An Interview with Jonathan Macey

We interview Jonathan Macey, who is Yale University's Sam Harris Professor of Corporate Law, Corporate Finance and Securities Law. Jonathan has authored several books on corporations and the law, and joins The Motley Fool to talk about his most recent work, The Death of Corporate Reputation.

Jonathan discusses how much has changed since the day when a scandal could lead a corporation -- and its employees -- to ruin. Do financial institutions even care about their reputations anymore? Should they? We discuss Morgan Stanley (NYSE: MS  ) , Goldman Sachs (NYSE: GS  ) and the credit rating agencies to determine what has changed and whether the genie can be put back in the bottle.

A full transcript follows the video.

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Brendan Byrnes: Hi folks, I'm Brendan Byrnes and I'm joined today by Jonathan Macey. Jonathan is the author of The Death of Corporate Reputation. Thanks for your time.

Jonathan Macey: Great to be here. Thank you.

Brendan: I wanted to ask you; in the first chapter you write that, in the past, reputation for financial firms was critical to their success, but that has changed now.

One of the examples you cite is the Facebook (NASDAQ: FB  ) IPO debacle with Morgan Stanley. Could you give us a rundown of why that's changed, and maybe a little bit more on this specific example?

Jonathan: Sure, sure. It really was the case, if one goes back 30, 40, certainly 50 years, that trust was very important to people. That people had the notion, when they turned their money over to a bank or to a stock broker, that if they didn't pick the right person, or if they didn't pick the right company, their money would just disappear.

If you think about the days of the Wild West -- the days before FDIC insurance, the days before the FDR-era regulation -- we've gotten away from that. To a very large extent, people are doing business online, they're trusting people, they're sending their money out to institutions that they really don't know, haven't heard of, have never seen their bricks and mortar location.

That is a very big change, a real sea change, in the way that the economy works with respect to the financial sector.

I think that, with respect to the Facebook IPO, that a lot of people lost a lot of money. A lot of people put their trust in a new company, in Facebook, and they thought that this IPO would go up, the way so many of them do.

It was a significant loss for a great many investors, a lot of whom were in the market for the first time. They were attracted to invest for the first time because it was Facebook and they were familiar with the product, having used it online of course.

That was not a happy day for the financial markets, with respect to trying to rebuild people's trust after the last decade or two.

Brendan: That didn't really hurt Morgan Stanley, though.

Jonathan: No. No, no, it did not. There are not very many investment banks. Morgan Stanley has, actually, to its credit, done some things with respect to compensation that suggest it's trying to build its reputation.

It may be the only major investment bank that really has sent any sort of a signal to the market that they're serious about rebuilding their reputation. Facebook may have been a wakeup call for them.

Brendan: I think, when you write about it in the book, Morgan Stanley, what they're doing now is half cash bonuses, and half in stock based on four installments, I believe?

Jonathan: Right.

Brendan: Do you think that needs to happen more to other firms? What else can they do to make it more about building a reputation and less about just living in the now?

Jonathan: This is a great, what we call a "natural experiment," because there are two schools of thought.

One school of thought is, "Morgan Stanley has it right and they're going to be able to have a strong customer commitment. These brokers are going to really be very concerned about long-term performance, not just short-term performance."

Then there's a whole other school of thought that says, "These guys are idiots. They're going to lose their best brokers. People don't want to be compensated this way," so we're going to see.


My own view is I think Morgan Stanley is right. I think that they'll lose people that they want to lose; people who are really into churning and short-term, unsustainable strategies, and they'll keep the people that are going to, in the long run, produce good returns not only for Morgan Stanley, but also for the people doing business with Morgan Stanley.

I think it's a good business, model, but we'll see because not everybody's following Morgan Stanley. We'll see who's able to attract the best talent in the long run.

Brendan: Goldman Sachs, of course, took a huge hit to their reputation after the financial crisis. They had a lawsuit. In their reply brief to the lawsuit, as you point out in the book, they claim that no one should take their claims of honesty and integrity seriously, which is pretty mind boggling.

Do you think anything has changed since the financial crisis, or is it still a problem due to the fact that they feel like they don't need to have that sterling reputation anymore, maybe?

Jonathan: Right. The business model used to be kind of a brokerage business model. You needed people to trust you, you needed people to buy investments from you and think that they were going to do well doing business with you on a long-run basis.

That business model does not exist anymore. Now the business model is, "We don't have clients, we have counterparties. We're the principal. We're going to trade against people, so we are going to expect people to be able to figure things out for themselves. They shouldn't rely on us, because we're often -- in fact most of the time -- on the opposite side of the trade, betting against our customers."

In that situation, the traditional reputational model really doesn't apply, when businesses like Goldman Sachs really thought about or cared about if their counterparties and their customers trusted them.

Brendan: We talked about this a little bit earlier, but you note in the book, a couple of decades ago Salomon Brothers, Bankers Trust Company, when they had their reputations eviscerated, they promptly folded, or a little bit afterwards. What happens now? Why is it different now? Is it because there are less banks out there?

Jonathan: This is really interesting to me, this whole phenomenon, that Bankers Trust Company essentially did a couple of big, complicated swap trades where they ripped off a couple of iconic U.S. Main Street companies -- Procter & Gamble (NYSE: PG  ) and Gibson Greeting Cards -- and they couldn't sustain that reputational hit.


Now we see trades that are even bigger rip-offs of the counterparties occurring regularly, with no effect. We see the same behavior going on on Wall Street that Bankers Trust did, to its peril, but it's not having any effect anymore.

That's a major, and I think noteworthy, phenomenon about the way that the market has changed and moved away from a business model where reputation was critical, or even relevant, to success.

Brendan: I wanted to ask you about the JPMorgan (NYSE: JPM  ) London Whale scandal. Their stock price now is up higher than it was back prior to the scandal. Do you think this is any kind of hit to their reputation, or hurts them long-term?

Jonathan: It's interesting. Every scandal is different.

The JPMorgan London Whale scandal was very different than, say, the Goldman Sachs Abacus scandal. The Goldman Sachs Abacus scandal, they're ripping off people. In the London Whale, you have a guy who's proprietary trading. He's trading with JPMorgan's own money, and he's losing money. He's just making bad bets.

There's nothing in that scandal that impugns JPMorgan's honesty or integrity, or the way they interface with customers. It's all about, do they have adequate internal controls...?

The London Whale scandal is really all about...if anybody cares about it, it really should be the shareholders, to the extent that it suggests weakness of controls, but as we see from the market, this seems to be something that JPMorgan has under control. It seems to be a bit aberrational.

Clearly, the company is taking it very seriously, so I don't think that the London Whale scandal really is...I think the market's right in not reacting to it. I think people are blowing it tremendously out of proportion. It's their problem. They made a mistake -- a big mistake; it cost them billions -- but they're moving on. They make a lot of money, and even in that quarter they didn't show a loss.

Brendan: We all know the big financial credit agencies -- in particular Moody's, Standard & Poor's, Fitch -- played a big role in the financial crisis. Do you think enough has been done to address that, post-financial crisis, or do you think something like that could happen again?

Jonathan: I think a lot was done. I think it definitely could happen again. The problem is that it's extremely difficult, if not impossible, to unscramble this egg. In other words, we created a regulatory system that lasted for decades, which basically required people to rely on these bogus ratings being issued for structured products by the big credit rating agencies.

With the Dodd-Frank Act, the statute says, "Well, don't pay any attention to what we've been saying the last 20 years. Now you shouldn't listen anymore to these credit rating agencies."

But it's very difficult to put that genie back in the bottle and it's been completely unsuccessful, in the sense that the credit rating agencies are still the salient point that people just look to, the way insects go to fluorescent lights in the dark.

Brendan: You write in the book that a lot of firms have less incentive, now, to stay on exchanges. Why is that?

Jonathan: It used to be -- one has to go back in history to even remember this -- it used to be that a primary motivation for listing on an exchange was that you got a reputational boost, if you're a company.

A company, say in Japan or the U.S., that listed on the Tokyo Stock Exchange or the New York Stock Exchange, this put that company on the map. People said, "Wow, this is a serious company," because they're a New York Stock Exchange-listed company. It was part of their marketing, and it really meant that a company had made it as a manufacturing entity, or a services entity, whatever the underlying business model happened to be.

Now it's just one of many, many trading venues. There's no reputational benefit to being on the New York Stock Exchange. That's just yet another reputational intermediary, like the credit rating agencies, that just don't serve that function anymore.

They're still around. They have a business function, which of course is to provide liquidity, but the reputational component of their business is just non-existent.

Brendan: You also write in the book that a lot of times in the past, individuals would actually go down with the firm. If the reputation of the firm went down, so did the individuals' reputation that worked there. It's not happening as much anymore. Is this a good thing? Bad thing? What do you think?

Jonathan: It's a mixed bag. This is a tremendous change. A lot of these problems are a function of regulation. This particular problem is not. It's just a phenomenon of information technology, and also some legal changes.

If you imagine you're a partner at Arthur Andersen, who was auditing Enron, and you're in the Atlanta office or the L.A. office, you don't have any idea about what's going on with Enron.

You're not involved in the scandal, and when Arthur Andersen implodes and they're indicted for obstruction of justice, it doesn't really affect your career because you just move to another big accounting firm, and you continue auditing exactly the same clients, because they move with you.

This is a good thing, in the sense that to some extent innocent people aren't suffering, these innocent professionals. On the other hand, it's a bad thing because nobody monitors. It used to be that these firms, like Arthur Andersen and the existing accounting firms, were general partnerships. People in L.A. and Atlanta would be personally liable for a debacle like Enron. But we've changed those rules, and that's no longer the case.

We have less accountability. I think the pendulum has probably swung a bit too far in the non-accountability direction. There should be a little bit more, but you don't want to capture all of these innocent people and ruin their careers. It's not efficient or fair.

Brendan: I wanted to read a quote from the book. You write, "The SEC appears to have a mission. Unfortunately, its mission appears to be that of advancing its own agenda, including its own budget and power, along with the careers of its most highly placed executives."

What needs to happen to fix that? Is it a more competent person to come in, hard-nosed, and lead the SEC?

Jonathan: This is a really difficult problem, because cultures are very difficult to change. Once a cultural norm becomes embedded, or a set of ways that people behave and think, it's very difficult to change. I think it's going to take a lot more than leadership.

Right now, the SEC is dominated by lawyers who view it as a kind of a career jumping-off point to go to the industries that they regulate. It's a very difficult problem.

I think we need to change the culture so that it's no longer a lawyer-dominated culture, it's an economist-dominated culture, that people understand finance, they really understand the businesses that they are responsible for dealing with, and it's not simply a bunch of rule-makers who are completely not trained or able to do the kind of cost/benefit analysis that's really central to the SEC's mission, with respect to rule making.

Brendan: You make the case that reputation is huge to a firm, but it's also declining among firms, not necessarily hurting them. How does this become more of a priority for firms? Is it deregulation?

Jonathan: I think that reputation is still very important in the manufacturing sector. Where we see a retreat from reputation is for the Wall Street firms, the financial firms, the credit rating agencies, the accounting firms, the investment banks.

There, deregulation would help a great deal, but also I think that people dealing with these firms need to trust a little bit less in regulation. They need to think, "It could be possible, despite this massive overlay of regulation, that I could be dealing with a Bernie Madoff, or I could be dealing with a Stanford."

When people stop randomly trusting firms, simply because they say, "Member CPIC," or "Member FDIC," or "Member New York Stock Exchange," and really start to think that they have some due diligence obligations on their own, and that reputation really matters, firms will respond to that incentive. But we're not there yet.

Brendan: I wanted to ask you a way too broad, 30,000-foot view kind of question. A lot of people obviously are wary of the big banks; your Bank of Americas, JPMorgans, Citigroups. Do you think people should be able to trust them, as a whole?

Jonathan: That depends on what you mean by "should be." Do I think that the world should change so that these people become trustworthy? Yeah, that would be great.

Brendan: Do you think they are trustworthy?

Jonathan: Oh, but do I think people would be rational to trust them?

Brendan: Right.

Jonathan: No. I think that these organizations have become way too big. There are certainly a lot of really great, wonderful trustworthy people who work at all levels in these companies. On the other hand, they have incentive systems that really don't incentivize people to act in the most ethical way.

They have a core inability -- just because of their sheer size and the number of businesses that they're in -- an inability to monitor what's going on in the hinterlands in these businesses, so you can never be sure when you're going to get some sort of strange pathology erupting, like the Libor price fixing scandal, or the NASDAQ price fixing that happened a couple of decades ago. These things just continue to happen, and they're very difficult to predict.

Brendan: Jonathan Macey, author of The Death of Corporate Reputation. Thank you so much for your time.

Jonathan: Great to be here. Thank you so much for having me on. 


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