NOW TO EXPLAIN THE PARTY FAVORS / THE NEW YORK TIMES ( RECOMMENDED READING )

April 5, 2010

Now to Explain the Party Favors

By ANDREW ROSS SORKIN

On Thursday, two of the biggest — and among the most tarnished — names on Wall Street will testify in front of the Financial Crisis Inquiry Commission in Washington: Charles O. Prince III, the former chairman and chief executive of Citigroup, and Robert E. Rubin, a former top adviser and director of the bank. On the watch of these men, Citigroup lost more money than almost any company in history, requiring an extraordinary government bailout.

There are, of course, many important questions for the commissioners to ask these men about how and why the bank filled its balance sheet with so many bad subprime loans, taking on enough risk to nearly topple the system.

But there is one small question, not so obvious, that has been crying out for an answer for years, and it has nothing to do with exoticisms like C.D.O.’s or C.D.S.’s. Instead, this question is about incentives and compensation on Wall Street and a mind-set — a group-think really — that pervaded not just Citigroup but the entire industry.

In 2007, Mr. Prince resigned from Citigroup under pressure, after the bank announced that it had written down $5.9 billion to account for the declining value of its mortgage assets and would most likely write down $8 billion to $11 billion more. (Boy, was that estimate off; those write-downs actually added up to tens of billions.)

As a thank-you present for running the bank into the ground, the board gave Mr. Prince a parting gift valued at $12.5 million. Yes, you read that correctly, $12.5 million. That exit bonus was on top of the $68 million he received in stock and options he had accumulated over his many years at the company; a $1.7 million pension; and an office, car and driver for up to five years. In exchange, Mr. Prince signed an agreement not to compete with Citigroup for five years.

This wasn’t a case of the board paying out an exit bonus to a chief executive with no whiff of a problem, only to find time bombs ticking after he left. Mr. Rubin and Citigroup’s other directors decided to pay the $12.5 million bonus knowing very well that Citigroup’s market value had dropped by $64 billion during Mr. Prince’s tenure.

So the simple question for Mr. Rubin and Mr. Prince is, Why? Why would you knowingly reward such failure? What is it about the culture of Citigroup and Wall Street that encouraged you to approve such a large party favor? Why was there reason to give a bonus at all?

Through representatives, both men declined to comment. But answers to these questions could be constructive in helping us understand the thought processes of those at the bank who were responsible for figuring out what had gone so terribly wrong that it led to the near failure of an American institution.

Ultimately, a $12.5 million payday (it turned out to be closer to $10 million based on a formula linked to Citi’s stock price) may seem mathematically irrelevant in the grand scheme of Citigroup’s problems. And some people might argue that it was a run of bad luck and nothing more that led Mr. Prince, like so many others on Wall Street, to take on so much risk.

But either way, the bonus is a symptom of a larger problem that has so enraged Main Street: a sense that on Wall Street, even big mistakes have no consequences.

A couple of intrepid shareholders sued Citigroup’s directors over the payment and several other questionable decisions. A Delaware judge dismissed most of their complaints, ruling that the board was protected by something called the “business judgment rule.” On the issue of the bonus, the judge said he didn’t have enough evidence but seemed to lean in the same direction.

Before we continue, a bit of background about “the business judgment rule,” also known among some lawyers as the “stupidity rule.” This rule, at its essence, means that no matter how dumb a board’s decisions proved to be, as long as they were not fraudulent and were made in good faith, they were O.K. Even running a company into the ground is O.K. as long as the board provided a “duty of care.”

In fairness, the rule itself is important to protect board members so they can make decisions on behalf of the company without fear that every one of them could be litigated to death. But it also has kept a whole lot of directors out of hot water.

For example, the court-appointed examiner in the Lehman Brothers bankruptcy case found that while the board might have made lots of mistakes along the way to Chapter 11, they were not liable to shareholder lawsuits for most of their decisions because they were protected by the business judgment rule.

But the judge’s finding in the Citi case is not likely to win sympathy from a bitter public or, for that matter, an angry Congress.

The judge, William B. Chandler III, the chief judge of the Delaware Court of Chancery, wrote: “It is understandable that investors, and others, want to find someone to hold responsible for these losses, and it is often difficult to distinguish between a desire to blame someone and a desire to force those responsible to account for their wrongdoing.”

Ultimately, he explained, “the discretion granted directors and managers allows them to maximize shareholder value in the long term by taking risks without the debilitating fear that they will be held personally liable if the company experiences losses. This doctrine also means, however, that when the company suffers losses, shareholders may not be able to hold the directors personally liable.”

Judge Chandler makes a well-reasoned argument. But paying an executive on his way out seems to have little to do with maximizing “shareholder value in the long term by taking risks” and everything to do with rewarding failure, the exact problem that so many want fixed.

So Mr. Prince and Mr. Rubin: Why? Please explain.