Ideoblog

More on the future of law and economics

I mentioned that Josh Wright is starting a valuable new series on the future of law and economics. Josh mentioned that one jumping off point for his project is my post from a couple of years ago. This, in turn, responded to this comment from Kate Litvak:

You can't do serious law-econ work today without either really, really knowing math, or really really knowing statistics, or really really knowing micro. If you can’t do serious regressions, you must model. If you can’t model, you must do serious regressions. If you make the tiniest noise about “excessive fees” or “bargaining power,” be prepared to either model them in excruciating detail or show original data. Chatter on a vague subject of “markets” and “efficiency” is basically ignored. People who tell you otherwise are, hmm, not quite the laughing stock of the field, but asymptotically approaching that status. They are in their last years of wishful thinking. Just take a look at the papers from the annual meeting of the American Law and Economics Association.

I responded in part:

[F]or law and economics to be successful at any level, it has to be accessible to both economists and legal academics. Just as there is a lot of bad law & ec being done by lawyers, so there is a lot of bad law & ec being done by economists because of their ignorance of the law and legal institutions. Careful law & ec lawyers can communicate with both the economists and the lawyers at the "retail" level. Forcing the work into math is going to create a “language” barrier that could seriously impede the intellectual development of the field. The field will stagnate, and become as marginalized as the study of, say, literature has become. Coase himself criticized "blackboard" economics that relied too heavily on formal models and not enough on a study of the relevant institutions. He also made an effort to understand the relevant regulatory and agency law to make his work relevant to law. * * *

One solution to the problem Kate mentions is collaboration. “Serious” work – say of the sort that Kate does – takes specialization and high-level skill, even if not a formal degree. When I do this kind of work, I do it with Bruce Kobayashi, an economist who is a lot better at it than most of the straight law professors who dabble in it. I doubt Kate would disagree. But I don't think that collaboration should be required for all law and economics articles written by law professors.

My colleague, Larry Solum, has jumped in by suggesting three models for law schools:

• An “interdisciplinary” model in which law schools are staffed by people trained in other disciplines.
• A “multidisciplinary” model in which law schools create PhD programs that introduce “future legal academics to empirical legal studies, positive legal theory, formal legal models, normative legal theory, advanced doctrinal methods, and so forth.”
• And a “professional school model” focusing on “the traditional academic-lawyer generalist, whose only rigorous skill sets are case crunching, code crunching, and clause crunching. Such generalists translate the work of other disciplines (sometimes with egregious errors), but they do not generate new interdisciplinary knowledge. If this path is taken, then interdisciplinarity will gradually fade into the background, with legal philosophers, empiricists, and economists slowly disappearing from legal academia as they migrate to other departments or retire.”

Not surprisingly in view of my comments above about collaboration, I favor the interdisciplinary model. I’m also sympathetic with the multidisciplinary model, as long as the products of this training are appropriately modest about their limitations.

Coincidentally, Alex Tabarrok of Marginal Revolution has provided a good example of what I think the problems are of leaving law and economics to the economists. He’s posted eight paragraphs, plus a couple of quotes, on the question of "What's up with limited liability corporations?" I basically agree with his analysis and conclusions, as far as they go. But I wonder if he really believes that’s all there is, or even a fair summary of the enormous literature on this subject. There’s an awful lot of nuance missing. For example (to name just one), consider the role of default rules and specific business associations.

I think that nuance is best supplied by legal and economic scholars working together. The economists do the modeling and the econometrics, while the legal scholars get enough training to understand the modeling and econometrics and then add the rich institutional environment that makes it all work and relate to the real world.

Without this collaboration, we're going to end up with a lot of silly economic models that assume the proverbial can opener, while we get a lot of dippy law review articles that ignore the shape of the can.

Sorkin and Milken on bubble laws

The NYT’s Andrew Ross Sorkin is willing to admit this about Mike Milken:

Did he invent the junk bond? Yes. Did he help make securitization popular? Yes. Did he have anything to do with the current mess? Absolutely not. Blaming Mr. Milken for today’s credit crisis is like blaming the inventor of paper money. He may have made some mistakes along the way, but Mr. Milken helped create a new generation of companies and an entirely new way to finance nascent ideas that have helped fuel the global economy far beyond his exit from Drexel. The list of companies that would not exist without him is long: MCI, CNN and Turner Broadcasting (now part of Time Warner), Barnes & Noble and Occidental Petroleum, just to name a few.

Ok, fine.  But Milken was blamed, villified and jailed for all the ills of his day. And this is quite common, as I explained a few years ago in my Bubble Laws, 40 Houston L. Rev. 77 (2003). Indeed, Milken, via Sorkin, explains the whole process along the lines that I do in this article:

Toward the end of every bubble, people misuse the financial tools at their disposal, and then a witch hunt begins for the villain. . . . . The biggest financial companies have every motivation to push for more regulation to quash competition, the way they did of him in 1990, he said. Using a somewhat strained analogy of medieval class conflicts, Mr. Milken said: “In England and other monarchies, the king enjoyed the allegiance of the nobles, who lorded it over the mercantile class. But with the spread of knowledge through the new technology of printing, the precursor of modern banking and capital markets began to develop. Eventually, some merchants acquired enough wealth to challenge the standing of the nobles.” So what did the nobles do? “Turned to the king” — that is, the government. In the early 1990s, Mr. Milken said, similarly unwise regulation, urged in part by large vested interests, helped push the economy into a full-blown recession.

Actually, this isn’t a “strained analogy,” as Sorkin says. It’s pretty much right on. The fact that it goes all the way back to medieval times (and actually before) indicates how deep-seated and persistent society’s fear of the capitalists is.

Maybe the lesson is: Being a capitalist can be very rewarding and a lot of fun. Just don’t be the tallest capitalist, because you’re likely to get your head chopped off.

Wright on the future of law and economics

Over at TOTM, Josh Wright is beginning a series of what looks to be a very interesting discussion of the future of law and economics.

Josh addresses the potential costs of the increasing sophistication and formalization of law and economics. He summarizes these costs as (1) economists doing work “that is detached from legal institutions and law and therefore less relevant;” (2) that legal scholars won’t know or care even about the good law and economics work that’s being done “because of the ‘translation’ issues;” and (3) that the qualified scholars will migrate from law to economics departments, leaving law schools to do lower quality work.

Josh concludes that the second problem – what he calls the “retail” problem -- is the most important, and promises to address all of the problems in future posts. I'm looking forward to, and expect to comment on, the discussion as it develops.

A bettor way to predict elections

The pollsters are calling a dead heat in Indiana. Should you even be interested? The pollsters haven’t done so well in calling past primaries. Gordon Crovitz discusses a better idea in today’s WSJ:

We think of forecasting stock-market performance and presidential outcomes as entirely different exercises. When stocks are assessed for future earnings, we don't look to opinion polls to define their price. Why shouldn't active, anonymous trading on politics, backed by money, work just as well in setting the odds of a political outcome? * * *In contrast, polls depend on getting a representative sample, truthful responses to poll questions, and proper use of statistics. Election-predicting markets seem to work so long as there are enough traders whose aggregate information is fully reflected in bets. * * *Iowa Electronic Markets claims that its results have been more accurate 75% of the time versus some 1,000 opinion polls since the early 1990s.

The problem is that regulations, primarily those against gambling, stunt these markets. The Iowa prediction market operates under a CFTC no action letter that limits bets, and still gets threats from state attorneys general, as Tom Bell writes. For a handy summary of the legal state of play, see Michael Abramowicz’s Predictocracy, 49-53.

Some influential economists call for a safe harbor for certain types of small stakes markets. But this sort of limited safe harbor sharply restricts people’s ability to put their money where their mouths are, and therefore these markets’ ability to provide accurate predictions. If prediction markets are unleashed, subjected to practical regulation rather than prohibited as immoral gambling (and competition for state-run lotteries), they could be powerful information generators. As James Surowiecki argues:

Sports bettors are closer to stock or commodities buyers than to people who buy lottery tickets. How much difference is there, after all, between betting on the future price of wheat (an activity banned in some states in the nineteenth century) and betting on the performance of a baseball team?

Indeed, Miriam Cherry thinks these laws regulate expression and therefore might violate the First Amendment.

And even if you think that prediction markets are like gambling, that doesn't necessarily justify regulating them.  As Steve Levitt argues:

To me, there is no difference between a “prediction” market and a “gambling” market. If there is demand for people who either want financial risk surrounding an event or want to hedge risk, why should the government get in the way? It doesn’t matter whether it’s the value of a bond, a share of stock, a presidential election, a firm’s likelihood of hitting its quarterly numbers, or the chances that the White Sox will win the pennant. In general I am not much of a libertarian, but our government’s policy towards gambling is completely idiotic and rife with internal contradictions.

Maybe all this thinking will gain some traction.  Then in future elections we may come to see as rather quaint the idea of getting information by asking people to give anonymous opinions about candidates, with no penalty or constraint on lying.

Backdating's latest victims: plaintiffs' lawyers

The poor plaintiffs’ lawyers, like so many others, fell for the notion that backdating was the scandal of the century. As I’ve discussed, e.g., here, after the securities class actions foundered over whether there was actually any harm to investors, the derivative suits are having trouble finding the harm, if any, to the corporations.

The lawyers, like anybody who's made a bad investment, would now be happy just to get their money back, in this case get paid for the time invested in the suit.  So like the guys who smear windshields with dirty rags, they’ll offer to leave if the defendants (or, more accurately, their insurers) pay them off.

The catch is that the courts need to approve these settlements. A judge may be forgiven for casting a jaundiced eye on a lawyer who filed a lawsuit with feverish allegations of horrendous harm only to try to say, like Emily Litella, “never mind.” Kevin LaCroix has the story (HT Law Blog) of a California federal judge who struck down an attempted fee-for-dismissal settlement as “collusive,” sending a somber warning to the lawyers in many other backdating cases:

[T]he participants that may face the biggest problems if these cases become more difficult to resolve are the plaintiffs’ lawyers. There is a suggestion . . . that the plaintiffs’ lawyers are starting to find the cases tiresome and just want them to go away. Indeed, one of the things that clearly seemed to be bothering Judge Alsup in these cases is that the plaintiffs’ lawyers were settling (too) cheap or walking away without even doing what the Judge at least believes to be minimally required. The plaintiffs’ lawyers piled into these kinds of cases with enthusiasm but they may now be repenting their involvement. The implication of Judge Alsup’s opinion may be that the plaintiffs’ lawyers may be challenged to extricate themselves.

Looks like a pathetic judicial denouement for the scandal of the century.

Your money or your wife?

Would you risk your life for your spouse? If so, how much would that cost you (or your estate)?  For your date?

Beylin & Malani have data!: Finding Love in the Wreckage: Estimating Spousal Altruism with Data on Fatal Car Accidents:

This paper estimates the degree of altruism among spouses by examining how often the driver of a car sacrifices his or her own self in a car crash in order to save a spouse. Holding constant the magnitude of a collision, a driver can maneuver the car to distribute the risk from collision between the driver and a passenger. We quantify spousal altruism by the degree to which drivers riding with their spouse redistribute the risk from a fatal accident to themselves - as measured by ex post mortality - as compared to drivers not traveling with their spouse. We find that drivers with their spouses are roughly 1.21 times more likely to sacrifice themselves. Assuming a $10 million value of life, this implies a willingness to accept a $2,100,000 loss to avoid the death of a spouse.

I dunno. Some things I'd like to know:  Why did the accident happen in the first place? With your date, you're more likely to be distracted, if you know what I mean. Is your life (or your passenger's life) worth more if you're married?  What happens if the driver is married, but the injured passenger is not his or her spouse? 

Law firm 10Ks

David Lat ponders, “What if New York’s Law Firms Went Public.” This in the wake of the IPO of the Australian firm Slater & Gordon, which I have discussed a lot over the last year (see my lawyers archive).

Steve Bainbridge notes that Lat's humorous take raises the serious question “how we’d square client confidentiality rules and SEC disclosure obligations.” Indeed, as discussed at the Georgetown conference last week (which Lat attended), a lot would change if law firms took on non-lawyer owners. I raised the question whether firms that include law practice as part of their business model would be fundamentally different from firms that don’t. For example, would a firm that combines investment banking and law (a scenario I discussed here) be essentially an investment banking or a law firm?

Slater & Gordon, which is a law-only firm, operates under disclosure exceptions that accommodate client confidentiality, indicating that this problem is manageable. But as law becomes absorbed into other businesses, I speculate that the practice of law will cease being so special. This affects not just confidentiality, but also conflicts rules, and the whole panoply of rules that keep lawyers from being treated like ordinary business people.

Whether one welcomes that result or not, the competitive pressures on the law biz virtually ensure that things will soon move in this direction.

The Democrats' super-dilemma: there must be some way out of here

As I said early last February:

It strikes me that there’s something of a prisoners’ dilemma coordination problem here. These [superdelegates] are motivated primarily by political gain rather than by principle. Indeed, that’s why they were given this power. The career pols are playing a long-term game and they want to be on the winning side. This involves a guess as to what their fellow prisoners delegates will be doing. And this stategic guessing game is likely to take some time. . . . Anyway, watch for this story to keep getting bigger.

Well, of course, it’s huge now. By way of doing some academic research (actually, by way of avoiding real work) I watched the candidates’ speeches last night, trying to see the superdelegates’ perspective. Here’s what I saw.

First Clinton: a poorly delivered speech, evidently read from notes, offering the usual chicken-in-every-pot.

Then Obama: a rousing yet carefully crafted stem-winder. He not only told the believers that he was going to deliver, but told the thinkers how: by changing politics as usual, letting the people speak not the lobbyists. Very effective.

Yet despite Obama’s manifest political skills, huge war chest and massive spending against a maladroit opponent who often looks and sounds ridiculous (Bosnia, shot-and-a-beer), at the end of the Pennsylvania campaign Obama found himself with: Philadelphia. Take away Philadelphia and a couple of suburbs, and Clinton’s win was massive. She was beating Obama 70-30 in the parts of the state where the fall election will be close, while a Democrat Donald Duck could probably take Philadelphia against a conservative Republican.

What’s going on here? I (the superdelegate) am figuring, there’s just too much we don’t know about this guy. He’s high variance as the finance types would say. Given our lack of background with him, each piece of news sharply changes his value, like some dot com stock. He thinks that ordinary people “cling” to religion? He likes this guy Wright? And what’s the story with this guy Rezko, and the whole Chicago thing? And anyway, I don't really believe in this change message.  After all, I'm part of the system, and the system basically works.

And yet:  look at Clinton's negatives, and all the bad will from the Obama folks if we hand the nomination to her after his supporters' expectations were so high.

So here I am (the superdelegate), a prince keeping the view.  There must be some way out of here. There’s too much confusion. I can't get no relief. But the hour is getting late. Two riders are approaching. The wind’s beginning to howl.

Maybe there is an answer.

The SEC at 75

The Virginia Law Review is throwing a party next September with some distinguished guests, undoubtedly reflecting on the past, present and future.

The unions and private equity: Money vs. politics

Labor unions play a significant role in corporate governance. Often they cast the fight in terms of shareholder wealth maximization and good governance, as in public fights over executive pay, or social responsibility, as in labor-led initiatives concerning working conditions. But it's always to some extent about using shareholder meetings to get leverage in negotiations with managers, and of course thereby achieving the ultimate goal of attracting more members.

But what do unions do when the firm is controlled by a private equity firm? Big problem: no shareholder meetings. This freedom from labor agitation, indeed, could be one impetus for firms seeking the shelter of these investments.

The logical next step is for the unions to try to cut off private equity investments.  The private equity firms themselves are, of course, private.  But their money has to come from somewhere, right? In fact, a lot of it comes from politically exposed public pension funds funds like CalPers.  So the unions might try replicating their good governance/social responsibility strategy in that arena.

The very active Service Employees International Union tried that by supporting a bill in the California legislature that would have restricted state pension fund allocations to private equity firms receiving investments from sovereign wealth funds in countries with bad human rights records. As an editorial in today’s WSJ editorial discusses, the SEIU really wanted to stop Carlyle Group and KKR from investing in firms whose workers SEIU wanted to organize.

Problem is, according to a spokesman for the California teacher pension fund (Calstrs) quoted in the editorial, "[y]ou cannot close off one of the main sources of high returns and think that it's not going to impact California's teachers' retirement." The editorial continues:

Calstrs and Calpers estimated that their funds would lose a combined $7.5 billion in the first five years alone under Mr. Stern's bill. "If you're denied access, by law, to the best performing investment players," said Calstrs CEO Jack Ehnes, "by definition you're going to start putting your money in mediocre investments."

I have argued (e.g., The Rise of the Uncorporation) that firms are increasingly seeking "uncorporation" forms of governance, including private equity management, partly to avoid the high costs of shareholder governance.  It seems that in coming years labor may increasingly have to decide whether to “overcome” the capitalists or join them.

The future of law practice

The Georgetown Conference on the Future of the Global Law Firm was, I think, a very successful conference featuring an interesting extended discussion among regulators, academics in various disciplines, law firm consultants and top partners of big law firms.  Here's some comments by Gordon Smith. There was much too much to summarize in detail, but here are some overall reactions.

To begin with, the shape of the legal industry today tells us very little about the future. That's because this shape has been largely dictated by regulation of the structure of law firms, including restrictions on conflicts of interest, ownership and enforcement of non-competition agreements. These rules constrain firms that practice law in raising capital, retaining talent, and attracting clients.

In the long run, this regulation is doomed. Markets are demanding lower legal costs and more flexibility, and there is international competition to supply these demands. Markets and contracts will work around the rules. The rules themselves will be history when, for example, New York law firms have to start competing with, among other things, a liberated UK legal services industry.

Post-deregulation, there's no telling what will happen. At the conference, I hypothesized law firms with varying levels of lawyer control, as well as a bewildering variety of non-law firms selling various types of legal expertise. Bruce MacEwen aptly referred to the coming "Cambrian explosion" in the legal business, in which evolution is unprecedented and rapid.

Certainly there will be many variations on the globalization of law practice – firms that send their lawyers all over the world, franchise local offices, or practice international law from a home base. Even firms with local clienteles will have global supply chains, just like non-law firms today. Much legal work is already being routinized and shipped to India.

These developments are going to force us to rethink what it means to practice law or have legal skills, and how to teach people these skills. It's important to keep in mind that practicing law didn't used to be high-falutin. Once upon a time you apprenticed for it like other trades, and didn't even need a college education. That was before a powerful trade group called the American Bar Association and its equivalents throughout the world figured out how to make law practice a high-priced profession. Global competition may return us to some version of those days.

Just as the lawyer market has been protected by regulation, so has the law school world. So we still put all law students through something like the standard three-year routine that has survived for a century. We say that every one of them needs to be able to do the same set of things.  After all, a specific definition of law practice is essential to what it means to be a profession. 

In the future, however, the legally skilled may be people sitting in Bangalore who have never seen the inside of a US law school. Others, as Bill Henderson suggested, may be trained by law firms, as these firms wake up to the inefficiency of buying resumes. The market value of some kinds of lawyers may skyrocket, while that of others may plummet. Surely in this world we can't expect to be selling all law students the same $100,000 education.

The bottom line is that lawyers have been living within the comfortable protection of a regulatory monopoly. One of these days the zoos will close and the animals will be left to fend for themselves in the wilds of the markets. I'm glad that I was able to spend a nice long career in the zoo, although I think it will be pretty exciting out there in the jungle.

The Blackstone suit

I suppose it had to happen. With Blackstone Group down about 45% from its IPO price, it's learning that all that extra valuation its principals got on their stock from going public has a price: The class action lawyers are starting to swarm. Specifically, Coughlin Stoia has sued Blackstone Group, Steve Schwarzman, and CFO Michael Puglisi. Here's the Forbes.com story.

This is a suit under the 1933 Act for issuing a false prospectus. So there's no Stoneridge-type problem of suing secondary parties: they're brought in explicitly under Section 11 of the 1933 Act, and possibly as control persons under Section 15. There's also a claim under Section 12(a)(2), though that claim might get tricky because of its privity requirement.

The real problem here, and one that could raise a significant issue in other IPOs by investment partnerships like Blackstone, is the nature of the alleged wrongdoing. Plaintiff is complaining of a failure to disclose problems in two of its investments – FGIC and Freescale – which would reduce performance fees, particularly as these were subject to clawback by limited partners.

As far as I can see, the prospectus didn't do any more than list these investments (indeed, on a quick search I didn't even see a reference to FGIC). The plaintiffs seem implicitly to be claiming that Blackstone was vouching for the absence of problems in the securities in its portfolio. Note that under Section 11, the issuer would be strictly liable, and the other defendants would liable unless they proved due diligence.

I wonder about this claim. Surely the investors knew they were taking risks.  They were trusting Blackstone's investment expertise -- a reasonable gamble given the exposure of Blackstone and its partners.  Of course that wouldn't excuse lies.  But this seems to be a straight non-disclosure case. Perhaps it also wouldn't excuse deliberately hiding risky investments.  But keep in mind that Blackstone has strict liability.

As a practical matter, imposing this kind of responsibility would seem to put a very heavy, cold wet blanket on IPOs by these kinds of investment firms. Maybe something KKR should be thinking about as it gears up for its offering.

Is SOX unconstitutional?

According to Ted Frank, at yesterday’s oral argument on Free Enterprise Fund v. PCAOB, which challenges the constitutionality of the PCAOB, “[a] panel of Judges Brett Kavanaugh, Judith Rogers, and Janice Rogers Brown expressed substantial skepticism to the PCAOB's position." Dow Jones’ Judith Burns also writes that “[t]he legality of a private oversight body charged by Congress to inspect and discipline public-company accountants came under sharp questioning Tuesday from one of the judges on a three-judge panel of the U.S. Court of Appeals for the D.C. Circuit."

Here’s some background on the suit, and Donna Nagy’s extensive discussion of the legal issues regarding the PCAOB.

So this suit, which has been lambasted by the pro-SOX crowd, and which is being ignored by the mainstream media, may actually have some legs. And if the PCAOB goes down, so does all of SOX. Congress was too busy falling over itself to adopt this misguided law to insert a severability clause.

I'd love to see Congress have to face the issue in an election year of whether to re-adopt SOX.

Tomorrow at Georgetown: The Future of the Global Law Firm

Here’s a prior post on this conference, with some links.

I’ll be speculating about what the law firm of the deregulated future may look like. Basically, law may be practiced in firms that lawyers don’t own or control, and that don’t even specialize in law. And this may have profound effects on what lawyers do, and on whether there will even be professionals that resemble the lawyers of today. Others will be talking about the interesting developments that have led us to the brink of these important changes. Many of the speakers are responsible for these developments.

I'll have more later.  This should be interesting.

Reforming state insurance regulation

Rep. Ed Royce writes in the WSJ about reforming the insurance industry, and on today’s hearings on this issue by the House Financial Services Committee. His particular concern is the problem of 51 state regulators, “punishing American consumers and insurance providers alike” by slowing product development, imposing outmoded price controls, and impeding federal responsiveness to global developments.

Royce is an author of the National Insurance Act, which would provide for optional federal chartering of insurers. He says, “by providing an alternative to the state-based oversight, an OFC would establish a national regulator for the industry and diminish the ability for state regulators to manipulate the market.”

As I discussed here a couple of weeks ago, Henry Butler & I have an alternative, proposed in our Jurisdictional Competition Approach to Reforming Insurance Regulation and presented Monday at Northwestern’s Searle Research Symposium on Insurance Markets and Regulation.

Butler and I agree that state regulation is a problem for the reasons Royce suggests. But replacing this system with one unwieldy monopoly regulator is not the right solution. Indeed, it is not really a feasible solution, since it is unrealistic to suppose that state regulation will simply disappear. There is likely to be very strong support for continuing state regulation of consumer protection, automobile and worker compensation insurance, and state solvency funds and solvency regulation.

So federal regulation really means adding a federal regulator. Moreover, “optional federal chartering” is illusory: the federal behemoth almost inevitably would wipe out at least state regulation of solvency. And, again, some state regulation would apply even to federally chartered firms.

Butler and I propose, instead, a federal law that permits insurers to choose a single state regulator. We would preserve some ability for non-chartering states to regulate to protect their residents, but we propose safeguards to mitigate the 51-regulator problem.

First, non-chartering states could not impose solvency safeguards. Rather, they could go no further than barring insurers from the state that do not maintain a minimum bond rating.

Second, our proposed federal statute would let a state override the law of a chartering state on other matters, but only if it does so by explicit legislation. This would give insurers clear notice and opportunity to avoid onerous state regulation. We also propose federal regulation of the states’ ability to impose exit restrictions.

Our proposal would mitigate the worst aspects of the current system of 51 state regulators. At the same time, it would deal with the reality of continuing state regulation by reforming it rather than wishing it away. The system that would emerge would allow for continued operation of our dynamic federal system, in which the states can experiment with a variety of different regulatory approaches, but without the oppressive over-regulation of the current approach.

We hope this approach gets some consideration amid the rush to federalize this area.

Say on pay: quack corporate governance

The WSJ writes today about the move heating up to require corporations to let their shareholders have a “say on pay.” It sums up the sentiment for this by quoting McCain: "There's a backlash in America today against corporate greed." Obama introduced the say on pay bill in the Senate, claiming that Washington needs to change "a system where bad behavior is rewarded.''

Clinton supports the bill as long as it includes an exception for former president speaking fees.

As I said last year when this issue was in the House:

Remember the quaint idea that the states were supposed to decide corporate governance, and the federal securities laws were supposed to be just about disclosure? Obviously this is a significant decision about the allocation of power between shareholders and managers that's being made by the U.S. Congress. Wasn't that supposed to be a matter for state law?

Efficient compensation must be crafted on an individual-by-individual and firm-specific basis to provide the right incentives and attract the best people. It's like designing a product. Can anybody seriously believe that shareholders en masse can make a meaningful, intelligent, up-or-down decision on executive compensation?

Although the bill requires merely a non-binding vote, the vote's potential for bad publicity gives a stick to shareholders, including politically-minded shareholders like unions that have something on their minds other than shareholder wealth maximizing.  Wealth-minded shareholders don't want constraints on being able to hire and motivate the best executives.

Note that even if this becomes federal law, that won’t mean that all executives will be subject to it. The law would apply only to corporations. It would therefore become still more fuel for the Rise of the Uncorporation. And if you apply it to all firms in the US, there are other places firms can go.

In short, it's fitting that the most vocal corporate supporter of this proposal is most famous for its quack. And even the CEO of that company (who happens to own ten million shares) doesn't think the proposal should be mandatory, as Holman Jenkins pointed out a couple of days ago. Aflac CEO Amos noted that in a company that makes a million dollars an hour profit, "it doesn't really matter what the CEO makes." 

I would add that the same is true in a company that loses a million dollars an hour. To quote the best comment I’ve heard yet on say on pay (from Dealbreaker, after discussing Lloyd Blankfein’s criticism of say on pay): "You want say on pay, I have two words for you, people: Jimmy Cayne. I hear he's looking for work, and will agree to just about anything."

The Apollo "IPO": another challenge to the corporate model

Steve Davidoff has some unfavorable comments on the recently filed IPO-that-is-not-really-an-IPO for Apollo Global Management LLC. As he points out:

This offering is not by Apollo, and it is not by the employees of Apollo. In fact, it may not even be an offering. Apollo is simply complying with its obligations to its new equity holders. This filing may be a prelude to an offering by these equity holders of the Apollo stock they own, but it may simply be a means for them to sell these interests on the open market.

That background aside, what particularly interested me is Davidoff’s comment on the firm’s governance structure:

I will repeat the now trite point about the limited governance public holders of the equity in this vehicle will have. Once again, shareholders who purchase into this will have limited voting rights, fiduciary duties are contractually eliminated in some circumstances and Apollo is applying to the NYSE for an exemption from the independence requirements for directors on the board and nominating and audit committees. If people want to buy into this, that is their business, but the rules requiring equity holder enfranchisement and independent directors are there for a reason — perhaps it is time to examine whether that reason is still justified. If it is, the rules should be applied to these private equity and hedge fund adviser public entities. Sermon over.

Indeed, the S-1 does spell out a structure that’s clearly not your typical publicly held corporation. Here’s some highlights:

We intend to continue to employ our current management structure with strong central control by our managing partners and to maintain our focus on achieving successful growth over the long term. . . . . [W]e have decided to avail ourselves of the “controlled company” exception from certain of the NYSE governance rules, which eliminates the requirements that we have a majority of independent directors on our board of directors and that we have a compensation committee and a nominating and corporate governance committee composed entirely of independent directors. It is also the reason that the managing partners chose to have a manager that manages all our operations and activities, with only limited powers retained by the board of directors, so long as the Apollo control condition is satisfied. * * *

We do not have a compensation committee. Our managing partners have historically made all final determinations regarding executive officer compensation. * * *

Whenever a potential conflict arises between our manager or its affiliates, on the one hand, and us or any Class A shareholders, on the other hand, our manager will resolve that conflict. Our operating agreement contains provisions that reduce and eliminate our manager’s duties (including fiduciary duties) to the Class A shareholders. Our operating agreement also restricts the remedies available to Class A shareholders for actions taken that without those limitations might constitute breaches of duty (including fiduciary duties).

[The S-1 states that the agreement provides that the manager may but is not required to set up an independent board with a conflicts committee, and may but is not required to get that committee’s approval to conflicts transactions. It also may, but is not required, to get approval from Class A shareholders.]

If our manager does not seek approval from a conflicts committee of our board of directors or our Class A shareholders and it determines that the resolution or course of action taken with respect to the conflict of interest satisfies . . . the standards set forth . . . above, then it will be presumed that in making its decision our manager acted in good faith, and in any proceeding brought by or on behalf of any shareholder or us or any other person bound by our operating agreement, the person bringing or prosecuting such proceeding will have the burden of overcoming such presumption. Unless the resolution of a conflict is specifically provided for in our operating agreement, our manager . . . may consider any factors it determines in good faith to consider when resolving a conflict. Our operating agreement provides that our manager will be conclusively presumed to be acting in good faith if our manager subjectively believes that the decision made or not made is in the best interests of the company. * * *

In addition to the provisions relating to conflicts of interest, our operating agreement contains provisions that waive or consent to conduct by our manager and its affiliates that might otherwise raise issues about compliance with fiduciary duties or otherwise applicable law.

For example, our operating agreement provides that when our manager, in its capacity as our manager, is permitted to or required to make a decision in its “sole discretion” or “discretion” or that it deems “necessary or appropriate” or “necessary or advisable,” then our manager will be entitled to consider only such interests and factors as it desires, including its own interests, and will have no duty or obligation (fiduciary or otherwise) to give any consideration to any interest of or factors affecting us or any Class A shareholders and will not be subject to any different standards imposed by the operating agreement, the Delaware Limited Liability Company Act or under any other law, rule or regulation or in equity. These modifications of fiduciary duties are expressly permitted by Delaware law.

* * * [E]ven if there has been a breach of the obligations set forth in our operating agreement, our operating agreement provides that our manager and its officers and directors will not be liable to us or our Class A shareholders for errors of judgment or for any acts or omissions unless there has been a final and non-appealable judgment by a court of competent jurisdiction determining that our manager or its officers and directors acted in bad faith or engaged in fraud or willful misconduct. These modifications are detrimental to the Class A shareholders because they restrict the remedies available to Class A shareholders for actions that without those limitations might constitute breaches of duty (including fiduciary duty).

The agreement details some of the conflicts the managers can decide in their own capacious discretion, including contracts between the manager and its affiliates, conflicts between investors in the subsidiary funds and the interests of the LLC members, and federal tax considerations.

The S-1 notes that the Delaware LLC Act permits elimination of fiduciary duties that might otherwise be owed, and details differences between standard form fiduciary duties and the operating agreement.

As for whether the Delaware courts actually would enforce the agreement as written, I have some thoughts based on a survey of recent Delaware LLC and partnership law in The Uncorporation and Corporate Indeterminacy.

Why would somebody invest in such a company?  In my Rise of the Uncorporation I detail what makes this sort of structure work, specifically including the tradeoff of high-powered incentives for costly corporate-style monitoring such as an independent board, shareholder voting and fiduciary duties.  The Apollo S-1 notes this tradeoff:

[W]e seek to retain the culture we have developed as a privately owned firm by having primarily performance-based compensation for our managing partners, contributing partners, and other professionals. Our managing partners and contributing partners retain personal investments in our funds * * * directly or indirectly, and we continue to encourage our managing partners, contributing partners and other professionals to invest their own capital in and alongside our funds. Our partners (other than our managing partners) retain a portion of their “points” in our funds and, in regard to future funds, will generally continue to receive allocations of points. * * *

It may be too early to see all the pitfalls in this structure, and whether it really will hold up in court.  But there is no doubt that large publicly held businesses are starting to look very different from the corporations of old, and it's a development that "corporate" scholars ought to be paying attention to.  The standard publicly held corporation is not the only governance game in town.

First date insurance

You probably don't think of restaurants as selling insurance, but apparantly they do, according to Png & Wang, Buyer Uncertainty and Two-Part Pricing: Theory with Evidence from Outsourcing and New York Restaurants. Here's the abstract:

We consider two-part pricing of a service offered to risk-averse buyers subject to independent demand uncertainty. Buyers subscribe to the service before the uncertainty resolves. Vendors maximize profit by balancing between insuring buyers against the uncertainty and reducing ex-post deadweight loss. We introduce the concepts of felicitous goods, for which the total and marginal benefits are positively correlated, and distress goods, for which the total and marginal benefits are negatively correlated. The profit-maximizing two-part price includes a usage charge greater than the marginal cost of service for felicitous goods, while the usage charge is less than the marginal cost for distress goods. We discuss how our analytical model could improve pricing practices in the IT services outsourcing industry. Further, using the Zagat Survey, we tested our analytical predictions on pricing by New York restaurants. For two diners on their first date, a major uncertainty is whether they would like each other. If they do, they would prolong the meal by ordering appetizer, soup, and dessert, while if not, they might just do with a main course. We found that, among "singles scene" and "romantic" restaurants, the prices of appetizer, soup, and dessert were 6-20% higher relative to main courses than among "business dining" restaurants. This is not consistent with alternative explanations of restaurant pricing.

So the lesson is, if you're on a first date, go to a restaurant where the main course is priced to protect you from uncertainty.  If you're an old married couple like my wife and me, maybe you go to a place that doesn't force you to buy insurance.  But, then, you don't really need a romantic restaurant, do you?

Subprime and the coming challenge to disclosure

The WSJ writes today about a bankruptcy trustee’s suit against investment banks for helping keep alive a lender, American Business Financial Services Inc., which had sold high interest notes to ordinary investors. Seems the lender had allegedly misstated the value of its assets by underestimating prepayments, which significantly affected the value of its interest-only strips.

The claim against the bankers sounds a bit like a “deepening insolvency” claim. Basically, it’s another way of getting at deep pockets a la Stoneridge, but this time under the bankruptcy laws. Or it might be aiding and abetting breach of fiduciary duty, or both.

The WSJ doesn’t analyze the niceties of these claims, which you might expect from a high-end business publication. It goes for the gut rather than the brain by detailing the woes of the poor investors who thought they were getting a great deal when they bought 12% notes at a time when Treasuries were 3%.

I was particularly interested in this from the article:

Risks were spelled out in lengthy prospectuses. The last one, for a $295 million offering dated Nov. 7, 2003, was 230 pages long, with 18 pages of "risk factors." The front page contained a bold-face warning: "You should only invest in these securities if you can afford to lose your entire investment." Some investors admit they never read the prospectuses, or didn't understand them. "There was a lot of mumbo jumbo there," says Mr. Magnon, the retired aerospace manager.

Back at the dawn of the securities laws, there was this idea that the way to protect investors was by letting many investments compete in the market as long as their risks were adequately disclosed. I have always been skeptical about federal disclosure regulation, but at least it can be said that it doesn’t set the government up as an investment advisor.

Stories like this suggest that this old idea is dying. The new idea taking hold is that investors should no longer be treated like adults. Rather, they should be treated like children, and protected from the big bad adults who want to sell them things they shouldn’t be buying.

This idea is getting a big push from the mass of lawsuits arising out the subprime mess. Surely, the WSJ seems to be suggesting, we should not let investors go all by themselves into the horribly complex worlds of derivatives and strips.

Of course it should be said that one reason for this attitude is that disclosure may not be working as intended. As the investor quoted by the WSJ says, “there was a lot of mumbo jumbo.” As I pointed out recently, this is what happens when liability risks drive disclosure documents.

Before we abandon disclosure and the idea of letting investors take risks, I just want to remind people of the long-ago words of William O. Douglas about the Securities Act of 1933: (Douglas & Bates, The Federal Securities Act of 1933, 43 Yale L.J. 171 (1933):

There is nothing in the Act which would control the speculative craze of the American public, or which would eliminate wholly unsound capital structures. There is nothing in the Act which would prevent a tyrannical management from playing wide and loose with scattered minorities, or which would prevent a new pyramiding of holding companies violative of the public interest and all canons of sound finance. All the Act pretends to do is to require the ``truth about securities'' at the time of issue, and to impose a penalty for failure to tell the truth. Once it is told, the matter is left to the investor. . . .

The economy under which we live is not static. Industry is not stabilized and under our present methods never can be. Competition and the progress of invention make it inevitable that many enterprises will fail. The toll of technology over a period of years is enormous. And the downward turn of the business cycle may eliminate more than just the marginal enterprise. Other factors of management, not related to cupidity and fraud, contribute to the same end. As a result, a substantial percentage of industrial investment will in any event be lost. To speak then of underwriting the values which are based on such unstable foundations is sheer nonsense. And to expect that the judgment of investors as respects these imponderable factors will improve perceptibly in this generation is baseless optimism.

LLCs and "good corporate governance"

Delaware’s Chancellor Chandler has had some interesting comments about LLCs. These came in the midst of what looks like a corporate proxy contest, except that it involves an LLC. And according to the Chancellor, that may make a difference.

The case involves TravelCenters of America LLC.  Here’s an opinion from last week on a books and records claim (HT Pileggi), an order on a notice of intent to nominate a person to the LLC’s board, and a letter ruling on admission of the expert testimony of Randall Thomas (the last two via Steve Davidoff).

The Chancellor said in the books and records opinion: "Because of a lack of reported decisions in the LLC context, the Court may look to cases interpreting similar Delaware statutes concerning corporations and partnerships.”

In responding to the notice to nominate, the Chancellor said: "[L]imited liability companies are creatures of contract. They are entities governed strictly by the language set forth in their LLC agreements. It's that language that will in large part govern and control my decision today." He then proceeded to apply the language of the contract as well as federal proxy law.

In the order on expert testimony, ruling on admissibility of Professor Thomas’s testimony for the plaintiff on the relevant bylaws as “good corporate governance,” the Chancellor said:

Delaware does not impose a legal requirement on LLCs to draft their bylaws to be consistent with some abstract notion of “good corporate governance.” On the contrary, limited liability companies are creatures of contract, “designed to afford the maximum amount of freedom of contract, private ordering and flexibility to the parties involved.” [citing several Delaware cases] to the extent defendants intend to argue otherwise, plaintiff need not offer a rebuttal.”

Finally, note that the complaint alleged:

The LLC Agreement creates a nomenclature that in some respects resembles that of a corporation. Under the LLC agreement, membership interests in the Company are called “Shares” or Common Shares,” holders of membership interests are called “Shareholders,” and the business and affairs of the Company are managed exclusively by a “Board of Directors.” However, Despite this nomenclature, the rights and obligations of TravelCenters and its members are governed by the Delaware Limited Liability Company Act . . . and the LLC Agreement.

Putting this altogether, after acknowledging the lack of cases on LLC governance (which would apply particularly to somewhat corporatized LLCs like TravelCenters) and the need to look outside LLC law for authority, the Chancellor nevertheless was careful to analyze even this corporate-like LLC as an LLC.  That meant applying the contract, even in a case to which federal law is relevant.

This approach is fully consistent with my view of what the Delaware courts should be, and have been, doing in LLC cases.  I discussed this view most recently in my The Uncorporation and Corporate Indeterminacy, which I presented this paper at Symposium in which the Chancellor participated.

I worried in the paper

that the judicial tendency to apply corporate rules is always lurking and that courts have not yet completely severed the uncorporate cases from corporate indeterminacy. In particular, it is important to keep in mind that the uncorporate cases have arisen mainly in closely held firms and has not been fully tested under the conditions that corporate law has had to face. Courts may be particularly tempted to apply corporate rules to uncorporate firms that resemble large-scale corporations.

The TravelCenters case sets me more at ease. It gives an early glimmer that even LLCs that look somewhat like corporations will be treated like what they are, and not like what they’re not. That means particularly applying the contract rather than fitting them into the rigid corporate mold, created by generations of scholars, judges, practitioners and an industry of experts on “good corporate governance.”