“Trust but verify.” -- Ronald Reagan
“We must combine the toughness of the serpent with the softness of the dove, a tough mind and a tender heart.” -- Martin Luther King
The saga of Bernie Madoff’s Ponzi scheme grows more baroque by the day. The latest news is that after agreeing to house arrest and an asset freeze in December, he tried to send valuables to family members. Meanwhile, the collapse of his scheme is fueling fears about the quality of due diligence research among hedge funds and “funds of funds” some of whom invested money with Madoff. In my recent column for Forbes.com, I argued that we have been here before: economic booms make rogues possible. Today, the impulse to tighten government regulations and hunt for miscreants is gaining stride—Bernie Madoff is Exhibit A.
The interesting subtext for the Madoff saga is trust. An op-ed last month in the Wall Street Journal began with the words, “Capitalism runs on trust.” This triggered letters to the editor taking exception to that notion. One writer argued that capitalism runs on self-interest; another that “capitalism runs on private property rights, the rule of law, and the informed assumption of risk.”
On what does capitalism really run, laws or trust? This is a profound question for business educators and students. On it hinge the very foundations of curriculum, teaching, and studies.
The Law is crucial. A lot of research supports the conclusion that value creation and economic growth are associated with transparency, rule of law, respect for the rights of investors, and suppression of corruption. All of this is necessary for capitalism to flourish. The laws are tangible guides for behavior, but they can breed a compliance mentality. And the law is a very wide avenue for behavior; if you narrow the avenue very considerably, you approximate a police state.
Trust is less tangible. But to acknowledge the importance of trust is to acknowledge the primacy of individual choice. You can choose to trust and to make the assessments on which trust must be based. As I have written before (“Transactional versus Relational”), this choice is founded on your assessment of sincerity, competence, and reliability.
I was influenced early in my career by one of the giants in the history of private equity, Stanley Golder. He impressed on me the limitations of the law as a protection for the investor. He said, “it is not what the contract says, but how one behaves afterward, that determines the outcomes.” Golder was saying that no matter how tight is the contract, the laws, or the regulations, the character of the participants in business is most important. This was the essence of the famous words of J. P. Morgan before a Congressional hearing in 1913, as he was questioned by the lead investigator, Samuel Untermyer:
UNTERMYER: Is not commercial credit based primarily upon money or property?
MORGAN: No, sir: the first thing is character.
UNTERMYER: Before money or property?
MORGAN: Before money or anything else. Money cannot buy it.
…
UNTERMYER: If that is the rule of business, Mr. Morgan, why do the banks demand, the first thing they ask, a statement of what the man has got, before they extend him credit…He does not get it on his face or character?
MORGAN: Yes; he gets it on his character…Because a man I do not trust could not get money from me on all the bonds in Christendom.[i]
A world of all laws and no trust would not be very appealing. A world of no laws and all trust leaves one vulnerable to the Bernie Madoffs. We need a Goldilocks solution: not too much or too little of either. We can be trusting, but we must also be tough-minded (like Martin Luther King). We can trust, but we should also verify (Ronald Reagan).
[i] U.S. Government, 1913. Money Trust Investigation: Hearings, I, page 1084.