Thursday, January 29, 2015

Universities and Hospitals: Time for American States to Tax Nonprofits?

The 2015 budget that Gov. Paul LePage proposed to the Maine legislature takes aim at the “sacred cow” of property-tax exemption for nonprofit organizations. Colleges and hospitals, for example, would be levied a property tax, with places of worship and government-owned entities remaining exempt. The rationale is that of fairness to home-owners, who must bear a disproportionate weight particularly in New England, where colleges and hospitals in particular are ubiquitous. However, I submit that a second justification exists—one based squarely on the colleges and hospitals themselves.

Not to be left undefended, non-profits in Maine claimed that their “special status is needed because they provide vital programs that governments often don’t.”[1] Universities, for example, provide knowledge and training, while hospitals provide health-care. The latter is arguably more vital than the former; a person can do without a higher education but one’s life is essential to oneself. This distinction can be the leading edge of a slippery slope stretching across the corporate world. Apple, for example, provides computers, which facilitate a person’s higher education. GE provides equipment that is used in hospitals to diagnose patients. In short, nonprofits can be viewed as part of a larger spectrum that is characterized by the provision of goods and services, rather than as separate and sacrosanct.

Indeed, corporate charters are the means by which governments essentially delegate important tasks to private companies. To say that only nonprofits perform functions needed by governments for society ignores the fact that governments charter companies. Which functions are vital seems too subjective for us to be able to rest on the conviction that only what nonprofit organizations provide is crucial in a society. In general, providing a product or service that is valued by consumers in a society is to perform a societally-worthy task; to claim that only nonprofit organizations provide vital products and services is dogmatic in the sense of being artificial or contrived.

As for profitability, executives at universities and hospitals are not unconcerned with maximizing revenue. As Gov. Jerry Brown was preparing his 2015 budget proposal, the University of California was demanding an increase of $100 million. Just because university administrations are bad at cutting spending does not mean that they are oblivious to capturing as much surplus as possible. To justify upcoming tuition hikes to students, the head of UC-Davis sent out an email insisting that the tuition increases would be necessary to keep education accessible and affordable. Maybe the Aggie cows have an opportunity, careerwise, in the university's administration (I'm afraid grass wouldn't cut it to cover tuition though).

The same underlying breed of greed can be said to characterize hospital administrations, though competition forces them to be more assertive in keeping spending in line. Were hospital administrators truly most interested in providing a vital service, they would not lie to the uninsured and turn them away. My point is that a realistic look inside nonprofits undoubtedly reveals an orientation chiefly to money (i.e., profit). Universities and hospitals are more like corporations than property-tax law in the States might suggest.




[1] Jennifer Levitz, “Maine Proposal Would Tax Property of Big Nonprofits,” The Wall Street Journal, January 24-25, 2015.

Wednesday, January 28, 2015

Syriza Party Governing in Greece: Austerity and the E.U.

Clarion calls of confrontation roiled through the E.U. after the state election in Greece on January 25, 2015. Would the E.U., heavily dominated by its largest state, and the European Central Bank (ECB) accept a larger public deficit (i.e., more government spending to alleviate the austerity) and continue the cheap loans, or would Alexis Tsipras, the new Greek prime minister, have to choose between continued austerity and default? 

In the election, the Syriza Party, the anti-austerity party in Greece, came close to an absolute majority in the state legislature. On the one hand, “Europe’s political establishment sought to show respect for the will of the Greek people.”[1] On the other hand, officials of other states—most notably Germany—portrayed a public face at least of holding the new Greek government to the current agreement. “There are rules, there are agreements,” German finance minister Wolfgang Schäuble declared.[2] Rep. Esteban Gonzalez Pons gave a distinctly federal perspective in worrying out loud whether relaxing Greece’s austerity would encourage “radical” parties in other states to gain power in order to go back on austerity/loan agreements.[3] According to the Wall Street Journal, “(t)hose opposed to relaxing the burden also worry that the electoral success of the leftist Syriza party, which surpassed many expectations, could energize other populist movements elsewhere in [the E.U.].”[4]

Of course, Schäuble’s could be sheer posturing before the anticipated arduous negotiations, and Pons’ conclusion that the E.U. could be “dismembered” should radical parties gain power at the state level is itself rather extreme. Furthermore, a decision at the federal level (including the ECB) and at lender state capitols to relax the “rules” on the allowable Greek deficit would not necessarily start a cascade of unraveled deals involving state debt and deficits. Such a change of government as occurred in Greece is not easy, and thus not easily “cascadible.” In other words, the populist parties in other states would still have their own heavy lifting to do, and that in itself, and the voters’ consent, would connote legitimacy and thus, theoretically at least, respect in other states and at the federal level.

Put in terms of negotiation, even Greece’s creditors must acknowledge the legitimacy of the Greek vote. In particular, it could not reasonably be contended that the Greek position should be unchanged. In other words, the area subject to negotiation shifted. This is not to say that the official (public) creditors would have to give in at all. Politically, Tsipras would have to decide whether to take on the factions in his party that want Greece to drop the euro (as he would do by compromising), or risk losing the “stream of cheap financing,” which in turn “ensures that Greek banks have access to cheap funding from the European Central Bank.”[5] Compromise could eviscerate his credibility among voters in the state, while holding firm to ending the austerity could mean default and whatever would ensue from it.

Even in the face of such a dramatic shift in government in one state, talk of the “dismemberment” of the E.U. strikes me as overblown. Even putting Tsipras’ political calculus in such stark terms as compromise vs. default may set up a false dichotomy. Even a huge shift in government must somehow reckon with the gravitas of governing (i.e., practicalities), which has a way of smoothing out what might seem on election night like a historic change on the verge of happening. Accordingly, the volatility in the markets and the drop in the euro likely reflected irrational exuberance more than any fundamentals.



[1] Matthew Karnittschnig and Gabriele Steinhauser, “Europe, Greece Dig In Over Debt,” The Wall Street Journal, January 27, 2015.
[2] Ibid.
[3] Ibid.
[4] Ibid.
[5] Charles Forelle, Nektaria Stamouli, and Alkman Granitsas, “Greek Vote Sets Up New Europe Clash,” The Wall Street Journal, January 26, 2015.

Saturday, January 24, 2015

Standard & Poors: Internal Controls Enabling a Conflict of Interest

After the financial crisis of 2008, rating agencies reassured the public that additional “internal safeguards” would prevent the sort of over-stated ratings that had contributed to the crisis. Congress did not deconstruct the structural conflict of interest wherein a rating agency is tempted to overstate the rating on financial security such as a corporate bond because the agency’s revenue would be higher if more of the bonds are sold. I contend that reliance on a company’s internal “fire walls” is naïve, given the strong, sustained temptation that exists as long as an institutional or structural conflict of interest is in place. To obviate the problem, the conflict itself must be deconstructed.

In January 2015, the SEC announced that Standard & Poor’s “softened standards to win business and misled investors long after [the financial crisis].”[1] S&P agreed to a $77 million settlement with the SEC and the attorneys general of New York and Massachusetts without having to admit to any wrongdoing. The rating agency was still negotiating to pay more than $1.37 billion to more than a dozen other States and the U.S. Justice Department “to resolve claims that the firm misrepresented its ratings as independent and objective during the run up to the 2008 financial crisis.”[2]

Simply put, S&P’s improved safeguards were not sufficient to thwart the underlying conflict of interest. Incredibly, “a number of control weaknesses . . . went unchecked inside S&P even as the ratings industry reeled from accusations that it [had] issued inflated mortgage-bond grades during the last real-estate boom.”[3] Andrew Ceresney, the SEC’s enforcement director, said investors were “in the dark” about some of S&P’s grading methods well after 2008.”[4] Behind the duplicity lay the strong gravity of the temptation to exploit the conflict of interest. Ceresney found “a deep cultural failure at S&P and a failure to learn the lessons of the financial crisis.”[5] The cultural element in particular points to the existence of the temptation, though a cognitive warping, which could be behind the learning deficiency would also point to a desire to continue to exploit the ongoing conflict of interest.

Instances of lying or even a mendacious organizational culture can also indicate the presence of a strong temptation. In early 2011, for example, S&P employees told investors that ratings on eight commercial-real-estate bonds were based on specific conservative criteria. Actually, the firm used a less conservative methodology, according to the SEC. “S&P misled market participants into thinking that the ratings for their investments were better and that their investments had more protection than was actually the case,” according to the office of the New York Attorney General.[6] The motive? S&P got about $7 million to rate and conduct surveillance on just six of those transactions. In other words, S&P managers slighted the firm’s stated benefit to the public for the sake of more private gain for the firm.

Even after S&P updated its rating methodologies and changed its senior management after 2011, the firm published, “Estimating U.S. Commercial Mortgage Loan Losses Using Data From the Great Depression,” which the SEC found is “a false and misleading article” that claimed that triple-A rated bonds could withstand Great Depression-era levels of systemic risk using a revised methodology even though the data that S&P actually used was “decades removed” from the 1930s.[7] That the lie was even in the title itself points to an organizational culture firmly ensconced in the conflict of interest. In particular, by misrepresenting marketing as science in order to gain financially at the expense of the investing public so brazenly, the managers at S&P were clearly at odds with their own public asseverations that the public could indeed rely on the additional internal-safeguards could be trusted.

The sordid culture ensconced in exploiting the conflict of interest continued on past 2012 to at least June 2014, during which time S&P “also failed to follow internal policies around the surveillance of previously rating residential-mortgage deals,” even as the firm agreed to an “extensive undertaking to improve its internal controls,” according to the SEC.[8]  The lesson for the American public is that internal safeguards in a company are no match for a structural conflict of interest. In fact, claims that additional policies and procedures are in place and will be sufficient can be sheer marketing (i.e., window-dressing)—essentially a subterfuge designed to render exploitation of the underlying conflict of interest easier rather than more difficult.

In conclusion, human nature itself is no match for the institutional conflicts of interest—especially those whose exploitation can bring with it great wealth. Going the route of strengthening internal safeguards is thus insufficient, and may even facilitate the exploitation. Even though redesigning an institutional system, such as the relationship between rating agencies and the issuers of financial securities to be rated, entails a great deal of effort, it is necessary to stop exaggerated private gain from compromising promised public benefit.




1. Timothy W. Martin, “S&P Lowered Ratings Bar, SEC Says,” The Wall Street Journal, January 22, 2015.
2. Ibid.
3.  Ibid.
4.  Ibid.
5. Ibid.
6. Ibid.
7. Ibid.
8. Ibid.

Wednesday, January 21, 2015

Police Snatching Property: A Conflict of Interest While American Federalism Sleeps

The U.S. Justice Department halted its adopted-forfeitures program in early 2015 out of a sense that state and local law-enforcement agencies had been using the federal program to retain a greater portion of seized property, including cash, than state laws permit. Asset forfeiture had grown since the 1980s largely as a strategy in combatting drug traffickers, yet the agencies themselves benefited in being able to spend the cash. Besides this conflict of interest, the federal-state dynamic here demonstrates federalism in action, though perhaps not as strongly as the system of government allows.

As police departments collected more and more in involuntarily forfeited property, an increasing number of people complained that their property had been seized without there being any evidence that they had committed any crime. In other words, the police were getting away with dismissing the “innocent until proven guilty” mantra of American justice. The ACLU, for instance, issued a statement saying the forfeitures violate the due process clause in the U.S. Constitution.[1] If so, then the Justice Department could have gone further than merely refusing to allow police departments to collect property at levels permitted only by federal law. Specifically, the federal agency could have sued police departments to contest even the state laws as unconstitutional. Presumably taking the property of anyone charged but not convicted of a crime, even of drug-dealing, violates constitutional rights. In a viable federal system, moreover, the federal government is obliged to act as a check against state and local abuses of power. That the Justice Department fell short of this function suggests that American federalism had already been compromised rather than fully functional.

Were the Federal Government acting as a viable check on the state (and local) governments in the U.S., surely going after governmental conflicts of interest would be on the federal radar screen. That the departments could spend the money from the forfeited property (whether under state or federal law!) points to a conflict of interest wherein a department’s own financial interests trumps or eclipses the wider protection inherent in the doctrine of presumed innocence.  Put another way, police could get away with exploiting a public benefit for private gain (that of the police). Of course, no police administrator would admit to it.

Ron Brooks, for example, headed the National Narcotic Officers’ Associations Coalition at one point. “While the money is helpful to us, that’s not the reason forfeiture occurs,” he explains. “It occurs because it removes the most critical component of these criminal organizations: the capital to operate.”[2] He claims that the helpful money is not even a temptation even though it is entirely reasonable to assume it is; he is dismissing the motive out of hand when it is anything but reasonable to do so. Typically, such an attempt to hide a conflict of interest is a subterfuge—meaning that one does in fact exist and it is being exploited. Put another way, if police administrators really were indifferent to the helpful money, why not admit that it could be a temptation?

Therefore, we can conclude that the departments’ discretion in forfeiture cases is problematic, given the active temptation to exploit the conflict of interest. Were the U.S. Government to have been acting as a check on the states, the Justice Department lawyers would have gone after that discretion, at the very least. Of course, going after the relevant state laws permitting the forfeiture practice would go even further in deconstructing the institutional conflict of interest, and thus evince a stronger federal system wherein the two systems of government—federal and state—act as checks against abuses in the other at the expense of the People.



[1] Devlin Barrett and Zusha Elinson, “Holder Moves to Curb Asset Seizures,” The Wall Street Journal, January 17-18, 2015.
[2] Ibid.

Sunday, January 18, 2015

Behind the Lower 2014 U.S. Federal Budget Deficit: A New Default

The U.S. Government’s fiscal deficit of $483 billion for fiscal-year 2014 is the lowest since 2007.[1] At a preliminary 3% of GDP, that deficit is much better than the 2010 deficit, which came in at 10% of the GDP. To be sure, the American economy was larger in 2014. Also, the federal government’s overall fiscal improvement masks changes “behind the curtain” that may not be so palatable.

In 2014, the federal government’s revenues first crossed the $3 trillion level.[2] Had the spending level of 2007 been that of 2014, the government would have run a budget surplus for the year. To be sure, going back to pre-recession spending-levels would ignore the gradual upward slope of spending since at least 2000; based on this slope, and assuming the actual revenue, the deficit for 2014 would have been appreciably more than $483 billion.

So, is the spending side to be lauded or criticized? In large part, this depends on the person’s political ideology. The same goes for the revenue side. What I find interesting about the spending is that a steeper upward slope (from that from 2000-2007) in from the fourth quarter of 2008 (the credit freeze having occurred that September) to mid-2009 is followed by flat-lined spending through 2014.[3] Put another way, spending departed from the gradual upward-sloped pattern to reach a new plateau. That it held from 2009 to 2014 explains why the spending level in 2014 is lower than it would have been had the gradual upward-sloped pattern continued unabated. Sequestration worked.

Even so, the jump in spending in 2008/2009 pushed it to a new, higher plateau. Even though spending might have been higher, fixing spending around roughly $35 billion represents a higher mark for revenue to reach, even during recessions. In short, the fiscal “new normal” after the 2008 financial crisis and the ensuing recession involves higher spending and more revenue in absolute terms. An alternative might have been to spike spending during the recession then peg the spending after 2009 to the level it would have been consistent with the previous gradually-ascending slope. That amount would have been roughly $30 billion (rather than $35 billion), and the U.S. Government would have shown a slight surplus for 2014.



[1] Josh Zumbrun, “Budget Deficit Reaches a Seven-Year Low,” The Wall Street Journal, January 14, 2015. The budget deficit for the calendar year came in at $488 billion.
[2] Ibid.
[3] Ibid.

Relaxing State Deficit Restrictions: Power-Grab by the European Commission

As the World Bank came out with its revised prediction of 1.1 percent economic growth for the E.U. (“eurozone”) in 2015, down from the earlier estimate of 1.8%,[1] the European Commission announced that it would allow states more leeway in meeting the federal requirement that state budget deficits be no more than 3 percent of their respective economic outputs. Lest this appear as a sign of political impotence, the “strings” demonstrate the opposite.

The Commission announced in January 2015 that states would be permitted to “stray from previous deficit-reduction commitments if they adopt structural reforms such as changes to labor rules that make it easier for businesses to hire and fire workers.”[2] At the time, the World Bank pointed to a lack of economic competitiveness as one reason for the languid growth expected in the E.U. It “is struggling to avert a third recession since the financial crisis as the currency union grapples with high debt and a lack of international competitiveness.”[3] To be sure, labor flexibility can enhance such competitiveness, yet structural labor reforms pertain to labor policy—something that a legislature, either federal or state—should presumably undertake. The Commission is the E.U.’s executive branch. In making significant labor reform a requirement for state governments having trouble meeting the 3 percent limitation, the Commission is demonstrating the power that it, and thus the E.U., has relative both to other federal institutions and the states.

To be sure, a more competitive E.U. internationally is in the states’ interest too. Indeed, state legislators could use the federal requirement as political cover when facing pressure from labor unions. Furthermore, the Commission also announced that states facing “very hard times” economically, such that they “have gaps between actual economic output and potential output of between minus 3% and minus 4% of gross domestic product, wouldn’t be required to cut their deficits at all, and only by 0.25% of GDP if their debt is over 60% of GDP.”[4] To state legislators in such troubled states, having to enact some structural labor reforms that would enhance economic competitiveness might be an easy sugar pill to swallow.

In short, the European Commission did not capitulate to wayward states by easing pressure on them to keep their respective deficits below 3 percent of economic output; rather, the federal institution used its power to interpret the law in a more lenient way to gain power in the domain of labor policy both from other E.U. institutions and the state legislatures.



[1] Ian Talley, “World Bank Lowers Global Outlook,” The Wall Street Journal, January 14, 2015.
[2] Matthew Dalton, “EU Eases Pressure on Nations’ Budget Deficits,” The Wall Street Journal, January 14, 2015.
[3] Talley, “World Bank Lowers.”
[4] Matthew Dalton, “EU Eases Pressure.”

Thursday, January 15, 2015

On a Central Federal Policy in Education in the U.S.: Implications for American Federalism

In a speech in January 2015, U.S. Education Secretary Arne Duncan urged a continued central role for the federal government in education policy. He said the president was proposing to increase federal spending on elementary and secondary schools by $2.7 billion; Congress had appropriated $67 billion to the U.S. Department of Education—with $23.3 billion for the Elementary and Secondary Education Act—in the 2015 budget.[1]  Typically, debate on the federal government’s role had focused on the use of standardized tests in holding schools accountable. I submit that a self-governing people has a duty to consider the wider implications, such as the impact of a greater role on the federal system. Otherwise, unintended consequences may show up after it is too late to do anything about them.

Federalism is rarely on the media’s radar screen in the U.S., yet this dimension can be detected in statements made by public officials. For example, in his speech, Duncan said, “If we walk away from responsibility as a country—if we make our national education responsibilities somehow optional—we would turn back the clock on educational progress, 15 years or more.”[2] In positing a responsibility as a country to education, he is claiming that national education responsibilities exist. This implies that the U.S. Government has a legitimate role. This is a contestable claim.

Under the U.S. Constitution, the powers of the federal government are limited, or enumerated, whereas those of the states are both enumerated and residual. Education is not explicitly listed among the federal government’s enumerated powers, but that government can spend money for the general welfare. Education certainly contributes to that. In fact, so many things do that reading “the spending clause” so broadly eviscerates (i.e., wipes out) the enumerating itself because the federal government could get around the list simply by spending money on an additional policy domain. Put logically, a broad reading of the spending clause contradicts the very notion of enumerating powers, so both in original intent and practically, the spending clause must surely apply to the general welfare via any of the enumerated powers. Spending on education is the task of the several states.

Sen. Lamar Alexander (R-TN), chairman of the Education Committee, brought federalism to the surface in his remarks at the time, but without presenting a coherent alternative. Referring to the “No Child Left Behind” law passed while George W. Bush was president, Alexander said, “My goal is to keep the best portions of the original law and restore to states and communities the responsibility for deciding whether teachers and schools are succeeding or failing.”[3] In other words, he wanted to retain the federal government’s role—making it better—even as he wanted to restore to the states and localities their responsibilities. Such cooperative or shared-competency federalism, while common in the E.U., runs up against the enumerated feature of federal power in the American system. Put logically, returning to the states their respective responsibilities would mean taking the federal government out of the education business. Practically speaking, retaining a role for the federal government risks further encroachment on the states.

Generally speaking, the more the enumerated feature of the U.S. Constitution is blurred or distended, the less the states will be able to act as a check against federal encroachment. The check feature of federalism can protect not only the states as viable republics in their own right, but also citizens from abuses of power on the federal level. Likewise, keeping the states from encroaching on the federal enumerated powers can enable the U.S. Government (e.g., the Department of Justice) to protect citizens from abuses of power from state officials. Civil rights during the 1960s is a case in point.

Therefore, the implications of education policy may be more important than the educational issues that pertain more directly to education. Keeping the implications on the system of public governance on the public’s radar screen is thus part of the responsibility of a self-governing people and its elected representatives.




[1] Caroline Porter and Siobhan Hughes, “Education Secretary Presses Central Federal Policy Role,” The Wall Street Journal, January 13, 2015.
[2] Ibid.
[3] Ibid.

Fiscal Responsibility in Alaska: On the Challenge of Falling Oil-Tax Revenue

With West Texas Intermediate (WTI), the U.S. benchmark oil price, at $46.07 on January 12, 2015, lawmakers in Alaska were getting nervous because the government was relying on oil-industry taxes to cover 89% of the government’s operating revenue.[1] At the time, the government had a $3.5 billion deficit in the $6.1 billion budget.  How the governor, Bill Walker, planned to deal with the shortfall can give us a glimpse of what fiscal responsibility might look like in government.

In spite of the huge deficit relative to the total budget, Walker was asking government agencies to reduce their respective budgets by only 5% to 8% for the coming fiscal year. To cover the rest, the governor planned to “dip heavily” into Alaska’s $14 billion in reserves.[2] Merely having reserves is itself fiscally responsible. In California, Gov. Jerry Brown had contributions to a “rainy day” fund as part of his budget even as the University of California clamored for $100 million more in funding—a request the governor rejected as exorbitant.

The fiscal responsibility goes even further in Alaska. The government was diverting only $300 million of the $6.76 billion in oil-tax revenues it expected to collect over the two-year period ending June 30, 2015 toward operating costs—the rest of the revenue going to trust funds, capital projects, and local governments.[3] The continued contributions to the trust funds strike me as particularly responsible, given the political temptation to skimp on them in order to obviate budget cuts of even 5 percent.

In short, Alaskan fiscal responsibility can be characterized as balanced, with budget cuts going along with tapping reserves and continued contributions to trust funds. A return to higher oil prices would signal attention to making up for the reserves’ depletions and adding still more to increase the reserves. In the long term, the reserves could reach a level at which the operating budget is funded entirely by the reserves’ investment revenue. With enough self-discipline to forge ahead with a sustained fiscal responsible policy, governing officials can make taxes obsolete.



[1] Ana Campoy, Mark Peters, and Erica Phillips, “Energy-Heavy States Get a Crude Awakening,” The Wall Street Journal, January 13, 2015.
[2] Ibid.
[3] Ibid.

Monday, January 12, 2015

Stockholder Activism at DuPont: A Conflict of Interest for Management

In American corporate governance law, the business judgment rule gives management expertise the benefit of the doubt over stockholder proposals. Compared with executive skill, they look rather populist and thus potentially irrational in nature. Nevertheless, with the rule chaffing up against the property-rights foundation of corporate capitalism, the managerial prerogative can be said to be dubious. Indeed, a strict private-property basis justifies displacing the default profit-maximization mission for a given corporation. Alternatively, stockholders may want to use their concentrated, collective wealth for other purposes, such as to alleviate hunger. Once enough profit has been made for the business to be sustained for another year or two, any additional surplus would be spent on food pantries, for example, rather than going out as dividends or being retained by the corporation. Because managerial skill is premised on the profit-maximization goal and its associated strategies, corporate executives intrinsically resist alternatives proposed by stockholders. The managers face a conflict of interest in providing their recommendation for stockholders. Even when the proposal assumes profit-maximization but differs from a current strategy (i.e., adopted by management), a conflict of interest exists should the management seek to provide a recommendation for the stockholders. In this essay, I use the activism of Trian Fund Management at DuPont to illustrate this point.

A conflict of interest can be characterized as a conflict between two roles held by a person or organization. The roles or functions differ in how broadly the associated benefits reach. Simply stated, one role tends to be more oriented to private benefits while the other typically has a responsibility to provide benefits to the public, or relatively public. For example, a financial ratings agency is in business to make a profit (private benefit) and to provide the benefit of accurate ratings on financial securities for the investing public and other parties. The inherent conflict between these two roles lies in the tension between the private and public benefit; the temptation is to exploit the public benefit at the expense of the public (i.e., risking or reducing its benefit) in order to increase the private benefits. Even if such a conflict is not exploited, the temptation to play with the broader benefit for the sake of the narrower is inherent in the institutional arrangement (i.e., the two roles held by one party, and the related private and public benefits to that party and stakeholders).[1]

Often, the temptation goes unnoticed even by the very public whose benefit is at risk. At DuPont, a huge conglomerate based in the chemicals industry, institutional and individual stockholders learned on January 8, 2015 that the company’s management would come out with its recommendation on Trian’s proposal to add four directors to the board of directors. The management claimed it would “make a recommendation that is in the best interest of all shareholders.”[2] That is to say, the management sought to present itself as a neutral party working to protect the stockholders as a body from possible over-reaches by one. This salubrious “selfie” image can reasonably be regarded as a subterfuge, for the management clearly had its own vested interest “in the game.”

Interestingly, the proposal itself lies beyond the domain of managerial expertise. The question of board size lies in the realm of corporate governance, and is thus exclusively for stockholders and/or board members to decide. Put another way, the business judgment rule does not (or else should not) apply here. So the management’s decision to provide a recommendation involves over-reaching, which in itself is not in the interest of the stockholders.

Furthermore, the management faced a conflict of interest in making a recommendation because the four additional seats were likely to take a minority position hostile to the management. Robert Gentry at Stewart & Patten said “dissenting viewpoints on the board could actually be a healthy thing.”[3] It would take a self-confident (i.e., strong) management to say, in effect, what is dissent to us! Let them have their say.[4] Typically, however, a management cadre will fight any opposition, even if that means overstepping on to corporate governance.

Regarding stockholder proposals that involve changes in strategy, managers would of course be tempted to substitute protecting themselves and their policies for protecting all of the stockholders. Managers are only human, after all. Indeed, an alternative strategy, which does involve managerial expertise in strategy, is the impetus behind the proposal to expand the DuPont board. Trian had argued that DuPont’s conglomerate structure is too unwieldy, and so the seven business lines should be split into three companies—agriculture and nutrition, industrial materials, and performance chemicals.[5] Citing synergies from the integrated research and sales efforts, the management agreed only to split off the performance chemicals. This managerial rationale is likely not the whole story though.

Splitting DuPont into three companies would go against the instinctual “empire-building” mentality that tends to grip corporate executives. That is to say, the spinning off only the performance chemicals may not actually be in the stockholders; rather, the management has wanted a relatively large company on account of the intangible and tangible private benefits to management even at the expense of the stockholders’ financial benefit. Shirking this relatively public benefit for the relatively private ones represents an exploitation of a structural or institutional conflict of interest. If merely permitting a management to be tempted is itself unethical, then it should not be allowed to make a recommendation (i.e., given its vested interest). Stockholders could rely on third-party analyses and discussion between themselves, effectively treating management as part of the topic up for debate and thus not a party to it.

In short, realizing structural or institutional conflicts of interest “right under our very noses” is only part of the treatment back to ethical recovery; the source of temptations—even those previously not acted on—must be eradicated for the problems associated with conflicts of interest to be effectively obviated. To naively assume that people subject to such conflicts will somehow not be tempted or will never act to exploit a conflict of interest is to ignore human nature or minimize its orientation to self-interest above public good. I suspect that one of the major blind-spots in modern society pertains to not just existing institutional conflicts of interest, but also how naïve we are concerning the people and groups in them. We tend to assume that people occupying high-status positions are enlightened and are therefore above the lure of such temptations. In fact, we tend to take them at their word, as if being on television on print lends sufficient validity to their asseverations. I submit we would be better off with a public policy aimed at deconstructing all institutional conflicts of interest.



[1] The temptation being inherent to a conflict of interest makes it inherently unethical, even if it is not exploited in practice. Simply having a person or institution in a conflict of interest is unethical if knowingly subjecting a person (or group) to an ongoing temptation to shirk a duty to provide “public” benefits in favor of additional private gain is itself unethical. Surely standing by even as you know that another person has been put in a situation in which he or she is tempted to commit murder is unethical; you would have an ethical duty to do what you could to get the person out or deconstruct the situation that he or she is in. Similarly, I contend that the general public, or society, has an obligation to deconstruct institutional conflicts of interest, such as exist in public accounting, rating agencies, and even campaign finance.
[2] David Benoit and Jacob Bunge, “Activist’s Bid Sets Stage for Brawl for DuPont,” The Wall Street Journal, January 9, 2015.
[3] Ibid.
[4] Here I am following Nietzsche, who writes that the strong are apt to say, “What are these parasites to us!” That is to say, the strong can afford to be generous, whereas the weak who seek to dominate are naturally petty and small.
[5] Benoit and Bunge, “Activist’s Bid.”

Is Dark Trading Ethical?

Dark trading” has a subterranean connotation, as if it were done by slithering snakes in the river Styx. In actuality, the term refers to trading in stocks that is done on computers that are less public than the exchanges. That is to say, the bid-and-ask quotations on a given computer network are known only to participants on it, and not to the traders on the public exchanges. Ethically, the public-private dichotomy is relevant. I submit that it reflects a wider trend in American society.

In the third quarter of 2014, the average daily volume of dark shares was 2.56 billion, accounting for 45 percent of the total average daily share volume in the United States, according to the TABB Group.[1]  Besides technological advancement, the proliferation of trading venues is behind the growth, according to Sayena Mostowfi at the TABB Group.[2] The fact that most of the expansion is in the form of private, or limited-access computer networks rather than additional public exchanges presents an ethical dilemma that has wider societal implications. Out of the 300 venues, only 13 were registered exchanges—the vast majority being alternative trading systems or broker-dealer platforms.[3]  Leaving aside questions such as how efficiency and the public quotes are impacted, I want to discuss the ethical implications of the increasingly salient insider vs. outsider dichotomy.

Even as the New York Times acknowledges that more computer networks might increase efficiency, the paper suggests that while “dark trading can benefit some insiders, it may cost the market as a whole.”[4] Private benefit may eclipse the common good, resulting in an unbalanced system. Perhaps the explosion in “privateness” in trading is a reaction to the increased scale of the public—meaning the stock market as a whole in the U.S.

The trend may be entirely natural. In American society at the time, “gated communities” were becoming increasingly popular as a means of erecting barriers to crime. Moreover, the sheer amorphous content of a mass public does not satisfy the human need for meaning in a lived context. For the vast majority of the species’ 1.8 million year existence, the iterations of natural selection fashioned the human brain when a given person had contact with less than 150 people. Hence, the expanded number of strangers with whom a typical person in a large city comes in contact presents problems for us. It is entirely natural, in other words, to seek environments in which the number of strangers is kept below 150.

In terms of dark trading, the human self-protective attempt to create a privateness in the midst of a huge publicness is only part of the story, however. The creation of the computer networks is also informed by the desire to achieve better trades than are available on the public exchanges.  In other words, the insiders want to come out better as a result of being members of the private networks. The morality of seeking to shore up advantages that are not available to all market participants can be distinguished from that of creating financial “gated communities.”  Even though both motives are to be found in human nature, evolutionarily speaking, the ethics of psychic self-protection and economizing can be distinguished such that only one is normatively blameworthy.

I submit that economizing to the extent that the public good is compromised is blameworthy (whereas seeking private gain without such a generalized cost is not), whereas seeking a psychological comfort zone by limiting interpersonal interactions to a number of people in line with the bounds established naturally when humans lived in small clans is salubrious.  Societally, the construction of gated communities may seem elitist, but the human motive may not be so arrogant; similarity of characteristics may be one means in which we try to keep within the bounds of contact with less than 150 strangers.  While the motive to exploit the public good and thus put it at risk for private gain is also natural, the systemic risk renders that motive blameworthy and thus appropriately restricted.

In conclusion, the proliferation of privately-accessible trading networks is not in itself unethical; the normative problem kicks in if the networks compromise the viability of the stock market as a whole. That is to say, if the functioning of the public exchanges is compromised or thwarted due to the separate prices on private networks, regulators are justified in stepping in keep the private networks from having such an effect.  



[1] Anna Bernasek, “The Rise of Trading in the Dark,” The New York Times, January 11, 2015.
[2] Ibid.
[3] Ibid.
[4] Ibid., italics added.