Of all the gin joints in all the towns in all the world, she walks into mine.
Humphrey Bogart (Rick) from CASABLANCA (1943)
DATELINE: January 2, 2009, Chicago
Bloomberg reported yesterday that noted corporate-governance lawyer, Ira M. Millstein, of the Weil, Gotshal & Manages law firm issued an opinion stating that J. Ezra Merkin could continue accepting funds from Yeshiva University as long as Merkin disclosed his role. Janet Frankston Lorin, Millstein Letter Helped Keep Yeshiva Money on Path to Madoff. The article suggests that the opinion was issued to Yeshiva. The article doesn't indicate whether Millstein was aware of an intention to invest all the funds with Madoff, who was another trustee. As we have pointed out before, that results in what looks to us like redundant fees, which we believe is hard to justfiy.
We have several reactions to the revelations about Millstein and the board's reliance on his opinion. Our basic one is the simplest and most...
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direct: If you have to ask for a legal opinion before taking action on what essentailly come downs to a question of ethics, you shouldn’t take the action.
That leads to our quote from Casablanca. Think of all the hedge funds, private equity funds, investment advisors, and other ways to invest or obtain investment advice in the world. In the apparent view of Yeshiva’s trustees, only one, J. Ezra Merkin, could spin straw into gold: Nobody else was capable of achieving the returns that Merkin could achieve. [As discussed below, there may have actually been two other trustees who were viewed as being able to spin straw into gold.] Therein lays the fundamental problem with Yeshiva’s decision to invest any funds with Merkin, a then trustee of Yeshiva and the head of its investment committee. This conflict was so easy to avoid because there were so many alternatives. There is little upside in establishing an investment relationship with a board member, but as Madoff has so clearly demonstrated, there is lots of downside when something unexpected happens. To generalize our rule of thumb, the more commodity-like the product or service, the more troublesome the conflict.
Now let’s return to Millstein, who we can’t lambast because we don’t know all the fact surrounding his engagement or advice. We are nevertheless troubled by the following line quoted by Bloomberg from Millstein's opinion:
There is no reason why the board or its committees should institute a blanket rule prohibiting members (or major donors) from doing business with Yeshiva.
This is bad advice given the context: The question was being asked about investing endowment with a board member. Some conflicts can be validated and may be acceptable. However, we don't think conflicts involving investments fall into that category, as we will discuss below. Furthermore, there are good reasons for a blanket prohibition. It sets an excellent tone at the top. It avoids appearances problems. It better assures objective decisions by eliminating opportunities for backscratching--"You approve my conflicted transactions and I'll approve yours or see that the compensation committee takes care of you." In short, Millstein overstates the case against a blanket prohibition.
Particularly distrubing is the apparent fact that Yeshiva may have invested funds with other members of the investment committee besides just Merkin. Bloomberg reports:
In September 2000, Sheldon Socol, then Yeshiva’s vice president of business affairs, sought Millstein’s advice about “investments in funds that are managed by members of the investment committee.” At least two members, including Merkin, were already doing business with the school, according to the individual with knowledge. At the time of the letter, the investment committee was considering making an investment in a fund managed by a third member of the committee, according to the individual. These facts do suggest the potential for backscratching. Yes, one of the investment professionals (Board Member A) may have recused himself from the board's decision over investing with the Board Member A's firm. But another board member (Board Member B), who was hoping that Yeshiva would invest with his firm, may not have recused himself from that decision. When the proposal to invest with Board Member B's firm comes up, will Board Member A vote in favor of it because Board Member B voted in favor the transaction with Board Member A's firm?
We will use Millstein's involvement to make several points about lawyers and boards. First, the role of lawyers has changed for the worse over the last three or four decades. There once was a time when an organization’s attorney was viewed and respected as the “wise man” in the corporate boardroom. The lawyer served as a check on organizations and boards. When a proposal had the appearance of impropriety or just didn’t smell right, the lawyer was the person who applied by the brakes by saying “No.” Unfortunately, clients have learned in today’s marketplace for legal services that they can always find a lawyer who will say “Yes” and issue an opinion. Maybe Millstein tried to serve that traditional role, telling Yeshiva’s trustees or Merkin that the investment with Merkin and the other board members was a bad idea. But at some point a lawyer is forced to abandon the high ground. He can give the client sage advice, but he has a professional obligation to tell the client what the law requires, not what the lawyer believes is the best course of action, when the client rejects the lawyer's wisdom. Perhaps Millstein was simply unable to convince the board or Merkin that the investment was a bad idea. Given the weak and permissive state law rules covering conflicts of interest involving nonprofit board members, Millstein easily could have given the opinion that he is reported to have rendered. At some point, the client has to bear the blame for not listening rather than the lawyer who counseled against a particular action. In short, the board sets the ethical tone and ultimately bears the blame.
Ira Millstein’s name appears frequently in the media following major nonprofit governance failures. He came in after the fact to help clean up the mess at the Nature Conservancy. His name also came up when the Red Cross ran into trouble following Hurricane Katrina.
We previously have reviewed the Nature Conservancy’s conflicts-of-interest policy and operating guidelines. They are superb documents. We assume Millstein had some involvement in their creation. If he did, it highlights the different roles a lawyer can play in corporate governance. He can be planner, developing the policies with an eye toward ethical conduct and good governance. He can be an advisor or the hired gun—get the deal done. It is the client who chooses the role. The lawyer knows the right answer—as evidenced by the Nature Conservancy policy. He also knows the legal answer, as evidenced by Yeshiva’s apparent decision to make the investment with Merkin. Boards could avoid lots of problems if they would engage lawyers at the planning rather than the reactive stage.
Now let’s leave Millstein and turn to the other bombshell reported this past week. Shortly after the Madoff scandal broke, Yeshiva became one of the first charitable organizations to announce a loss. University President Richard M. Joel sent an e-mail to students reporting a $110 million loss. President Joel could have described the loss as significant or material, but he chose in his e-mail to attach a fixed number to it.
Roughly two weeks later, J. Michael Gower, the university’s vice president for business affairs and CFO sent an e-mail to Bloomberg announcing the out-of-pocket loss was only $14.5 million. Janet Frankston Lorin, Yeshiva’s Madoff Losses Based on ‘Fictitious’ Profits’ (Dec. 30, 2008). The remaining $95.5 million represented fictitious profits. This announcement is troublesome to the say the least. Charitably speaking, it suggests that Yeshiva’s accounting system might be in disarray. It is hard for us to understand how the university could not have easily accessible records that show its cost basis in each of its investments. How could it possibly determine whether the investment was performing as expected if it didn’t know its cost? Maybe a hundred years ago it took some time to calculate cost, but in this day of computers and financial management software, the university’s revised loss is a mysterious and troubling revelation.
We can only wonder whether the purpose underlying this revelation is to reduce the pressure on the university to sue Merkin and some of its trustees. One could interpret the revelation as a statement by the university that “It isn’t nearly as bad as we thought so we should be thankful.” In other words is this a case of hitting yourself in the head with a hammer because it feels good when you finally stop?
In any event, even if the $14.5 million loss is the out-of-pocket loss, it still doesn’t reflect the true loss. First there is opportunity cost which can be measured by the alternative investments that could have been made with the $14.5 million. At a 5% rate of return, a $14.5 million investment in 2000 would have grown to $21.42 million by 2008. At the purported Madoff 10% rate of return, it would have grown to $31.08 million over the same period. We chose 2000 because that is the date of Millstein’s opinion letter, although the Bloomberg story suggests that the investment may have been made earlier. In any event, neither of those numbers is anywhere close to $110 million. Yeshiva would be wise to keep its mouth shut, gather all the facts, and release a report. Joel and Gower may think dribbling out information is transparency, but all we’ve seen them do is add to the confusion.
There is a second cost: uninformed decisions by the board. The trustees were calculating spending rates and making decisions based on endowment numbers that were overstated. The university may now find itself squeezed for funds because it spent more than it should have. Will scholarships be cut, will tuition rise, will students be forced to leave school, will research programs be put on hold, will capital projects be deferred or halted? Having $95 million less in endowment certainly has to have some negative consequences.
Most importantly, $14.5 million isn’t anything to sneeze at. To the extent there was a conflict and inappropriate behavior, the fact that less was involved doesn’t eliminate our concerns about Madoff's, Merkin's, and the board's behavior. If a lawsuit was warranted at $110 million, it is still warranted at $14.5 million, $21.6 million, or $40 million.
Here are the results of annual compounding at different rates of return:
4%
5%
10%
12%
Initial Invesment
14.5
14.5
14.5
14.5
15.08
15.225
15.95
16.24
15.6832
15.98625
17.545
18.1888
16.310528
16.78556
19.2995
20.37146
16.9629491
17.62484
21.22945
22.81603
17.6414671
18.50608
23.3524
25.55395
18.3471258
19.43139
25.68763
28.62043
19.0810108
20.40296
28.2564
32.05488
19.8442512
21.4231
31.08204
35.90147
20.6380213
22.49426
34.19024
40.20964
Annual Compounding
21.4635421
23.61897
37.60927
45.0348
22.3220838
24.79992
41.37019
50.43897
23.2149672
26.03992
45.50721
56.49165
24.1435659
27.34191
50.05793
63.27065
25.1093085
28.70901
55.06373
70.86313
26.1136808
30.14446
60.5701
79.3667
27.1582281
31.65168
66.62711
88.89071
28.2445572
33.23427
73.28982
99.55759
29.3743395
34.89598
80.6188
111.5045
30.5493131
36.64078
88.68068
124.885
31.7712856
38.47282
97.54875
139.8712
33.042137
40.39646
107.3036
156.6558
34.3638225
42.41628
118.034
175.4545
35.7383754
44.53709
129.8374
196.509
37.1679104
46.76395
142.8211
220.0901
38.6546268
49.10215
157.1032
246.5009
40.2008119
51.55725
172.8136
276.081
41.8088444
54.13512
190.0949
309.2108
43.4811981
56.84187
209.1044
346.3161
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