law firms are not capital intensive. There should be no need to borrow money, other than to fund a credit line to periodically pay for needed capital equipment, i.e. computers. By definition, partnerships provide variable returns to its partners. There will be good years and bad years. The guaranteeing of compensation to partners is antithetical to the concept of a partnership.
Retirees, lower level employees and, in fact, partners chose to look the other way, as Dewey & LeBoeuf elected to guaranty compensation to partners, as opposed to offering them larger shares of what proved to be a shrinking pie. It is not the notion of partnership ownership that should be under the microscope; it is that the tenants of partnership were violated by the partners at Dewey & LeBoeuf. Ironically, limited liability partnerships, like Dewey & LeBoeuf, remove some of the risk for individual partners, but increase the likelihood a firm will over extend. Nevertheless, the idea of partnerships – shared risk and reward – is fundamental to capitalism.
That concept seemed to have been missed by John Gapper in an op-ed he wrote for last Thursday’s Financial Times, entitled, “Law firms have struck the limits of partnerships.” They have not “struck the limits,” Dewey & LeBoeuf violated the principle of partnerships. Mr. Gapper’s answer to the failure of the firm is to take a lesson from law firms in the UK and Australia – divide the industry into a few top-end firms and “some large utilities that employ paralegals and lower-paid lawyers to do standard work.” He also suggests permitting some law firms to be owned by non lawyers, tantamount to public ownership. Does he believe that management will then be less risky? If Mr. Gapper believes that utility-like regulation and public ownership of law firms will remove the risks of another Dewey & LeBoeuf, he has not paid attention to the lessons from the near-collapse of the financial sector of a few years ago. The more one is distanced from risk, the less cautious he or she becomes. It is the fear of failure more than regulation that ensures prudent behavior. Capitalism’s best governor is the threat of bankruptcy; it is not another regulator in Washington, and certainly not the socialization of risk.
Bruno Iksil’s trade that cost J.P. Morgan Chase $2.3 billion is a case in point, and points out the flaw of getting bigger just to be the biggest guy in town. The dollar amount relative to the bank’s assets may be very small, as Holman Jenkins pointed out in Saturday’s Wall Street Journal. But that is not the critical point. The dollar loss is large, and the fact that it was only 1% of shareholders equity only serves to prove the point that the bank is just too big. It is ironic that under Mr. Obama’s watch – he the supposed scourge of Wall Street – big banks have gotten bigger and there is nothing in Dodd-Frank that will make them smaller and therefore less risky for taxpayers.
In fact, it has been the more conservative commentators and practitioners who have urged a more commonsensical approach, one that would reduce risk for taxpayers. Richard Fisher, President of the Dallas Fed, has spoken of preventing banks from getting too large by breaking them up or re-imposing something akin to Glass-Steagall. Allan Meltzer, the economist, has suggested something far simpler – just raise the capital requirements of banks as their assets increase. That way management would be incentivized to stay smaller and more profitable, instead of taking Mr. Dimon’s route, which appears to be, become as big as possible, ignoring the risk to taxpayers, (or, more likely, relying on them.) The problem with former Fed Chairman Paul Volcker’s rule is that, in determining what constitutes hedged trades and what is proprietary, it depends on regulators who are smarter than bankers. With all due respect to government workers, that is simply wishful thinking.
There was no reason, other than greed and stupidity, for the managing partners of Dewey & LeBoeuf, to have fallen as far as they did. They had no need to take on the level of debt that they did. Guaranteeing payments to partners goes against the very principle of what a partnership is. Promising benefits without funding those benefits is dumb. While we may feel sorry for individuals, there is no way that society should make amends. It is a lesson of capitalism, a system that has benefitted millions, if not billions, of people. Capitalism, more than any other system, has raised living standards around the world. But nothing in life is without risk, and that is the lesson we should take away from the misguided misfortune at Dewy & LeBoeuf.