John Stumpf, chairman and CEO of Wells Fargo, should be glad the legal principles the U.S. Supreme Court imposed on now largely exonerated Japanese World War II Gen. Tomoyuki Yamashita are not applied to banking violations. If they were, Stumpf’s goose would be royally cooked, along with those of several other highly placed Wells Fargo managers.
Yes, Stumpf may still possibly be forced to resign after revelations that for years, his bankers created false customer accounts and in some cases raided customer funds to pay for those unauthorized products, all to meet sales goals set by the company.
As part of the fallout, the House Financial Services Committee said Friday that it’s starting an investigation of Wells Fargo, and Stumpf and several regulators are scheduled to appear before the Senate Banking Committee at a hearing Tuesday.
This hits home because Wells Fargo is Minnesota’s largest bank by deposit market share. Stumpf, a Pierz, Minn., native, worked his way up at then Minneapolis-based Norwest Bank, which eventually acquired Well Fargo and took on the Wells Fargo brand. The bank is now based in San Francisco.
Yet there are legal, ethical and economic issues here.
Generally illegal actions taken by employees of large corporations in the name of business don’t trickle up to the corporate suite. These companies may be fined for breaking the law. Or they may agree to some negotiated monetary settlement without admitting any criminal action (Wells Fargo is paying $185 million). But corporate executives seldom go to jail for things done by the business while they were in charge.
There are exceptions from recent business history.
In the wake of the savings-and-loan debacle of the 1980s, regulators made some 30,000 criminal referrals of individuals. About 1,000 people got felony convictions deemed “major” by the Justice Department. Also, from time to time there are prosecutions of individual financial traders for dealing on inside information. And former AIG Chairman Hank Greenberg, together with one aide, will soon go to trial for accounting fraud perpetuated 16 years ago.
Yet, there were zero prosecutions for any action in the mortgage-backed securities debacle that began to unfold in mid-2007. Some banks and other financial firms did agree to multi-billion-dollar settlements, others received multi-million dollar bailouts, but no person was put behind bars.
Now, after it’s revealed that Well Fargo workers fraudulently opened more than 2 million customer accounts, the top executives seem unaffected. Was all this activity really due to the dishonesty of one manager of retail banking? Didn’t anyone else in top management play a role? Didn’t they have a responsibility to know what was going on in the company they supposedly were running? Didn’t they play a role in setting up the incentives that led thousands of employees to open false accounts for millions of customers? These are the questions of the week.
At this point, it is useful to reflect on who was harmed.
The customers for whom false accounts were opened are one group. Some suffered concrete harm to credit ratings or were charged fees for services they did not want. Most did not, but feel outrage that a contractual legal relationship was established in their name without their consent. So far they have gotten a pittance, $5 million out of the $185 million settlement. But they may have the basis for a class action lawsuit.
Then there are the shareholders, who bought stock in Wells Fargo on the assumption that it was being run honestly and that its claimed success in cross-selling additional services to its customers was not fraudulent. This group, which has seen the value of these shares drop sharply, probably suffered the greatest pecuniary loss.
Then there is the citizenry of the country, increasingly skeptical that government will fulfill the expectation that “the laws be faithfully enforced.” This seems increasingly haphazard when it comes to financial firms.
There are at least two economic issues here.
The first is that of the “principal-agent” problem, which arises when incentives are not correctly structured so that some employee, an “agent,” does not fulfill his or her duties in a way that best serves the interest of the employer or “principal.” The stockholders in a corporation are the principals. Managers and other employees of it are agents. So are the directors, who are highly paid to ensure that top management does, in fact, run the corporation to maximize shareholder well-being.
It is hard to argue that incentives set up by Wells Fargo managers that motivated thousands of employees to open fraudulent accounts furthered the interests of shareholders. Perhaps the directors are discreetly pressuring Stumpf and other managers to clean things up. Perhaps the board will yet clean house themselves, firing Stumpf and other key executives. But I wouldn’t bet on it.
Principal-agent problems like this are a large drain on economic efficiency. And they often seem intractable.
The other economic issue is the role of limited liability. The invention of the modern limited-liability joint-stock corporation was an important advance in marshaling capital for productive ends. Sole proprietors and partners in business traditionally had unlimited legal liability for business activities. If the business failed to pay a loan, the individuals were personally liable for repayment. If a business vehicle struck and harmed someone, individual owners were legally responsible to pay damages.
Limited liability in modern corporations means a shareholder has no personal liability for debts or damages incurred by the company. They may lose whatever value there was in their share of stock, but no one can come after them for anything beyond that. This legal limitation on liability removes a huge economic disincentive to people pooling their money to carry out large enterprises. The poor widow and Warren Buffett alike can invest their funds without worrying that they might lose all their other property in the event corporate managers make errors or do wrong.
Limited liability always referred only to the personal financial liability of shareholders. It never had anything to do with a corporation having special exemption from financial obligations, tort liability for damages or compliance with the law. In these, a corporation was the same as any other business.
In practical terms, however, the size and complexity of modern corporations means that assigning responsibility for misdeeds to specific individuals is problematic. Should Stumpf be personally liable if a Wells Fargo messenger drives a company car through red light, knocking down a pedestrian? Of course not. But what if a loan officer changes amounts on a financial statement so that a loan to a buddy gets approved? No. But what if there is something systemic, like more than 5,000 employees all creating false accounts because they believed the bank’s incentive policies forced them at the risk of losing their livelihood?
Which brings us back to Gen. Yamashita.
A Japanese Army general, he was executed by a U.S. military court because he was a commander in the Philippines when Japanese forces committed terrible atrocities against civilians and U.S. prisoners of war. Evidence was clear that Yamashita did not order the atrocities, was not aware ahead of time that they were going to take place and, in many cases, did not have the means to stop them had he known. Moreover, many atrocities were committed by Japanese naval forces over which he had no command.
The U.S. Supreme Court refused to hear his appeal, though two justices wrote dissents that were insightful and poignant. He was arrested, charged, tried, denied appeal and executed in six months. Most constitutional scholars now think that, however terrible the conduct of Japanese forces, the execution of Yamashita was a miscarriage of justice.
However, the general principle that military commanders are personally accountable for acts perpetrated by their subordinates was incorporated into international treaties on the laws of war. For war generals, the “I knew nothing” defense generally doesn’t fly.
Back at Wells Fargo, Stumpf continues to utter pieties about how important honesty and integrity are to Wells Fargo and how top management is going to get to the bottom of things and make changes. Like Yamashita, he argues he did not order anyone to do anything wrong and that he had no knowledge it was happening. These arguments actually seem a lot more valid for the old general than for the modern CEO, but don’t count on any change at the top anytime soon.