The February 25 Wall Street Journal carries an insightful piece of commentary by James K. Glassman (president of the World Growth Institute and a former undersecretary of state) and William T. Nolan (president of Devonshire Holdings and former associate at Brown Brothers Harriman & Co. in the early 1970s) .
The Glassman and Nolan piece, entitled "Bankers Need More Skin in the Game; Partnerships may be a more trustworthy business model than corporations," echoes in the context of Wall Street financial institutions the theme of inappropriate managerial risk-taking that I have previously blogged on a number of times regarding the consequences of the "limited liability" corporate form. Glassman and Nolan point to the sterling performance of Brown Brothers Harriman & Co., the oldest and largest partnership bank in the U.S., founded in 1818.
The Glassman and Nolan editorial is worth reading in whole, for purposes of discussion I excerpt portions here (bolding is mine):
"Of all the causes of the financial meltdown of the past few years, the easiest to understand is that an irresponsible attitude toward risk led to terrible mistakes in judgment. But where did this casual approach to risk originate?
"A major culprit, we believe, is a change in the way Wall Street financial institutions are organized. During the late 1970s and '80s, much of the responsibility for risk was transferred away from the people who made the financial decisions. As a result, leverage rose from 20-1 to 40-1 or higher, creating shaky towers of debt, which, as we know, eventually collapsed. ...
"The trick is to find a way to encourage sensible risk-taking, while dampening the impulse to take chances that can throw an economy into recession and force taxpayers to bail out a banking system.
"Can government accomplish this feat through rule-making and regulatory oversight? It is unlikely. As the Nobel Prize-winning economist Friedrich von Hayek correctly emphasized, no one -- not even a politician or a bureaucrat -- can gain the broad and deep knowledge necessary to make wise enough rules. Moreover, in a $14 trillion economy, you can't hire enough overseers to pore over everyone's books.
"There is, however, a better solution: expose players in the financial game to greater personal loss if their risk-taking fails. When you worry that a mistake will cause you to lose your second home, your stocks and bonds and your club memberships, then you're less likely to take the kinds of risks that expose the rest of society to your failures.
"A simple mechanism exists to achieve this purpose: the private partnership. Partners face liability that extends to their personal assets. They aren't protected by the corporate shield that limits losses to what the corporation itself owns (as well as the value of the stocks and bonds the corporation has issued). Unfortunately, the partnership is a legal form of business organization that was largely abandoned by banks over the past quarter-century. Our advice is to bring it back. ...
"Even John Gutfreund -- the man who kicked off the dramatic change in investment-banking culture and structure when he took Salomon Brothers, a longtime partnership, public in 1981 -- confirms our thesis. Michael Lewis wrote in the December issue of Condé Nast Portfolio that Mr. Gutfreund now believes "that the main effect of turning a partnership into a corporation was to transfer financial risk to the shareholders. 'When things go wrong, it's their problem,'" said Mr. Gutfreund.
"But when the personal wealth of executives is put at risk, as it is in a partnership, their behavior changes. Risk aversion increases. Few partnerships would leverage themselves to the hilt to load up on risky subprime loans.
"How do we know this? Luckily, for this financial experiment, there is a control case: Brown Brothers Harriman & Co. ....
"Some would say that BBH is sui generis. Would its structure work more broadly for financial institutions? It already is. As large brokers merged into huge corporations with greater concentration in real-estate finance, corporate finance migrated to private equity firms and hedge funds, which are generally structured as partnerships. While many of these new engines of finance have suffered in the recent meltdown, they generally didn't engage in such extreme risk-taking and thus haven't become wards of the state.
"We know from Alfred Chandler, the great business historian, that "strategy determines structure." Similarly, structure determines behavior -- in this case, a healthier attitude toward risk. It is unlikely that a partnership will grow to the size of a Bank of America or Citigroup, but, while size can boost efficiency, it also poses systemic risk. As partnerships -- and corporations with partnership attributes -- replace behemoths, the current crisis will spawn structures for future success. ...
We do not believe that government should require banks to be partnerships. Rather, investors -- and governments -- should recognize the extra safety inherent in doing business with partnerships."
I have previously argued that one of the key state interventions that has fuelled the rent-seeking and risk socialization that we see today is the grants of blanket limited liability to shareholders, along with the grant of legal personhood (with unlimited purposes and life and Constitutional rights) to corporations:
Limited liability has enabled corporate managers to act without close shareholder oversight and management; this I believe has played a key role in the vast misalignment of incentives that Michael Lewis and David Einhorn describe at the NYT, and in the risk mismanagement that Joe Nocera of the NYT describes at length in the NYT Magazine. Those taking large bonuses (whether in the financial industry or large corporations) were essentially playing with OPM - Other People's Money - and capturing the upside of short-term gains while leaving shareholders and taxpayers holding the bag for loses.
I hope that you and others here will look more deeply at the role of the state in the problem of misaligned incentives that continue to corrupt American capitalism.
It is not clear what Glassman and Nolan intend with their reference to "corporations with partnership attributes", but I would note that corporations that make use of an unlimited liability structure (as American Express once did) share the main "partnership attribute" - that the owners of the firm may be, if the assets of the firm are insufficient, personally liable to creditors for all debts of the firm (other than those whose creditors agree in advance to limit recourse), particularly for torts to involuntary third parties. The availability of the unlimited liability corporate form in various jurisdiction should be further investigated.
I agree with Glassman and Nolan that governments should recognize the better risk management that partnerships are likely to conduct, but not merely in the financial sector but in other industrial, commercial and professional fields as well. Such recognition could take the form of eased regulations, for example. I favor aggressive pursuit of this "carrot" approach to encouraging better risk management and less shifting of risks to shareholders, government and citizens generally. However, this fails to consider what should be done about existing public companies and other limited liability corporations. I would urge more aggressive veil-piercing, both judicially and by statute.
In any case, it is gratifying to see this topic getting some of the attention that it deserves.