With apologies for the double negative, the rest of this piece will be a more straightforward argument for why Corporate Social Responsibility (CSR) is not only a good idea but – like breathing – somewhat necessary.

Last week Dr. Aneel Karnani published an Op Ed in The Wall Street Journal titled “The Case Against Corporate Social Responsibility.” It is somewhat ironic that the author represents the Ross School of Management at the University of Michigan which is hosting this year’s Net Impact conference – an annual gathering of more than 2500 business students, educators and business leaders focused on CSR.  Dr. Karnani’s article seems almost deliberately provocative, generating more than 250 comments and this response from Liz Maw, Net Impact’s Executive Director.

While it is hard to add anything new to the maelstrom of criticism Dr. Karnani received for his opinion, I will share three short observations on why I believe CSR has taken root from business schools to board rooms and is growing faster than even China’s GDP.

More and more companies are winning with CSR.

Tim Mohin, AMD

Dr. Karnani asserts that CSR only makes sense when the business’ interest and the public’s interest line up. So why are so many companies jumping on the CSR bandwagon?  Sure it could be external pressure from watchdog groups or the herd mentality of businesses trying to keep up with the competition.  But these are weak reasons for the magnitude of this trend. More than 85 percent of the Fortune 50 companies are now publishing corporate citizenship and/or sustainability reports in some format.   A more likely answer is that smart managers see potential for profit.  They look at megatrends in the world and ask themselves – “how can we apply our core competencies to win in the future?”  This is business 101 – find the need and fill it…  It so happens that the many of today’s trends point to CSR issues – resource scarcity, poverty, pollution, etc.

While a litany of doom for some, these issues can also look like opportunities for a wise business manager.  (See my blog on “less is more obvious”).  General Electric CEO Jeff Immelt – a speaker at last year’s Net Impact conference - would likely say that this alignment doesn’t just happen; wise managers develop strategies and position their companies for success in a resource constrained world.  General Electric’s eco imagination line topped more than $18B in revenues in 2009 and is a growing profit center.

Smart Companies Take the Long View

Dr. Karnani warns that CSR may be dangerous because, by doing the right thing voluntarily, companies may obscure the need for government regulation.  One is left to conclude that a better path is for companies to ignore CSR in the quest for short-term profit, and in so doing help increase the size and power of government.  Gosh, wouldn’t this be a great outcome!

With no evidence or examples, this notion rests on the shaky ground of conjecture.  What is not conjecture is the flood of companies exploiting lower cost locations – which often translates to weaker environment and labor laws and/or enforcement.  Rather than obstruct the role of government, responsible companies have actually been propping up the role of government around the world.  For example, electronics companies sourcing from China have tangibly improved labor, safety and environmental conditions in supplier factories.  Why would they do this when the government does not?  The answer lies in taking a longer view.

Sure it may be more work and some initial investment to responsibly manage a business, but when left unchecked, poor conditions can go awry costing many thousands of times more.  Perhaps if BP had placed more of its focus on safety and contingency measures, it might have saved itself billions in hard costs, irreparable damage to its corporate brand and prevented the epic harm caused to the Gulf region.

While failures like BP are obvious, successes tend to go unnoticed. A great example of long-term thinking is management of hazardous waste.  Many developing countries have yet to implement laws to deal with the scourge of toxic waste.  Following the logic of the Op Ed, companies operating in these locations should save money and just dump their toxic materials out the back door or into the local river.  Well, it turns out that many of these companies are US owned and have tried this before.  Then came Superfund.  The Superfund law said that it did not matter whether dumping was legal at them time; if you did it, you had to pay for the cleanup.  And, oh by the way, you might also have to pay to clean up everyone else’s waste in the same dump if they could not afford the bill.  Smarter companies learned a hard lesson this way - better to manage toxics responsibly now than get stuck with a bill later – and these companies manage this way whether they are in Chicago or China.

Companies know CSR Impacts Brand Value and investment

Last but not least – CSR is a vital component of brand value. Often listed as the largest intangible asset on the balance sheet, brand reputation can make or break a business.    The Reputation Institute and others estimate that about 40% of brand reputation is manifest through CSR.  Hmmm, 40% of one of the larger items on the balance sheet…CSR is starting to sound a bit more important to even the most self interested shareholder.   And, if that is not enough business value, the latest estimates of socially screened investment assets are closing in on $3 trillion in the US, making it tougher still to ignore the business implications of CSR.

Rather than struggling with definitions and rationales for CSR, it seems that most companies intrinsically understand their duty to account for their impact and, if possible, lend a hand to make things better. This change did not happen because CEOs woke up one day with a desire to save the planet. I believe the trend toward sustainability stems from a common realization of scarcity and the instinctive imperative to husband our resources.

Perhaps it is the “Tragedy of the Commons” on a global scale. Increasingly, the public consciousness is demanding accountability and action not only to protect, but to enhance our common good and our shared resources.  It is encouraging that the thousands of young MBA students who sign up for Net Impact know this.

The trade-offs inherent in this debate are difficult. Balancing the needs of people, impact on the planet and making a profit is not easy. Perhaps I am an optimist, but I believe that as companies are increasingly held accountable for their impacts and their behavior — both negative and positive — there will be a steady stream of innovation leading us toward sustainability. If the past is prologue, the private sector will be the engine of change by actively selecting and deselecting winners and losers in the new paradigm.

While it may not have been his intent, Dr. Karnani’s provocative opinion may have done more to promote CSR than to slow it.  Having stirred up legions of impassioned objectors, he has added momentum to the movement.  Hopefully, Dr. Karnani will have a chance to share his views with the Net Impact audience at his campus this October…I volunteer to moderate the panel!

Tim Mohin is Director of Corporate Responsibility at AMD and a board member of Net Impact. His postings are his own opinions and may not represent AMD’s positions, strategies or opinions. Links to third party sites are provided for convenience and unless explicitly stated, AMD is not responsible for the contents of such links sites and no endorsement is implied.

Recent leadership failures in several high profile companies draw increased attention to the reality that achieving goals – performance – is only part of the formula for success. Another critical piece is the way leaders do it which impacts others – relationships.  Leaders who are low in self-awareness, self-regulation, motivation, empathy and social skills lack something called “emotional intelligence” (EQ), a behavior model popularized by the work of Daniel Goleman.

Rather than being one of the many leadership fads that shed fleeting light on how those in power can be more successful, EQ is an enduring mirror that reflects back who a leader is and how he or she behaves, defining “tone at the top” more compellingly than any words on email, paper or video.

EQ also has a direct bearing on corporate reputation, something that boards of directors have watched impact stock price, media coverage, public opinion and a leader’s viability. Consider how public sentiment turned more negative against BP after former CEO Tony Hayward made the comment, “I want my life back,” and later watched his yacht race while gushing oil was destroying the livelihoods of Gulf residents.

Recently, retired Coast Guard Adm. Thad Allen gave BP credit for doing about as well as any company could have in stopping the oil flow, but Allen, in charge of overseeing the government and industry response to the Gulf spill, gave BP low marks for how it dealt with the people and communities affected. If leaders don’t feel or know how to genuinely express empathy, it makes it that much harder for them to be trusted or supported.

Ethical Failures

Korn Ferry’s Robert Hallagan, Vice Chair and Managing Director, Board Leadership Services, says the percentage of cases where EQ derails a CEO is higher than what we read about in the media, but still a small percentage of the total population of CEOs. “However, because of the press around it,” Hallagan says, “boards are becoming more sensitive to EQ.” Korn Ferry uses various assessment tools to assess EQ and other leadership competencies in the searches they do.

“Leaders’ lack of emotional intelligence can lead to ethical failures if they believe they will never get caught and feel smart enough to worm their way out of it,” says Keith Darcy, Executive Director of the Ethics and Compliance Officer Association. “Arrogance distorts a leader’s capacity to read accurately situations. They can reach a position of power and sometimes develop contempt for ‘the small people’ as BP Chairman Carl-Henric Svanberg was quoted describing the Gulf residents.”

In a recent Wall Street Journal article, Jonah Lehrer talks about the contradiction of power, essentially how nice people can change by having authority. To the point on vulnerability to ethical lapses, Lehrer says that “people in power tend to reliably overestimate their moral virtue, which leads them to stifle oversight. They lobby against regulators, and fill corporate boards with their friends. The end result is sometimes power at its most dangerous.”

Lehrer points out that company surveys are a good barometer of what is happening in the culture of the organization, and surveys provide evidence that the vast majority of rude and inappropriate behavior comes from the offices of those with the most authority.

One of the fallouts from former HP CEO Mark Hurd’s ouster seems to bear witness to this. Immediately after his resignation was announced, past and current HP employees began commenting on blogs about Hurd’s arrogance, rudeness, and treatment of people he disagreed with in meetings. He had the lowest employee approval rating (34 percent) of major tech industry CEOs.  Granted, few CEOs who are credited with significant cost-cutting and layoffs win popularity contests, but a healthy amount of EQ can mitigate the impact of difficult decisions.

Importance of Soft Skills

Recent publicized leadership failures do invite thinking about what it takes to be a good boss, a theme in an article in the most recent McKinsey Quarterly.  Self-awareness wins as probably the most important skill good bosses must have because, aware of their flaws, these bosses work not only to overcome them and reverse the resulting damage, but involve others to help compensate for whatever their own weaknesses might be - and the organization is stronger as a result.

In the rush to find what works, what will create leadership success, something has been staring us in the face, not often acknowledged. Executive coach Jordan Goldrich, who works with the Center for Creative Leadership, points out that “increasingly, research is showing that what we used to think of as the soft skills (building and mending relationships, communication, and humility etc.) are completely connected to the business results.”

A recent story about incoming General Motors’ CEO Daniel Akerson used the headline “Brash, Blunt, Demanding.” Recognized for his discerning questions and for holding others accountable, a style that gained him respect on Wall Street in his role as a GM board member, Akerson will take over on September 1 as CEO. Tagged with a style of being brash, blunt and using colorful language, he will have a chance to demonstrate if soft skills are also important to the success of the new GM.

“It’s interesting (that) leaders lacking EQ see no higher purpose generally than themselves, hearing nothing more than the sound of their own voice, and can’t see beyond quarterly results,” says ECOA’s Darcy. “Those with a well developed sense of self are capable of hearing the deep moaning in the world. They realize everything that we do gets done with, by, for, and through people. They understand that the well being of people translates into a well functioning organization.”

Gael O’Brien is a Business Ethics Magazine columnist. Gael is a thought leader on building leadership, trust, and reputation and writes The Week in Ethics.

Dear EarthTalk: I’ve been hearing about the great gas mileage for Volkswagens that use diesel fuel. But is it better for the environment to use diesel or unleaded gasoline? -- K. Cronk, Bay City, MI

In the past, diesel fuel was always considered dirtier than gasoline. But newer standards regulating sulfur content and improved technology in diesel engines have made diesel somewhat kinder to the environment. Many eco-advocates now tout diesel as a viable and preferable alternative to regular unleaded gasoline.

2009 Volkswagen Jetta TDI Clean Diesel

Where diesel fuel really shines over gasoline is improved fuel economy thanks to its higher “energy density”: Diesel contains more power per liter than gasoline. Today’s diesel engines have 20-40 percent better fuel economy than their gasoline counterparts, which some say more than makes up for the fact that they also produce about 15 percent more greenhouse gases. This greater efficiency means that diesel engines emit less carbon monoxide and carbon dioxide and fewer hydrocarbons than gasoline engines.

Diesel’s downside is that it emits larger amounts of nitrogen compounds and particulate matter (soot) that can cause respiratory problems and even cancer. The California Air Resources Board (CARB) attributes 70 percent of that state’s cancer risk from airborne toxins to soot from diesel cars and trucks. Nationwide, studies have shown a 26 percent mortality increase for those living in soot-polluted areas.

But diesel’s dark side is getting a little brighter, thanks to new technologies such as Mercedes-Benz’ BlueTEC system (now used in many VW, Audi and Chrysler diesel models) that filters particulates while improving overall engine performance. The Diesel Technology Forum (DTF), a trade association of carmakers, engine builders and petroleum distributors, reports that technologies now commonplace in new diesel engines reduce the tailpipe output of particulate matter by as much as 90 percent and nitrogen oxides by some 50 percent compared to diesel engines on the road just a decade ago.

“The industry has made significant strides in recent years to develop diesel systems that are cleaner and more efficient than ever before,” reports DTF. “Thanks to state-of-the-art engines, cleaner-burning fuels, effective emissions-control systems, and advancements in the fuel injection system, it would take 60 trucks sold today to equal the soot emissions of one 1988 truck.” U.S. Environmental Protection Agency (EPA) data shows that airborne diesel particulate levels fell by more than 37 percent during the 1990s.

Meanwhile, continually improving fuel efficiency standards in the European Union (where the majority of new cars purchased in many member countries use diesel fuel) are forcing carmakers to design more fuel efficient, less polluting vehicles around the world. After all, there’s no sense in designing better engines for one region with high standards and another for areas with less stringent rules. Another green benefit of diesel-powered engines is their ability to run on plant-derived biodiesel instead of petroleum-based diesel. And in the near future consumers may be able to shop for new diesel-electric hybrid cars now on the drawing boards of major automakers around the world. For now, consumers looking to buy a new or used car—diesel or otherwise—can see how different models stack up in regard to efficiency and emissions via the FuelEconomy.gov website, a joint effort of the EPA and the U.S. Department of Energy.

Photo: Chris Luckhardt, courtesy Flickr

SEND YOUR ENVIRONMENTAL QUESTIONS TO: EarthTalk®, c/o E – The Environmental Magazine, P.O. Box 5098, Westport, CT 06881; earthtalk@emagazine.com. E is a nonprofit publication. Subscribe: www.emagazine.com/subscribe; Request a Free Trial Issue: www.emagazine.com/trial.

Dear EarthTalk: What are the differences between farmed versus wild salmon when it comes to human and environmental health? -- Greg Diamond, Nashville, TN

Salmon farming, which involves raising salmon in containers placed under water near shore, began in Norway about 50 years ago and has since caught on in the U.S., Ireland, Canada, Chile and the United Kingdom. Due to the large decline in wild fish from overfishing, many experts see the farming of salmon and other fish as the future of the industry. On the flip side, many marine biologists and ocean advocates fear such a future, citing serious health and ecological implications with so-called “aquaculture.”

A salmon farming operation in Chile

George Mateljan, founder of Health Valley Foods, says that farmed fish are “far inferior” to their wild counterparts. “Despite being much fattier, farmed fish provide less usable beneficial omega 3 fats than wild fish,” he says. Indeed, U.S. Department of Agriculture research bears out that the fat content of farmed salmon is 30-35 percent by weight while wild salmons’ fat content is some 20 percent lower, though with a protein content about 20 percent higher. And farm-raised fish contain higher amounts of pro-inflammatory omega 6 fats instead of the preponderance of healthier omega 3s found in wild fish.

“Due to the feedlot conditions of aquafarming, farm-raised fish are doused with antibiotics and exposed to more concentrated pesticides than their wild kin,” reports Mateljan. He adds that farmed salmon are given a salmon-colored dye in their feed “without which their flesh would be an unappetizing grey color.

Some aquaculture proponents claim that fish farming eases pressure on wild fish populations, but most ocean advocates disagree. To wit, one National Academy of Sciences study found that sea lice from fish farming operations killed up to 95 percent of juvenile wild salmon migrating past them. And two other studies—one in western Canada and the other in England—found that farmed salmon accumulate more cancer-causing PCBs and dioxins than wild salmon due to pesticides circulating in the ocean that get absorbed by the sardines, anchovies and other fish that are ground up as feed for the fish farms. A recent survey of U.S. grocery stores found that farmed salmon typically contains 16 times the PCBs found in wild salmon; other studies in Canada, Ireland and Great Britain reached similar conclusions.

Another problem with fish farms is the liberal use of drugs and antibiotics to control bacterial outbreaks and parasites. These primarily synthetic chemicals spread out into marine ecosystems just from drifting in the water column as well as from fish feces. In addition, millions of farmed fish escape fish farms every year around the world and mix into wild populations, spreading contaminants and disease accordingly.

Ocean advocates would like to end fish farming and instead put resources into reviving wild fish populations. But given the size of the industry, improving conditions would be a start. Noted Canadian environmentalist David Suzuki says that aquaculture operations could use fully enclosed systems that trap waste and do not allow farmed fish to escape into the wild ocean. As for what consumers can do, Suzuki recommends buying only wild-caught salmon and other fish. Whole Foods and other natural foods and high end grocers, as well as concerned restaurants, will stock wild salmon from Alaska and elsewhere.

Photo: Sam Beebe, EcoTrust

SEND YOUR ENVIRONMENTAL QUESTIONS TO: EarthTalk, P.O. Box 5098, Westport, CT 06881; earthtalk@emagazine.com. Read past columns at: www.emagazine.com/earthtalk/archives.php. EarthTalk is now a book! Details and order information at: www.emagazine.com/earthtalkbook.

Over the last two years of the housing bubble, Wall Street bankers perpetrated one of the greatest episodes of self-dealing in financial history.

Faced with increasing difficulty in selling the mortgage-backed securities that had been among their most lucrative products, the banks hit on a solution that preserved their quarterly earnings and huge bonuses:

They created fake demand.

A ProPublica analysis shows for the first time the extent to which banks -- primarily Merrill Lynch, but also Citigroup, UBS and others -- bought their own products and cranked up an assembly line that otherwise should have flagged.

The products they were buying and selling were at the heart of the 2008 meltdown -- collections of mortgage bonds known as collateralized debt obligations, or CDOs.

As the housing boom began to slow in mid-2006, investors became skittish about the riskier parts of those investments. So the banks created -- and ultimately provided most of the money for -- new CDOs. Those new CDOs bought the hard-to-sell pieces of the original CDOs. The result was a daisy chain that solved one problem but created another: Each new CDO had its own risky pieces. Banks created yet other CDOs to buy those.

Individual instances of these questionable trades have been reported before, but ProPublica's investigation, done in partnership with NPR's Planet Money, shows that by late 2006 they became a common industry practice.

An analysis by research firm Thetica Systems, commissioned by ProPublica, shows that in the last years of the boom, CDOs had become the dominant purchaser of key, risky parts of other CDOs, largely replacing real investors like pension funds. By 2007, 67 percent of those slices were bought by other CDOs, up from 36 percent just three years earlier. The banks often orchestrated these purchases. In the last two years of the boom, nearly half of all CDOs sponsored by market leader Merrill Lynch bought significant portions of other Merrill CDOs.

ProPublica also found 85 instances during 2006 and 2007 in which two CDOs bought pieces of each other's unsold inventory. These trades, which involved $107 billion worth of CDOs, underscore the extent to which the market lacked real buyers. Often the CDOs that swapped purchases closed within days of each other, the analysis shows.

There were supposed to be protections against this sort of abuse. While banks provided the blueprint for the CDOs and marketed them, they typically selected independent managers who chose the specific bonds to go inside them. The managers had a legal obligation to do what was best for the CDO. They were paid by the CDO, not the bank, and were supposed to serve as a bulwark against self-dealing by the banks, which had the fullest understanding of the complex and lightly regulated mortgage bonds.

It rarely worked out that way. The managers were beholden to the banks that sent them the business. On a billion-dollar deal, managers could earn a million dollars in fees, with little risk. Some small firms did several billion dollars of CDOs in a matter of months.

"All these banks for years were spawning trading partners," says a former executive from Financial Guaranty Insurance Company, a major insurer of the CDO market. "You don't have a trading partner? Create one."

The executive, like most of the dozens of people ProPublica spoke with about the inner workings of the market at the time, asked not to be named out of fear of being sucked into ongoing investigations or because they are involved in civil litigation.

Keeping the assembly line going had a wealth of short-term advantages for the banks. Fees rolled in. A typical CDO could net the bank that created it between $5 million and $10 million -- about half of which usually ended up as employee bonuses. Indeed, Wall Street awarded record bonuses in 2006, a hefty chunk of which came from the CDO business.

The self-dealing super-charged the market for CDOs, enticing some less-savvy investors to try their luck. Crucially, such deals maintained the value of mortgage bonds at a time when the lack of buyers should have driven their prices down.

But the strategy of speeding up the assembly line had devastating consequences for homeowners, the banks themselves and, ultimately, the global economy. Because of Wall Street's machinations, more mortgages had been granted to ever-shakier borrowers. The results can now be seen in foreclosed houses across America.

The incestuous trading also made the CDOs more intertwined and thus fragile, accelerating their decline in value that began in the fall of 2007 and deepened over the next year. Most are now worth pennies on the dollar. Nearly half of the nearly trillion dollars in losses to the global banking system came from CDOs, losses ultimately absorbed by taxpayers and investors around the world. The banks' troubles sent the world's economies into a tailspin from which they have yet to recover.

It remains unclear whether any of this violated laws. The SEC has said that it is actively looking at as many as 50 CDO managers as part of its broad examination of the CDO business' role in the financial crisis. In particular, the agency is focusing on the relationship between the banks and the managers. The SEC is exploring how deals were structured, if any quid pro quo arrangements existed, and whether banks pressured managers to take bad assets.

The banks declined to directly address ProPublica's questions. Asked about its relationship with managers and the cross-ownership among its CDOs, Citibank responded with a one-sentence statement:

"It has been widely reported that there are ongoing industry-wide investigations into CDO-related matters and we do not comment on pending investigations."

None of ProPublica's questions had mentioned the SEC or pending investigations.

Posed a similar list of questions, Bank of America, which now owns Merrill Lynch, said:

"These are very specific questions regarding individuals who left Merrill Lynch several years ago and a CDO origination business that, due to market conditions, was discontinued by Merrill before Bank of America acquired the company."

This is the second installment of a ProPublica series about the largely hidden history of the CDO boom and bust. Our first story looked at how one hedge fund helped create at least $40 billion in CDOs as part of a strategy to bet against the market. This story turns the focus on the banks.

Merrill Lynch Pioneers Pervert the Market

By 2004, the housing market was in full swing, and Wall Street bankers flocked to the CDO frenzy. It seemed to be the perfect money machine, and for a time everyone was happy.

Homeowners got easy mortgages. Banks and mortgage companies felt secure lending the money because they could sell the mortgages almost immediately to Wall Street and get back all their cash plus a little extra for their trouble. The investment banks charged massive fees for repackaging the mortgages into fancy financial products. Investors all around the world got to play in the then-phenomenal American housing market.

The mortgages were bundled into bonds, which were in turn combined into CDOs offering varying interest rates and levels of risk.

Investors holding the top tier of a CDO were first in line to get money coming from mortgages. By 2006, some banks often kept this layer, which credit agencies blessed with their highest rating of Triple A.

Buyers of the lower tiers took on more risk and got higher returns. They would be the first to take the hit if homeowners funding the CDO stopped paying their mortgages. (Here's a video explaining how CDOs worked.)

Over time, these risky slices became increasingly hard to sell, posing a problem for the banks. If they remained unsold, the sketchy assets stayed on their books, like rotting inventory. That would require the banks to set aside money to cover any losses. Banks hate doing that because it means the money can't be loaned out or put to other uses.

Being stuck with the risky portions of CDOs would ultimately lower profits and endanger the whole assembly line.

The banks, notably Merrill and Citibank, solved this problem by greatly expanding what had been a common and accepted practice: CDOs buying small pieces of other CDOs.

Architects of CDOs typically included what they called a "bucket" -- which held bits of other CDOs paying higher rates of interest. The idea was to boost overall returns of deals primarily composed of safer assets. In the early days, the bucket was a small portion of an overall CDO.

One pioneer of pushing CDOs to buy CDOs was Merrill Lynch's Chris Ricciardi, who had been brought to the firm in 2003 to take Merrill to the top of the CDO business. According to former colleagues, Ricciardi's team cultivated managers, especially smaller firms.

Merrill exercised its leverage over the managers. A strong relationship with Merrill could be the difference between a business that thrived and one that didn't. The more deals the banks gave a manager, the more money the manager got paid.

As the head of Merrill's CDO business, Ricciardi also wooed managers with golf outings and dinners. One Merrill executive summed up the overall arrangement: "I'm going to make you rich. You just have to be my bitch."

But not all managers went for it.

An executive from Trainer Wortham, a CDO manager, recalls a 2005 conversation with Ricciardi. "I wasn't going to buy other CDOs. Chris said: 'You don't get it. You have got to buy other guys' CDOs to get your deal done. That's how it works.'" When the manager refused, Ricciardi told him, "'That's it. You are not going to get another deal done.'" Trainer Wortham largely withdrew from the market, concerned about the practice and the overheated prices for CDOs.

Ricciardi declined multiple requests to comment.

Merrill CDOs often bought slices of other Merrill deals. This seems to have happened more in the second half of any given year, according to ProPublica's analysis, though the purchases were still a small portion compared to what would come later. Annual bonuses are based on the deals bankers completed by yearend.

Ricciardi left Merrill Lynch in February 2006. But the machine he put into place not only survived his departure, it became a model for competitors.

As Housing Market Wanes, Self-Dealing Takes Off

By mid-2006, the housing market was on the wane. This was particularly true for subprime mortgages, which were given to borrowers with spotty credit at higher interest rates. Subprime lenders began to fold, in what would become a mass extinction. In the first half of the year, the percentage of subprime borrowers who didn't even make the first month's mortgage payment tripled from the previous year.

That made CDO investors like pension funds and insurance companies increasingly nervous. If homeowners couldn't make their mortgage payments, then the stream of cash to CDOs would dry up. Real "buyers began to shrivel and shrivel," says Fiachra O'Driscoll, who co-ran Credit Suisse's CDO business from 2003 to 2008.

Faced with disappearing investor demand, bankers could have wound down the lucrative business and moved on. That's the way a market is supposed to work. Demand disappears; supply follows. But bankers were making lots of money. And they had amassed warehouses full of CDOs and other mortgage-based assets whose value was going down.

Rather than stop, bankers at Merrill, Citi, UBS and elsewhere kept making CDOs.

The question was: Who would buy them?

The top 80 percent, the less risky layers or so-called "super senior," were held by the banks themselves. The beauty of owning that supposedly safe top portion was that it required hardly any money be held in reserve.

That left 20 percent, which the banks did not want to keep because it was riskier and required them to set aside reserves to cover any losses. Banks often sold the bottom, riskiest part to hedge funds. That left the middle layer, known on Wall Street as the "mezzanine," which was sold to new CDOs whose top 80 percent was ultimately owned by ... the banks.

"As we got further into 2006, the mezzanine was going into other CDOs," says Credit Suisse's O'Driscoll.

This was the daisy chain. On paper, the risky stuff was gone, held by new independent CDOs. In reality, however, the banks were buying their own otherwise unsellable assets.

How could something so seemingly short-sighted have happened?

It's one of the great mysteries of the crash. Banks have fleets of risk managers to defend against just such reckless behavior. Top executives have maintained that while they suspected that the housing market was cooling, they never imagined the crash. For those doing the deals, the payoff was immediate. The dangers seemed abstract and remote.

The CDO managers played a crucial role. CDOs were so complex that even buyers had a hard time seeing exactly what was in them -- making a neutral third party that much more essential.

"When you're investing in a CDO you are very much putting your faith in the manager," says Peter Nowell, a former London-based investor for the Royal Bank of Scotland. "The manager is choosing all the bonds that go into the CDO." (RBS suffered mightily in the global financial meltdown, posting the largest loss in United Kingdom history, and was de facto nationalized by the British government.)

By persuading managers to pick the unsold slices of CDOs, the banks helped keep the market going. "It guaranteed distribution when, quite frankly, there was not a huge market for them," says Nowell.

The counterintuitive result was that even as investors began to vanish, the mortgage CDO market more than doubled from 2005 to 2006, reaching $226 billion, according to the trade publication Asset-Backed Alert.

Citi and Merrill Hand Out Sweetheart Deals

As the CDO market grew, so did the number of CDO management firms, including many small shops that relied on a single bank for most of their business. According to Fitch, the number of CDO managers it rated rose from 89 in July 2006 to 140 in September 2007.

One CDO manager epitomized the devolution of the business, according to numerous industry insiders: a Wall Street veteran named Wing Chau.

Earlier in the decade, Chau had run the CDO department for Maxim Group, a boutique investment firm in New York. Chau had built a profitable business for Maxim based largely on his relationship with Merrill Lynch. In just a few years, Maxim had corralled more than $4 billion worth of assets under management just from Merrill CDOs.

In August 2006, Chau bolted from Maxim to start his own CDO management business, taking several colleagues with him. Chau's departure gave Merrill, the biggest CDO producer, one more avenue for unsold inventory.

Chau named the firm Harding, after the town in New Jersey where he lived. The CDO market was starting its most profitable stretch ever, and Harding would play a big part. In an eleven-month period, ending in August 2007, Harding managed $13 billion of CDOs, including more than $5 billion from Merrill, and another nearly $5 billion from Citigroup. (Chau would later earn a measure of notoriety for a cameo appearance in Michael Lewis' bestseller "The Big Short," where he is depicted as a cheerfully feckless "go-to buyer" for Merrill Lynch's CDO machine.)

Chau had a long-standing friendship with Ken Margolis, who was Merrill's top CDO salesman under Ricciardi. When Ricciardi left Merrill in 2006, Margolis became a co-head of Merrill's CDO group. He carried a genial, let's-just-get-the-deal-done demeanor into his new position. An avid poker player, Margolis told a friend that in a previous job he had stood down a casino owner during a foreclosure negotiation after the owner had threatened to put a fork through his eye.

Chau's close relationship with Merrill continued. In late 2006, Merrill sublet office space to Chau's startup in the Merrill tower in Lower Manhattan's financial district. A Merrill banker, David Moffitt, scheduled visits to Harding for prospective investors in the bank's CDOs. "It was a nice office," overlooking New York Harbor, recalls a CDO buyer. "But it did feel a little weird that it was Merrill's building," he said.

Moffitt did not respond to requests for comment.

Under Margolis, other small managers with meager track records were also suddenly handling CDOs valued at as much as $2 billion. Margolis declined to answer any questions about his own involvement in these matters.

A Wall Street Journal article ($) from late 2007, one of the first of its kind, described how Margolis worked with one inexperienced CDO manager called NIR on a CDO named Norma, in the spring of that year. The Long Island-based NIR made about $1.5 million a year for managing Norma, a CDO that imploded.

"NIR's collateral management business had arisen from efforts by Merrill Lynch to assemble a stable of captive small firms to manage its CDOs that would be beholden to Merrill Lynch on account of the business it funneled to them," alleged a lawsuit filed in New York state court against Merrill over Norma that was settled quietly after the plaintiffs received internal Merrill documents.

NIR declined to comment.

Banks had a variety of ways to influence managers' behavior.

Some of the few outside investors remaining in the market believed that the manager would do a better job if he owned a small slice of the CDO he was managing. That way, the manager would have more incentive to manage the investment well, since he, too, was an investor. But small management firms rarely had money to invest. Some banks solved this problem by advancing money to managers such as Harding.

Chau's group managed two Citigroup CDOs -- 888 Tactical Fund and Jupiter High-Grade VII -- in which the bank loaned Harding money to buy risky pieces of the deal. The loans would be paid back out of the fees the managers took from the CDO and its investors. The loans were disclosed to investors in a few sentences among the hundreds of pages of legalese accompanying the deals.

In response to ProPublica's questions, Chau's lawyer said, "Harding Advisory's dealings with investment banks were proper and fully disclosed."

Citigroup made similar deals with other managers. The bank lent money to a manager called Vanderbilt Capital Advisors for its Armitage CDO, completed in March 2007.

Vanderbilt declined to comment. It couldn't be learned how much money Citigroup loaned or whether it was ever repaid.

Yet again banks had masked their true stakes in CDO. Banks were lending money to CDO managers so they could buy the banks' dodgy assets. If the managers couldn't pay the loans back -- and most were thinly capitalized -- the banks were on the hook for even more losses when the CDO business collapsed.

Goldman, Merrill and Others Get Tough

When the housing market deteriorated, banks took advantage of a little-used power they had over managers.

The way CDOs are put together, there is a brief period when the bonds picked by managers sit on the banks' balance sheets. Because the value of such assets can fall, banks reserved the right to overrule managers' selections.

According to numerous bankers, managers and investors, banks rarely wielded that veto until late 2006, after which it became common. Merrill was in the lead.

"I would go to Merrill and tell them that I wanted to buy, say, a Citi bond," recalls a CDO manager. "They would say 'no.' I would suggest a UBS bond, they would say 'no.' Eventually, you got the joke." Managers could choose assets to put into their CDOs but they had to come from Merrill CDOs. One rival investment banker says Merrill treated CDO managers the way Henry Ford treated his Model T customers: You can have any color you want, as long as it's black.

Once, Merrill's Ken Margolis pushed a manager to buy a CDO slice for a Merrill-produced CDO called Port Jackson that was completed in the beginning of 2007: "'You don't have to buy the deal but you are crazy if you don't because of your business,'" an executive at the management firm recalls Margolis telling him. "'We have a big pipeline and only so many more mandates to give you.' You got the message." In other words: Take our stuff and we'll send you more business. If not, forget it.

Margolis declined to comment on the incident.

"All the managers complained about it," recalls O'Driscoll, the former Credit Suisse banker who competed with other investment banks to put deals together and market them. But "they were indentured slaves." O'Driscoll recalls managers grumbling that Merrill in particular told them "what to buy and when to buy it."

Other big CDO-producing banks quickly adopted the practice.

A little-noticed document released this year during a congressional investigation into Goldman Sachs' CDO business reveals that bank's thinking. The firm wrote a November 2006 internal memorandum about a CDO called Timberwolf, managed by Greywolf, a small manager headed by ex-Goldman bankers. In a section headed "Reasons To Pursue," the authors touted that "Goldman is approving every asset" that will end up in the CDO. What the bank intended to do with that approval power is clear from the memo: "We expect that a significant portion of the portfolio by closing will come from Goldman's offerings."

When asked to comment whether Goldman's memo demonstrates that it had effective control over the asset selection process and that Greywolf was not in fact an independent manager, the bank responded: "Greywolf was an experienced, independent manager and made its own decisions about what reference assets to include. The securities included in Timberwolf were fully disclosed to the professional investors who invested in the transaction."

Greywolf declined to comment. One of the investors, Basis Capital of Australia, filed a civil lawsuit in federal court in Manhattan against Goldman over the deal. The bank maintains the lawsuit is without merit.

By March 2007, the housing market's signals were flashing red. Existing home sales plunged at the fastest rate in almost 20 years. Foreclosures were on the rise. And yet, to CDO buyer Peter Nowell's surprise, banks continued to churn out CDOs.

"We were pulling back. We couldn't find anything safe enough," says Nowell. "We were amazed that April through June they were still printing deals. We thought things were over."

Instead, the CDO machine was in overdrive. Wall Street produced $70 billion in mortgage CDOs in the first quarter of the year.

Many shareholder lawsuits battling their way through the court system today focus on this period of the CDO market. They allege that the banks were using the sales of CDOs to other CDOs to prop up prices and hide their losses.

"Citi's CDO operations during late 2006 and 2007 functioned largely to sell CDOs to yet newer CDOs created by Citi to house them," charges a pending shareholder lawsuit against the bank that was filed in federal court in Manhattan in February 2009. "Citigroup concocted a scheme whereby it repackaged many of these investments into other freshly-baked vehicles to avoid incurring a loss."

Citigroup described the allegations as "irrational," saying the bank's executives would never knowingly take actions that would lead to "catastrophic losses."

In the Hall of Mirrors, Myopic Rating Agencies

The portion of CDOs owned by other CDOs grew right alongside the market. What had been 5 percent of CDOs (remember the "bucket") now came to constitute as much as 30 or 40 percent of new CDOs. (Wall Street also rolled out CDOs that were almost entirely made up of CDOs, called CDO squareds.)

The ever-expanding bucket provided new opportunities for incestuous trades.

It worked like this: A CDO would buy a piece of another CDO, which then returned the favor. The transactions moved both CDOs closer to completion, when bankers and managers would receive their fees.

ProPublica's analysis shows that in the final two years of the business, CDOs with cross-ownership amounted to about one-fifth of the market, about $107 billion.

Here's an example from early May 2007:

• A CDO called Jupiter VI bought a piece of a CDO called Tazlina II.
• Tazlina II bought a piece of Jupiter VI.

Both Jupiter VI and Tazlina II were created by Merrill and were completed within a week of each other. Both were managed by small firms that did significant business with Merrill: Jupiter by Wing Chau's Harding, and Tazlina by Terwin Advisors. Chau did not respond to questions about this deal. Terwin Advisors could not reached.

Just a few weeks earlier, CDO managers completed a comparable swap between Jupiter VI and another Merrill CDO called Forge 1.

Forge has its own intriguing history. It was the only deal done by a tiny manager of the same name based in Tampa, Fla. The firm was started less than a year earlier by several former Wall Street executives with mortgage experience. It received seed money from Bryan Zwan, who in 2001 settled an SEC civil lawsuit over his company's accounting problems in a federal court in Florida. Zwan and Forge executives didn't respond to requests for comment.

After seemingly coming out of nowhere, Forge won the right to manage a $1.5 billion Merrill CDO. That earned Forge a visit from the rating agency Moody's.

"We just wanted to make sure that they actually existed," says a former Moody's executive. The rating agency saw that the group had an office near the airport and expertise to do the job.

Rating agencies regularly did such research on managers, but failed to ask more fundamental questions. The credit ratings agencies "did heavy, heavy due diligence on managers but they were looking for the wrong things: how you processed a ticket or how your surveillance systems worked," says an executive at a CDO manager. "They didn't check whether you were buying good bonds."

One Forge employee recalled in a recent interview that he was amazed Merrill had been able to find buyers so quickly. "They were able to sell all the tranches" -- slices of the CDO -- "in a fairly rapid period of time," said Rod Jensen, a former research analyst for Forge.

Forge achieved this feat because Merrill sold the slices to other CDOs, many linked to Merrill.

The ProPublica analysis shows that two Merrill CDOs, Maxim II and West Trade III, each bought pieces of Forge. Small managers oversaw both deals.

Forge, in turn, was filled with detritus from Merrill. Eighty-two percent of the CDO bonds owned by Forge came from other Merrill deals.

Citigroup did its own version of the shuffle, as these three CDOs demonstrate:

• A CDO called Octonion bought some of Adams Square Funding II.
• • Adams Square II bought a piece of Octonion.
• • A third CDO, Class V Funding III, also bought some of Octonion.
• • Octonion, in turn, bought a piece of Class V Funding III.

All of these Citi deals were completed within days of each other. Wing Chau was once again a central player. His firm managed Octonion. The other two were managed by a unit of Credit Suisse. Credit Suisse declined to comment.

Not all cross-ownership deals were consummated.

In spring 2007, Deutsche Bank was creating a CDO and found a manager that wanted to take a piece of it. The manager was overseeing a CDO that Merrill was assembling. Merrill blocked the manager from putting the Deutsche bonds into the Merrill CDO. A former Deutsche Bank banker says that when Deutsche Bank complained to Andy Phelps, a Merrill CDO executive, Phelps offered a quid pro quo: If Deutsche was willing to have the manager of its CDO buy some Merrill bonds, Merrill would stop blocking the purchase. Phelps declined to comment.

The Deutsche banker, who says its managers were independent, recalls being shocked: "We said we don't control what people buy in their deals." The swap didn't happen.

The Missing Regulators and the Aftermath

In September 2007, as the market finally started to catch up with Merrill Lynch, Ken Margolis left the firm to join Wing Chau at Harding.

Chau and Margolis circulated a marketing plan for a new hedge fund to prospective investors touting their expertise in how CDOs were made and what was in them. The fund proposed to buy failed CDOs -- at bargain basement prices. In the end, Margolis and Chau couldn't make the business work and dropped the idea.

Why didn't regulators intervene during the boom to stop the self-dealing that had permeated the CDO market?

No one agency had authority over the whole business. Since the business came and went in just a few years, it may have been too much to expect even assertive regulators to comprehend what was happening in time to stop it.

While the financial regulatory bill passed by Congress in July creates more oversight powers, it's unclear whether regulators have sufficient tools to prevent a replay of the debacle.

In just two years, the CDO market had cut a swath of destruction. Partly because CDOs had bought so many pieces of each other, they collapsed in unison. Merrill Lynch and Citigroup, the biggest perpetrators of the self-dealing, were among the biggest losers. Merrill lost about $26 billion on mortgage CDOs and Citigroup about $34 billion.

Additional reporting by Kitty Bennett, Krista Kjellman Schmidt, Lisa Schwartz and Karen Weise.

ProPublica is an independent, non-profit newsroom that produces investigative journalism in the public interest.   This article is republished with permission under a Creative Commons license.

Given the green light by Congress, the Securities and Exchange Commission approved and released a long-awaited rule on proxy access — procedures under which shareholders can get their nominees for corporate directors included in proxy materials issued by public companies.

The SEC three times had made a run at proxy access rules, which include changes long sought by corporate governance activists, but hadn’t issued a final policy in the face of political and corporate resistance.  This year’s Dodd-Frank Wall Street Reform and Consumer Protection Act (Section 971) authorized the SEC to write the rules.

Under the new rule approved by the Commission, shareholders seeking access to corporate proxy  materials would:

--have  to own at least 3% of the total voting power entitled to vote at the meeting.
--be able to aggregate holdings to meet the 3% requirement.
--be required to have held their shares for at least three years.
--not be able to use the new rule "if they are holding the securities for the purpose of changing control of the company."
--be able to include one nominee or a number up to 25% of the board, whichever is greater. (If a board had three members, shareholders could nominate one; if a board had eight members, up to two nominees could be proposed).

The SEC said "'smaller reporting companies" would be subject to the rule only after a three-year phase-in period. Commission staff said the three-year delay would enable smaller companies to see how the rule works at larger companies and how it would affect them.  It would also let the commission determine whether changes in the rule might be required, the staffers said.

New rules generally take effect 60 days after publication in the Federal Register, SEC staff said.

The new rule -- called Rule 14a-11 -- requires shareholders to submit nominees no later than 120 days before the anniversary date of the mailing of the prior year proxy statement. Thus, if the rule becomes effective on Nov. 1, 2010, it would be available at companies that mailed their last annual meeting proxy statement no earlier than March 1, 2010.

Vote on Party Lines

As had been widely expected, the SEC acted on a 3-2 vote to adopt the new procedures, with Republican commissioners Troy Paredes and Kathleen Casey voting no.  Commissioner  Casey said the proposal represents “a series of arbitrary choices” that empower institutional shareholders “to the detriment” of individual shareholders and that the proposal is “likely to result in significant harm” to the economy.

Commissioner Parades protested that under the new rules, shareholders would be “unable to opt out” of the procedures “even if they want to,” and said it is at odds with state corporate law, particularly in Delaware.

SEC Chairman Mary Schapiro said shareholders should expect to see “dozens of instances of give and take” as the new rules take effect.  She called the proposal “rational, balanced and necessary” and pledged the SEC would prepare to make “prompt changes” to the rules if they seem appropriate.

Commissioner Elisse Walter said the proposal at last gives shareholders “a genuine alternative” in voting on directors.  The right to vote is meaningless, she said, if shareholders have no choice other than nominees presented by management.

Three Percent Rule

The 3% rule is a significant hurdle, making challenges at large companies such as International Business Machines or Exxon Mobil Corporation particularly difficult.  But pension, union and other large funds could pool their votes with other investors to offer candidates. (Congressional conferees turned down efforts by Sen. Christopher Dodd of Connecticut to include a 5% ownership threshold in the financial reform bill.)

Reacting to the proposal, the U.S. Chamber of Commerce said the SEC “is responding  to the campaign of a small group of special interest activist investors while ignoring the needs of the vast majority of investors who will never be able to use proxy access.”

Some groups had urged the SEC to permit “private ordering” of proxy access procedures — letting companies establish their own procedures to create proxy access under Delaware and other state corporate regulations.  Across-the-board rules, they argued, aren’t always appropriate. And a number of companies urged the SEC to permit shareholders to opt out of proxy access procedures.

Opponents gave the SEC a number of objections to proxy access.  Richard Templeton, chairman, president and chief executive of Texas Instruments, said the process “would promote a focus on short-term interests and could result in what are essentially annual proxy contests...distracting management and board attention from the creation of long-term shareholder value.”

Legal Challenges Likely

Challenges to the rules seem likely.  Bloomberg recently reported that the U.S. Chamber of Commerce has retained Eugene Scalia of the law firm Gibson, Dunn & Crutcher (and son of U.S. Supreme Court Justice Antonin Scalia) to “review the forthcoming SEC rules for a potential legal challenge.” The Chamber’s Center for Capital Markets Competitiveness says “...the SEC has failed to demonstrate a compelling need for this rule-making or how capital markets will be made more efficient by its adoption.”

Some companies have found the best defense is a good offense — engaging major shareholders to see if some middle-ground resolution is possible short of a board challenge.  Indeed, Weil, Gotshal & Manges LLP corporate partner Holly Gregory has advised companies to “Know who your large owners are — the top twenty or thirty shareholders — and consider whether to reach out to them in advance of the next meeting to find out what their concerns are, especially with regard to board composition and executive compensation.”

And, she adds, “Ensure that investor relations personnel are well-versed on institutional investor and proxy advisor positions on ‘hot button’ issues — as well as the company’s rationale where its approach departs from these positions.”

Proxy battles can also be expensive, notes writer Julie Connelly in Corporate Board Member magazine (Third Quarter 2010) in an article titled “Proxy Access: Worth Little More Than a Hill of Beans.”

Proxy battles entail legal fees, proxy-solicitation costs, and, in some cases, payments to prospective board candidates.  Indeed, there’s general agreement that finding candidates to serve on board is getting more difficult, given increased demands on a director’s time and exposure. To help identify potential board candidates, the pension fund of the California Public Employees’ Retirement System, the nation’s largest in terms of assets, is creating a "Diverse Director Database.”

J. W. Verret, an assistant professor of law at George Mason University’s law school, has been thumbing his nose at proponents of proxy access with a series of “16 defenses” he is proposing for boards of directors to thwart the expected SEC proposal. (One example: if shareholders can nominate a quarter of the board, give decision making to an Executive Committee of the Board made up of the other 75%.)

Editor's Note 8/25/2010: This article has been updated from an earlier version to reflect the outcome of the SEC vote and to incorporate additional comments.

Correction 8/30/2010: This article has been updated from an earlier version to correct a reporting error with regard to advice given to companies by Holly Gregory of Weil, Gotshal & Manges LLP.

Three leading sustainability investment firms said they filed shareholder resolutions at Target and Best Buy seeking to have independent board members review the companies’ political contributions and spending processes.

Human Rights Campaign Ad

The two national retailers, both headquartered in Minnesota, have been under fire since the disclosure last month of their political contributions to an organization that backs a state gubernatorial candidate who opposes gay marriage.

Target has contributed $150,000 and Best Buy $100,000 to MN Forward, an independent expenditure committee that has taken out ads in support of Tom Emmer, a Republican state lawmaker.

The contributions have drawn widespread media coverage and criticism from customers and organizations such as Human Rights Campaign, a national advocacy group for lesbian, gay, bisexual and transgender (LGBT) rights.

Investment firms Walden Asset Management, Trillium Asset Management Corporation and Calvert Asset Management Company, Inc. said they joined together to file a proposal at Target Corporation that asks the company's independent board members to undertake a "comprehensive review of Target's political contributions and spending processes including the criteria used for such contributions" and "oversight processes by management and the Board." Calvert and Trillium have filed a similar resolution at Best Buy, Trillium on behalf of the Equity Foundation, which works to eradicate prejudice towards the sexual and gender minority communities of Oregon.

Collectively, the firms said they control more than 1.1 million shares of common stock in Target worth $57.5 million, and 344,000 shares of Best Buy worth $11.3 million.

Target and Best Buy have both previously stated that their contributions were aimed at supporting candidates whom they felt would foster economic growth in Minnesota. Target has since issued apologetic statements directed toward employees and customers.

The investment firms noted that Target and Best Buy have traditionally had “exceptionally strong workplace policies” for LGBT employees.   They said their shareholder proposals were intended to draw “attention to the misalignment between the donations and the companies' corporate values.”

Human Rights Campaign has sought to have Target and Best Buy make contributions to groups supporting gay-rights candidates in Minnesota.  However, “after two weeks of good-faith discussions – and two tentative agreements,” the organization said this week, Target has declined “to take corrective action.” Discussions with Best Buy continue, according to Human Right Campaign.

The controversy involving Target and Best Buy is the most high-profile since the U.S. Supreme Court’s decision last January in Citizens United, which gave corporations and unions new freedom to support political candidates through contributions to Independent expenditure committees.

Tim Smith, senior vice president at Walden, said, "It is unclear how frequently companies will decide to spend shareholder monies in controversial political races. But if the Best Buy and Target contributions are any indication, imprudent donations can potentially have a major negative impact on company reputations and business if they don't carefully and fully assess a candidate's positions. Funding ballot initiatives or ‘issue ads’ can similarly backfire."

Shelley Alpern, vice president at Trillium, said, "Tom Emmer has made it no secret that as governor he would deny members of the LGBT their full civil rights. No company can credibly claim that it continues to support the LGBT community if at the same time it is financing a deliberate effort to keep it in second-class citizenship."

Stu Dalheim, Director of Shareholder Advocacy at Calvert, said, "We continue to call for increased transparency and disclosure of corporate political spending. The absolutely wrong conclusion for companies to draw from this controversy is that everything will be all right as long as they conceal their political contributions."

Moveon.org, the national advocacy group, has announced an effort to organize boycotts of Target and Best Buy.

When big banks have announced settlements with the Securities and Exchange Commission, we’ve put those agreed-upon fines into perspective, and have often found that even millions of dollars in fines aren’t too hard for these big financial firms to shell out.

Judges, increasingly, seem to agree. This week, a federal judge even called a $298 million settlement between U.S. prosecutors and Barclays—the U.K.’s second largest bank—“a sweetheart deal,” asking prosecutors, “Why isn’t the government getting tough with the banks?”

Barclays was accused of altering financial records to hide that it was breaking U.S. sanctions in trades with Iran, Cuba, Sudan, Libya and Burma from 1995 through 2006. Its deal with the Justice Department would help it avoid prosecution, according to The Wall Street Journal, but the judge has ordered that the lawyers return to court today to address his concerns about the settlement’s leniency.

A federal lawyer argued on Tuesday that the settlement is “in excess of what the company earned” when it processed the trades from the sanctioned countries, Bloomberg reported; Barclays declined to comment.

Earlier this week, another federal judge rejected a $75 million settlement between Citigroup and the SEC.

Citigroup was accused of hiding its exposure to more than $40 billion in subprime CDOs. As we’ve noted, under its agreement with the SEC, it would’ve paid a $1 fine for every $500 worth of hidden exposure. The judge demanded additional information from both parties and scheduled another hearing in September, reported The Washington Post.

Last year, a judge also took issue with a $33 million SEC settlement with Bank of America over the bank’s disclosure of bonuses paid to Merrill Lynch employees before Merrill was taken over by BofA. The judge grudgingly approved the settlement when it was quintupled to $150 million, but still called it “half-baked justice at best,” reported The New York Times.

Update, 7/18: In today's hearing, the judge approved the $298-million settlement between Barclays and the Justice Department. Despite approving the settlement, U.S. District Court Judge Emmet G. Sullivan continued with his criticism, reported the Journal: "It's proceedings like these that raise concerns in the public's mind about fairness and justice."

ProPublica is an independent, non-profit newsroom that produces investigative journalism in the public interest.   This article is republished with permission under a Creative Commons license.

When financial results aren’t what they seemed to be – and a company is forced to issue material financial restatements - how does it recoup the incentive pay and bonuses that were awarded to senior managers on the basis of rosier outcomes?

It’s not a simple process, as evidenced by reactions to a provision in the newly-enacted Dodd-Frank financial reform legislation viewed by governance advocates as effective in increasing management accountability for financial results.

Under the law, companies must develop policies to recoup improperly awarded compensation from all current and former “executive officers” for three years preceding the date on which the company was required to file a restatement.

Such financial restatements are not uncommon.  From 2002 through 2009, there were over 2,900 negative restatements of net income by listed public companies, according to an analysis by the law firm Latham & Watkins.

And most companies do not have clawback policies in place.  Only about 17% of 3,680 companies have disclosed clawback policies that at least cover senior management, up from a handful in 2005, according to proxy advisers ISS, as reported in The Wall Street Journal.

Large companies are more likely to have clawback policies: 71 of the largest U.S. companies have policies in place, according to a new survey by the law firm Shearman & Sterling.  But even those will likely need to be revised and updated in response to forthcoming SEC regulations regarding the Dodd-Frank requirements.  The SEC has said it will publish rules in time for the 2011 proxy season.

Proper Risk Management

When designed properly, a policy allowing for clawback of pay from high-level executives “is a significant mechanism for corporate accountability,” says former GE senior vice president Benjamin W. Heineman, Jr., writing on the Harvard Law School Forum on Corporate Governance and Financial Regulation.

The problem, according to Mr. Heineman, is that hundreds of companies that don’t have policies must now design one.   Among the questions they need to answer: Which executives are covered by a policy?  What event triggers implementation of a clawback?  What types of compensation should be recovered?  What is the forum for resolving issues?  Is a “holdback” (cancelling unvested benefits) better than a clawback?

Mr. Heineman makes a number of recommendations for what he calls a “broad, flexible holdback/clawback approach” for holding senior leadership accountable to what he says is the fundamental mission of the corporation: “proper risk taking balanced with proper risk management and the robust fusion of high performance with high integrity.”

Clawbacks are not entirely new.  The Sarbanes-Act of 2002 gave the SEC the power to recover restatement-related compensation and stock profits from Chief Executive Officers and Chief Financial Officers.

But the Dodd-Frank Act expands the breadth of the clawback requirement, according to the Latham & Watkins analysis, because it requires reimbursement from a broader pool of “executive officers” and forces the company (not the SEC) to take action.   The Dodd-Frank legislation also expands the period subject to compensation clawback and, importantly, does not require a restatement to have been the result of “misconduct” by an executive, as required by Sarbanes-Oxley.

Latham & Watkins suggests that the Dodd-Frank clawback provision may provide shareholder plaintiffs and shareholder activists “with a major new weapon.”

“We will not be surprised to see shareholder plaintiffs bring derivative suits challenging the implementation of the company’s clawback policy and attempting to exercise the company’s rights to repayment,” the firm says. “Whether such suits will find any measure of success and how often they will be filed is difficult to predict.”

Dear EarthTalk: Many people oppose dams because they change the flow of rivers and affect the migrating patterns of fish and other species, but aren’t they also a great renewable energy source? -- Ryan Clark, Milton, WA

Hydroelectric dams are among the greenest and most affordable electricity sources in the world—and by far the most widely used renewable energy sources—but they also take a heavy environmental toll in the form of compromised landscapes, ecosystems and fisheries. Hydroelectric dams have been an important component of America’s energy mix since the powerful flow of rivers was first harnessed for industrial use in the 1880s. Today hydroelectric power accounts for seven percent of U.S. electricity generation—and some two-thirds of the country’s renewable power—according to the U.S. Geological Survey.

Globally, about 19 percent of electricity comes from hydroelectric sources. The U.S. Energy Information Administration reports that China is the world’s largest producer of hydroelectricity, followed by Canada, Brazil and the U.S. Some two-thirds of the economically feasible potential for hydro power remains to be developed around the world, with untapped resources most abundant in Latin America, India and China.

Of course, despite the inexpensive and emissions-free power, many environmentalists consider hydroelectric dams to be man-made abominations that prevent salmon and other fish from swimming upstream, divert otherwise natural riparian settings, and fundamentally change the character of surrounding ecosystems. Green groups including American Rivers, Defenders of Wildlife, Earthjustice, the Endangered Species Coalition, Friends of the Earth, National Wildlife Federation and the Sierra Club are pushing the federal government to mandate the removal of four dams along the Snake River in Washington State that help the region have the lowest power-related carbon footprint in the country. The dams have decimated once teeming salmon runs, and upstream forest ecosystems have suffered accordingly.

But the Bonneville Power Administration, the quasi-federal utility that runs the dams and distributes the electricity they produce, says that keeping them going is crucial even as wind plays an increasingly larger role in the region’s electricity mix. Since hydro power can be generated and released when most needed, it is an important resource for backup power when intermittent sources like wind (and solar) aren’t available.

The scheduled removal of two century-old dams on the Elwha River in Washington State’s Olympic National Park beginning in 2011 may well serve as test cases for larger dam removal projects in the Pacific Northwest and beyond. Planners hope wild salmon numbers will rebound as a result, and that other wildlife—such as bald eagles and black bears—will follow suit.

President Obama has committed $32 million to modernize existing hydropower dams, increase efficiency and reduce environmental impacts. “There’s no one solution to the energy crisis, but hydropower is clearly part of the solution and represents a major opportunity to create more clean energy jobs,” U.S. Secretary of Energy Steven Chu told reporters last year. “Investing in our existing hydropower infrastructure will strengthen our economy, reduce pollution and help us toward energy independence.”

Photo: George Green, U.S. Army Corps of Engineers

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