The Demise of Merrill Lynch and the Need for Corporate Governance Reform

The New York Times had a piece in the weekend edition on the fall of Merrill Lynch.  The piece is not very insightful, doing little more than noting that Merrill piled into the mortgage business and took on too much risk.

The piece notes, for example, that "it was never clear how well Merrill’s management understood the risks in the mortgage business."  Similarly, as the debt markets began to implode, Merrill found itself holding too many mortgage backed securities.  Again, according to the NYT:  "Unlike the C.D.O. pioneers at J. P. Morgan who saw themselves as financial designers and intermediaries wary of the dangers of holding on to their products too long, Merrill seemed unafraid to stockpile C.D.O.’s to reap more fees."  Moreover, the investment banking firm apparently found itself without hedges or guarantees for the inventory.

• For years, Merrill had paid A.I.G. to insure its C.D.O. stakes to limit potential damage from defaults. But at the end of 2005, A.I.G. suddenly said it had had enough, citing concerns about overly aggressive home lending. Merrill couldn’t find an adequate replacement to insure itself. Rather than slow down, however, Merrill’s C.D.O. factory continued to hum and the firm’s unhedged mortgage bets grew, its filings show.

In short, Merrill Lynch took on too much risk by holding onto large inventories of unhedged debt instruments, a bad position to be in when the mortgage market collapsed.  While the names of the instruments are complicated (derivatives, synthetic CDOs), the mishap wasn't.  Somehow the company did not have in place sufficient oversight to prevent what now appears to be a completely inappropriate level of risk taking.

As we have noted often on this Blog, the board of directors apparently did nothing to prevent this from occurring.  While it is possible that the board was aware of the looming crisis, it is more likely that the  board was unaware.  In other words, under Delaware law, boards do not have to be informed of such a high level of risk taking.  The failure, therefore, was in the negligible obligations imposed on boards to monitor the activities of the company.  In other words, the collapse was likely a consequence of the failure of the Delaware model of governance.