Asymmetrical Information

Jane - You missed your opportunity. When your boss said such benefits were only available to CEO's, you should have indicated your willingness to accept the position. What do they teach you MBA's, anyway?

Yeah, Jane don't sell yourself short. Throw back you shoulders, lift up your chin and become that CEO. We know you can do it, we're rooting for you.

'Contract theory' says that economic principals contract agents to do things they're unable or unwilling {...for whatever reason} to do themselves.

In every such 'principal/agent' transaction there are extra costs incurred -- Economists call these costs 'agency costs'.

So what if, under an 'agency' contract, the interests of the agent diverge from the interests of the principal ?
{..what if a company's stockholders get a crook as their CEO ?}.

.......... Economists have a name for problems like this: "moral hazard".

Moral hazard happens when the actions of an agent can be hidden from a principal, creating extra agency costs - because the agent is able to shirk and generally not deliver on his end of the bargain.

[More generally, "Moral Hazard" is the risk or fact that you can't TRUST the other guy to perform his end of the bargain !]

Whom can you trust ??

Hi,

Just stumbled across this blog. I'm constantly amazed at the richness of libertarian material in the blogosphere. This is a great site. Now, I don't want to seem like an idiot, but WHO IS Jane Galt (other than a play on Rand's hero)? Are you based in NYC? What kind of work do you do? I'm an MD currently doing an MBA at Columbia, always interested in fellow libertarians out there,

Paris.

Paris: Megan ("Jane") lives in NYC. Scroll way down to "About the authors" in the left sidebar and follow the links below it. Megan's section on Employment is far out of date. She's now working as a journalist, I presume trading on her fame from the blog. She's far less of a Randian than her pseudonym might make you think.

So what's the big problem here (other than in the clarity of the reporting? In one paragraph, Mr. Bennett is accused of "defrauding investors by hiding hundreds of millions of dollars in loans to another company that he controls." We are not apprised of whether or not these loans were secured, non-recourse, guaranteed or what-have-you, nor of whether or not such loans to insiders were allowed under Refco's By-Laws. Moreover, what were the terms of the loan? Prime + 2? 5? 7? What? How do the terms compare to other loans in the industry?

Further on we learn that:

Mr Bennett had borrowed $430m through a third company. The money was repaid on the day of the announcement, and Mr Bennett was placed on leave. An investigation began immediately and prosecutors worked round the clock to prepare a case. They say that since late last year Mr Bennett had "actively participated" in a scheme to hide as much as $545m, with the money cleverly repaid just before routine audits.

The meatiest paragraph informs us that:

The initial internal review found a receivable owed to Refco by a firm controlled by Mr Bennett. This largely consisted, the firm believes, of “uncollectible historical obligations owed by unrelated third parties” to Refco. These obligations were transferred periodically to Mr Bennett's firm; Refco's accounts then reflected a receivable from that entity. The fact that the receivable was from a firm controlled by Mr Bennett was “hidden at the end of…reporting periods”, says Refco, in transfers to a (probably unconnected) customer account.

Sorry to be so skeptical as I'm sure that Mr. Bennett is every bit the fraudulent playboy he is being made out to be (after all, he IS a capitalist). But this story raises many more questions than it answers, and seems to be written merely to scare investors and belt yet another tired verse of the same old song ... (Capitalist) Piggies.

The reporting is sloppy, but if it's accurate at all the big deal is that Bennett used his position in the corporation to make large loans of other people's money to himself, and did not inform those other people (investors) of the loans and other self-dealing (the collection agency-like transfer). Maybe the transactions made perfect business sense, but the investors had a right to know about the self-dealing and make their own assessments.

I can easily think of two ways Bennett could have cheated the corporation, and one of them isn't even a conscious decision to cheat:

1. The interest on a loan (if there was a real loan and not just collectible transfers), and whether to make a loan at all, depends on how much risk there is of the debtor becoming unable to keep up payments on the loan. Bennet is hardly the right person to make an objective estimate of how risky his side business is.

2. When delinquent receivables are transferred to a collection agency, the agency gets a pretty good percentage of whatever they manage to collect. When the debts look unlikely to be paid, that's no problem; a percentage of whatever is collected is better than nothing. But maybe Bennet gave himself a sweetheart deal, with debts that looked likely to be paid just a little late being sent to his agency under an unjustifiably large discount, giving higher profits to Bennett's agency. Note that this may hurt the corporation by far more than the money lost. If I mail one payment a few days late (or the Post Office loses a stack of mail for six months - this happened to me once) and suddenly I'm hearing from a collection agency, I'm going to look at switching to another supplier.

I think that you have the analysis backward; the NYSE would not have acted so aggressively if the problem was merely concealed payments to the CEO.

The problem seems to be that Refco was hiding uncollectible obligations in another entity. In other words, it was taking uncollectible receivables and converting them into (apparently) collectible ones, by transferring them to a third party that really was not a third party, then keeping them from being closely looked at by paying them off temporarily when audited. This would inflate earnings, and hide the actual risks and actual profitability of the business.

Hi, markm:

...the big deal is that Bennett used his position in the corporation to make large loans of other people's money to himself, and did not inform those other people (investors) of the loans and other self-dealing (the collection agency-like transfer). Maybe the transactions made perfect business sense, but the investors had a right to know about the self-dealing and make their own assessments.

The fact that the receivable was from a firm controlled by Mr Bennett was “hidden at the end of…reporting periods”, says Refco, in transfers to a (probably unconnected) customer account.

I can easily think of two ways Bennett could have cheated the corporation, and one of them isn't even a conscious decision to cheat:

1. The interest on a loan (if there was a real loan and not just collectible transfers), and whether to make a loan at all, depends on how much risk there is of the debtor becoming unable to keep up payments on the loan. Bennet is hardly the right person to make an objective estimate of how risky his side business is.

2. When delinquent receivables are transferred to a collection agency, the agency gets a pretty good percentage of whatever they manage to collect. When the debts look unlikely to be paid, that's no problem; a percentage of whatever is collected is better than nothing. But maybe Bennet gave himself a sweetheart deal, with debts that looked likely to be paid just a little late being sent to his agency under an unjustifiably large discount, giving higher profits to Bennett's agency. Note that this may hurt the corporation by far more than the money lost. If I mail one payment a few days late (or the Post Office loses a stack of mail for six months - this happened to me once) and suddenly I'm hearing from a collection agency, I'm going to look at switching to another supplier.

I carry no brief for Bennett or Refco, but article does no more than raise a specter of wrongdoing without presenting any evidence of such wrongdoing. In fact, the only facts presented about the allegedly fraudulent transactions appear to be on their face perfectly legal. Even if we assume that something seedy happened here, is it too much to ask that such evidence be presented in the article? All the more so that normal transactions where there is no malfeasance can be differentiated. Judging from the article, all loans from corporation to affiliated corporations are "bad", but in the real world that just is not the case.

Hi, SamChevre:

The problem seems to be that Refco was hiding uncollectible obligations in another entity. In other words, it was taking uncollectible receivables and converting them into (apparently) collectible ones, by transferring them to a third party that really was not a third party, then keeping them from being closely looked at by paying them off temporarily when audited. This would inflate earnings, and hide the actual risks and actual profitability of the business.

I agree with you that "the NYSE would not have acted so aggressively if the problem was merely concealed payments to the CEO," but why doesn't the article actually spell out what the real problems were? Why are we left to speculate as to what the transactions were, and what made the transactions fraudulent? Again, my beef is with the reporting of the story which only seems to point out that there was a business transaction and that somebody may have a problem with it. The illegality is assumed.

The problem seems to be that Refco was hiding uncollectible obligations in another entity. In other words, it was taking uncollectible receivables and converting them into (apparently) collectible ones, by transferring them to a third party that really was not a third party, then keeping them from being closely looked at by paying them off temporarily when audited. This would inflate earnings, and hide the actual risks and actual profitability of the business.

Very nearly what fried Enron, in other words?

MichaelW,

To me, the key line in the article is the following: The initial internal review found a receivable owed to Refco by a firm controlled by Mr Bennett. This largely consisted, the firm believes, of “uncollectible historical obligations owed by unrelated third parties” to Refco. It is also based on the fact that Mr Bennett was arrested for securities fraud in connection with the IPO; it does not seem that loans to the CEO would be sufficient to trigger a security fraud complaint (the complaint in that case would be the executive defrauding the company, rather than the company defrauding the shareholders.)

SamChevre wins a cupie doll. Refco was keeping bad debts off its books using matching loans from a third party.

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