Ideoblog

The media and securities arbitration

Jill Gross and Barbara Black have an interesting addition to the arbitration debate: When Perception Changes Reality: An Empirical Study of Investors' Views of the Fairness of Securities Arbitration. Here’s the abstract:

Arbitration in securities industry-sponsored forums is the primary mechanism to resolve disputes between investors and their brokerage firms. Because it is mandatory, participants debate its fairness, and Congress has introduced legislation to ban pre-dispute arbitration clauses in customer agreements. Missing from the debate has been empirical research of perceptions of fairness by the participants, especially investors. To fill that gap, we mailed 25,000 surveys to participants in recent securities arbitrations involving customers to learn their views of the process. The article first details the survey's background, explains the importance of surveying perceptions of fairness, and describes our methodologies, procedures, and survey error structure. We then present our findings, including our primary conclusions that (1) investors have a far more negative perception of securities arbitration than all other participants, (2) investors have a strong negative perception of the bias of arbitrators, and (3) investors lack knowledge of the securities arbitration process. We also offer several explanations for these negative perceptions. We conclude that customers' negative perceptions transform the reality faced by policy-makers and mandate reform of the process, including the elimination of the industry arbitrator requirement and further public deliberation on the value of the explained award.

So where do investors’ negative perceptions come from? Keep in mind that the investors lack knowledge of the process and that there’s mixed evidence of the actual fairness of the process. But the authors speculate:

Customers’ negative perceptions could be fueled by what they read in the media. Indeed, 39% of customers reported they had concerns about the fairness of the process before their claim was filed.158 These concerns may stem from a variety of sources including media coverage. Exploring this hypothesis, we reviewed 51 articles on customers’ securities arbitration that were printed in major newspapers between January 1, 2002 and December 31, 2006. We determined that 46% of the articles contained objective, neutral assessments of customer arbitration, 45% of them were critical of customer arbitration, and 8% contained favorable assessments of the process.159 Thus, contemporaneous media coverage of securities arbitration was far more negative than positive. Whether the media coverage’s portrayal of securities arbitration was accurate or not is somewhat inapposite; it may well have colored customers’subjective perceptions.

The authors conclude:

Whatever the underlying explanation, we have no doubt that our survey results are illuminating as to subjective perceptions by arbitration participants of fairness, albeit inconclusive as to objective standards of fairness. As stated above, subjective perceptions are important because participants’ views of fairness, particularly procedural fairness, are critical to the integrity of the dispute resolution process. Simply put, even if the system meets objective standards of fairness, a mandatory system that is not perceived as doing so cannot maintain the confidence of its users and, in the long run, may not be sustainable. As a result, customers’ negative perceptions are changing the realities of the current system of securities arbitration and require a re-thinking by policy-makers. Accordingly, based on the findings of our Report, we urge the SEC and FINRA to give serious consideration to eliminating the requirement of an industry arbitrator on every threeperson arbitration panel.

I have an alternative suggestion that accepts the authors premises: how about responsible media coverage of arbitration fairness that reduces the need for potentially costly industry responses to misguided consumer perceptions? 

The transfer debate: the case of the unconvincing numbers

Bill Henderson and I have been discussing whether the trend toward increasing transfer students is a problem, and if so how much. I think the tradeoff between increasing IL LSATs and giving low LSAT students a chance to trade up as transfers is at least an arguably reasonable compromise: schools get higher quality IL classes as measured by LSATs and students get a chance to prove themselves in the first year and then trade up.

Bill emphasizes the costs of this strategy: schools accept fewer ILs, forcing students into the transfer pool, which makes for a lower quality law school experience; and lower-tier schools have less ability to test curricular innovations because they’re losing their better students. We disagree about the tradeoff. I have always accepted there’s room for disagreement.

What exercises me about all this is not our little dispute about transfer students -- I would be happy to be persuaded otherwise about my conclusion -- but about how it illustrates the danger of being hypnotized by numbers. Bill’s numbers have power because they definitely show something -- shrinking class sizes, correlation with LSATs.  Unfortunately, they do not advance his argument because they do nothing to shed light on the critical tradeoff. In the end, they have not only failed to persuade, but diverted our attention from the real issues.

There are three facts or assumptions that we’ve both accepted all along: (1) the LSAT competition has forced some students to miss out on three years at the school they wanted; (2) increasing transfers has given them an opportunity to at least get two years; and (3) this opportunity should be balanced against the costs of increasing transfers. The data about shrinking class sizes which Bill cites in his most recent post (the original post just discussed a correlation between class size and higher LSAT) turns out to be the hypnotist’s prop that makes our eyelids grow heavy.

To begin with, what would change if IL class sizes hadn’t shrunk along with the increased transfers? Students who would have made it through Bill’s “whole person review” (see below) still wouldn’t be getting into their preferred schools the first time around because of the LSAT competition. Would maintaining IL class size have made the increasing transfers more palatable? If schools had somehow managed to increase transfers without reducing IL class size, does that mean that they were adding resources to compete for LSATs? If so, would we prefer that they use these resources to increase IL class size, rather than keeping the class size the same? No matter how we answer these questions, the problem remains LSATs and transfers.

What if the class sizes had not shrunk, and because of that the schools did not take more transfers? I doubt students would be better off if they not only couldn’t get into their first choice, but also couldn’t transfer. So as long as we’re assuming that low-LSAT-good-whole-person students are barred from their first-choice school, it would follow that class shrinkage is a good thing. The problem is still about the focus on LSATs, as I’ve said all along, and the data on class size doesn’t help at all.

Ok, but we do know that class sizes did shrink, which would seem to be the likeliest byproduct of the LSAT competition. Let’s assume for the sake of argument that class shrinkage is the inevitable result of the LSAT competition. In that case, the data on class shrinkage has just proved the inevitable. Aside from that, is this link between LSAT competition and IL class shrinkage a problem? That depends on whether we have some clear notion of optimal class size. Should class size depend on, for example, the number of available seats, the impact of numbers on classroom dynamics, or student quality? I would hypothesize that higher average student quality makes for a better learning experience for the whole class. If we suppose (as I’ve been assuming) that LSAT is the best single quality datum, then shrinking the class has an independent payoff. Maybe I’m completely wrong on this but, again, my basic point is that Bill’s data does nothing to prove my error.

As indicated above, Bill implicitly argues in his most recent post that a “whole person review” would do a better job than LSATs. So this suggests that the schools aren’t getting a payoff in terms of higher student quality. I have been open all along to being persuaded that LSATs are not the best measure of quality. But, again, nothing in Bill’s data sheds any light on that issue. Anyway, for what it’s worth, I’m skeptical having done two years worth of “whole person reviews” during my admissions committee stint and being left with a very uneasy feeling.

But the problem for Bill’s data is even worse than I’ve indicated, since he does show something interesting that I didn’t know before: that the correlation between class size and LSAT scores is rougher than I expected. It takes a fully 10% shrinkage to produce only .37 difference in LSAT media. Moreover, his most recent data suggests that class shrinkage is related both to part-time programs and to transfers. So the relationship between the LSAT strategy, transfers and shrinkage seems to be more complex than I had suspected. Now, instead of having a simple and clear correlation that doesn’t advance the argument, we have a complex and uncertain correlation that doesn’t advance the argument. 

Finally, we have the argument that I’ve been ignoring about incentives to innovate. I ignored it because I just didn’t see why or how this hurt the schools’ ability to test their innovations or how this reduced ability to test would affect their incentives to innovate. But now I see that the problem is worse than that. The best test of curricular innovations is the market, and transfer students are the market participants who are the best informed about the quality of innovations. So there’s a pretty strong argument that the transfer market actually increases incentives to innovate. Again, I can be persuaded to the contrary. Again, my main point is that Bill’s data sheds no light on the conclusion.

So, to sum up this very long post: I’m not at all sure that my initial conclusions are correct. But I am sure that pointing to numbers and bar graphs about shrinking class size has no bearing on those conclusions, as convincing a this seems to be.

Don't get me wrong -- I'm a big fan of empirical legal scholarship, and Bill is doing many constructive and innovative things in that vein.  I'm just warning here of a potential danger lurking in the numbers.   

The SEIU and private equity

I’ve previously written about the problems unions have with private equity, coming to a head with the aggressive publicity/organizing campaign of one particular union, the SEIU.

One problem is that private equity doesn’t offer unions and other social activists the usual corporate levers of publicity and power, particularly including public shareholder meetings and the proxy process. So the union has to find other modes of entrée. Indeed, as I’ve written in Uncorporating the Large Firm, foregoing costly corporate-style monitoring is part of the essence of private equity and other “uncorporate” approaches to governance.

Another problem the unions face in confronting its new enemy is that the enemy is them.  Some of the biggest investors in the funds are, guess who: labor pension funds, such as Calpers. As I discussed in my last post, that was a particular sticking point when the SEIU supported a bill in California 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.

Of course the pension funds' private equity investments aren't surprising, since that's where the money is. In effect, the union battle against private equity pits union leadership and current workers against retirees, which of course all of the workers will be one day. I pointed out that “in coming years labor may increasingly have to decide whether to “overcome” the capitalists or join them.”

The SEIU lost the California fight, but as the NYT’s Dealbook reports today, it isn’t giving up. Now it

will call upon people to attend protests on July 17 in 100 cities in 25 countries. The rallying cry will be: Take back the economy from buyout firms that the union says have exploited tax loopholes to amass great wealth at others’ expense. “It’s important to unite our strength globally and make sure these companies live up to social responsibility,” Andrew L. Stern, the president of the S.E.I.U., told DealBook.

The union notes the power of private equity: “Companies owned at least in part by Kohlberg Kravis employ more than 816,000 people, according to the firm’s Web site more than the population of San Francisco.”

The union is noisily claiming the tax code should change, but they haven’t said exactly how. Eliminate the tax deductibility of debt? That’s a non-starter, unless as a precursor to the elimination of the corporate tax, which would only hasten the changes the unions are fighting. Or focusing on private equity debt? That’s harder than you think, because as my article shows, “private equity” is only a part of the much larger uncorporate story. Try to focus on private equity and you’ll find other functionally similar finance mechanisms taking over.

The union thinks “it is possible to amend current law to specifically target private equity’s use of tax deductibility without wrecking havoc with modern finance.” But it’s not clear how. The union is using comic Lewis Black to in “a video professing bewilderment at how buyout executives make their living via financial engineering.” But they’re going to have to go beyond bewilderment and actually understand what’s happening. Maybe they should read my article.

And of course we come back to the problem I highlighted above: the SEIU’s three largest pension funds are invested in private equity.

So, it turns out, the SEIU is actually talking rationally to private equity executives. The SEIU’s Adler notes at the end the difference between what it’s actually doing and it’s headline-grabbing activities.

My article predicts this political confrontation between the forces of corporate social responsibility and the uncorporation, which is a powerful mechanism of managerial accountability to owners' interests.  The story is just beginning, and has a long way to play out.

Henderson on transfer students

Bill Henderson responds to those, like me, who defend law school transfer student policies.  His post is called "Transfer students -- the data." But his conclusion runs a bit past the data.

Bill says in part that transfers are a gaming strategy that produces higher LSATs, citing his article with Morriss. To be precise, Henderson and Morriss find:

We assumed that elite law schools were well-positioned to admit fewer entering 1L students, receive a credential bump, and make up any loss in revenues by admitting more transfer students who were anxious to improve the pedigree of their graduating institution. Despite the small sample size (N = 44), the predicted relationship emerges with p values below the .10 significance level. For example, after controlling for initial starting position, cost, and the number of Am Law 200 lawyers in the MSA, a 10% decline in the 1L class was associated with a 0.37 gain in the law school’s reported median LSAT score.

Note that they find that fewer IL students = higher median LSAT – not that this was the result of gaming class size, or even that it was the result of a policy favoring transfer students. Examining the rest of the article, the gaming hypothesis appears to be based on anecdotes.

Moreover, the gaming hypothesis is limited to “elite” schools. But many of the top net-transfer schools Leiter lists are non-elites, while many of the elites have much lower net transfers. So the most plausible hypothesis would seem to be not that schools were gaming IL class size size, but that they were trading grades for LSATs, which is the assumption I was making in my post. And that has different implications, as discussed in my previous post and below.

Bill also says that a policy of admitting more transfers has adverse social effects on the students. That’s plausible and supported in his post. But the overall conclusion is much more ambiguous than the one Bill draws. The tradeoff would seem to be one of adverse social impact for more opportunity for students who prove themselves to "trade up." With adequate disclosure of the risks, those tradeoffs are internalized by the students and the schools.

The bottom line, as I said in my previous post, is that maybe schools shouldn’t emphasize LSATs to the extent that they do, but that’s not clear. Moreover, liberal transfers is an arguably reasonable strategy given the emphasis on LSATs.

The Clinton speech

What will Clinton say tonight?  Will she say that Obama "is the nominee"? 

My guess is that Clinton is convinced that by convention-time either Obama will self-destruct or the party will escape his hypnotic grasp and come to its senses, and she wants to still be around when that happens. So whatever she says, she'll leave herself wiggle room. 

So in terms of whether Obama is the nominee, I guess it depends on what the meaning of "is" is. If 'is' means is as of now, that is one thing. So If somebody says, is Obama the nominee as of right now, and currently is likely to be, the nominee, then that is a completely true statement.  But the nomination isn't going to happen for awhile, as we all know.  If that statement means Obama is going to be the nominee, then I would have to say I don't know. And that would be completely true too.

Leiter on law school transfer students

Brian Leiter, discussing some law schools' high net inflows of transfer students, comments:

I must say these startling figures give me real pause about the reliability of [LSAT-based] measure of student quality (quite apart from the limitations of LSAT as a measure). For comparative purposes, consider that for other top schools. . . .

Leiter's concern is warranted on the reasonable assumption that transfer students have lower scores than non-transfers. 

But while high transfer rates might be taken as evidence of gaming the USNWR system, not all “gaming” is bad. Suppose USNWR causes an admission bias favoring LSAT scores that may be greater than warranted by the scores' actual predictive ability -- a supposition with which Brian would readily agree. The transfer system allows schools to compensate for that bias by giving low-score students who have proved themselves a second chance.

As one who has actually sat on the admissions committee, I can vouch for the fact that we have to make some pretty close calls that I’m not at all comfortable about. Generous admission of transfer students improves rather than reduces the rationality of an admittedly imperfect system

Perhaps eliminating the LSAT bias would be the best approach.  But that's hard to do even without the USNWR, since the LSAT may be the single best predictor, even if it's imperfect.

I'm not going to say that this is the best of all possible worlds, but I'm also not sure it's the worst.

The Grasso pay case gets a hearing

The NYT reports on the pending NY Court of Appeals arguments in the Grasso excessive compensation case. The storyline is that Grasso may have the last laugh, after his nemesis Spitzer is down the tubes, and some of the directors who approved his compensation, and who should have taken the heat for it instead of Grasso, have not been treated kindly by the subprime meltdown.

As I have been writing for years, this case is a monument to the ambition of Eliot Spitzer. As I pointed out two years ago:

the main thing to keep in mind is that the pay was approved by a highly sophisticated board. The only issue should be whether that board was informed. This is the way it should and would be in a standard fiduciary duty case (e.g, Disney). There is significant reason to believe it was, according to a detailed review of the depositions in the case* * *

And I added this:

Significant resources of the state of New York (not to mention of the defendants) have been spent on this trial. I can't wait to see what Spitzer will do as governor.

It's worth noting that the NYT’s, Gretchen Morgenson was complicit in letting Spitzer reap political gain.  A couple of years I described slanted coverage by Morgenson of the Grasso pay issue. Interestingly, I noted that three years earlier Morgenson had criticized

the hypocrisy of the New York Stock Exchange directors giving Mr. Grasso his money and then booting him for taking it." After Spitzer decided not to charge the directors for "giving Mr. Grasso his money," Morgenson seems to be focusing on Spitzer's new theory -- that the money was too much and the board was misled. . .

Morgenson, in other words, chose to focus on Grasso's "greed" in taking the money.  This nicely fit both Morgenson's obsession with excessive executive compensation and Spitzer's position in the case. Now, a jaundiced observer might say that it doesn't hurt if you're a crusading columnist to have the attorney general and future governor in your corner -- information, access and all that.  (And if you were even less charitable, you might say that sorta resembles analysts currying favor with companies.) In any event, Morgenson helped give this case its political legs, which in turn got Spitzer to the governor's mansion.  The rest, as they say, is history.

Unlike some of Spitzer’s maneuvers, this one, partly due to Grasso’s determination, is actually getting a court hearing. As I wrote last year ago,

Grasso got an important victory when the lower NY appellate court held that the state attorney general has to prove not only that the pay was illegal but also that Grasso knew he was wrong to accept it.

At that point the case became a legal white elephant bequeathed to Spitzer’s successor. The Court of Appeals is hearing the appeal of that decision.

I'm waiting for Morgenson to continue her coverage of this case -- unless, of course, it's not as newsworthy anymore. Funny how the NYT determines newsworthiness.

Reflections on the Weiss sentence

So Mel Weiss got 30 months. Possibly he deserves this, and I’m not going to use this space to sing his praises. But I want to recap a couple of arguments Bruce Kobayashi and I have been making for awhile that put this in perspective.

First, whatever one thinks about class actions, it’s still a legitimate business, and Weiss and Lerach were among the best at it. As Bruce and I argue in Class Action Lawyers as Lawmakers, these lawyers make valuable contributions to the production of law, particularly through their complaints. We suggest ways the law might provide better incentives by protecting class action lawyers' investments in their complaints. The kickbacks can be understood as a form of (illegitimate) self-help. That doesn’t mean they should be excused, but it does point to this broader policy issue.

Second, the positive role of class action lawyers suggests that the kickbacks, though wrong, may not have harmed class members. Mike Perino disagrees. Watch for more on this in a forthcoming post.

Third, as Bruce and I discuss in The Hypocrisy of the Milberg Indictment, the kickbacks these lawyers were convicted for are functionally similar to the “payments” prosecutors make to witnesses all the time in the form of promises of leniency. Both types of payments compensate witnesses and plaintiffs for their time and trouble. The critical difference, of course, is that the prosecutors (hopefully) make full disclosure and get court approval. Weiss and Lerach couldn’t disclose because the payments they made are illegal. Bruce and I recommend changing the law from prohibition to disclosure. This would, among other things, enable the courts to better police these payments.

Weiss and Lerach may have gotten what they had coming, but we shouldn't let the celebrating obscure the deeper policy lessons.

The Democrats finally figure out how to settle the nomination

Next vote wins. 

All eyes are on a woman in Puerto Rico who seems to be closing in on the polling place. Camera crews have gathered.  Interviews with her family indicate she's leaning toward Clinton.  Clinton is at 85 in the Iowa "next vote" market. 

Alas, the whole thing may be moot because this report suggests that Obama supporters are loudly arguing for best two out of three.

I can't stand the suspense.  I'm going out for a walk. Wake me up when the Democrats finally get rid of the evil Republicans and figure out how to solve our more trivial problems, like the war in Iraq, health care, etc.

Additional note:  I see that The Onion is now a Washington Post "partner." That's great news. I don't know how else we're going to get through this.

Jurisdictional competition, regulatory arbitrage, and duck liver

As the civilized world knows by now, Chicago has finally abandoned its stupid ban on foie gras. Today I want to reflect on what lies behind that move.

In the first place, Chicago had to compete as an international city. The current Mayor Daley is arguably the first and certainly the best at that game in Chicago's history. Despite having gorged myself for a year on New York’s wonderful restaurants, I conclude that New York restaurants arguably are to Chicago restaurants what New York architecture is to Chicago architecture. There’s a lot of very high quality and interesting stuff in both categories in NY, but Chicago is closer to the cutting edge. That attracts the high end of the travel biz, and Daley knows this. He understood that these days the high end traveler can go to NY as easily as Capone went to Cicero.

Chicago's tourist boom won’t continue if Chicago’s going to go all provincial. Daley comes from the same background as his grain-fed colleagues on the city council, but he’s way more tuned to Chicago’s competitive challenges. So duck liver becomes another case study, to go with corporate law and same sex marriage, in my growing file of examples of jurisdictional competition driving the law.

Even before the ban's repeal, Chicago chefs played a little regulatory arbitrage, according to Raymond Sokolov’s article on "foie gras freedom" in today’s WSJ. One chef was “running a "duckeasy" on the model of Prohibition speakeasies. He gave foie gras away and “overcharged for the salad underneath.” Others just flouted the ban: “Hot Doug” Sohn “served a hot dog laced with foie gras and named after the edict's sponsor, Alderman Joe Moore.” He paid the fine and got tons of free publicity.

Now, for the animal rights crowd, you should know: I respect your right to love animals; comments on this blog are moderated; and we have many jurisdictions in which your views can be heard, and they all have jurisdictional limits.

Let me suggest Evanston.

The loophole legend

The supposed Pulitzer-Prize fodder over at the WSJ about the Bear Stearns collapse includes what is now being called the “loophole legend”:

The hurried deal had a loophole that could give angry Bear Stearns investors powerful leverage to seek a higher price: J.P. Morgan had pledged to finance Bear Stearns's trades for a year -- even if shareholders rejected the deal. Unfortunately for the drama of the story,

I discussed this legend-in-the-making at the time the transaction was unfolding.

But John Carney over at Dealbreaker points out yet again that this legend “probably isn’t true.” In fact, JP Morgan needed the durable guarantee to send a very strong signal that would stop the run on Bear. Indeed, the WSJ story supports this take, since it emphasizes that previous efforts to shore up confidence didn’t work.

(Carney also asks whether JP Morgan would have been willing to pay 750 million more over a mistake.  Actually, yes, given the difficulty of proving that the parties' actual intent deviated from the words of a very heavily lawyered document.)

Carney adds that no one has been willing to support the legend on the record, and it was not in Bear Stearns' proxy statement description of the transaction. As Carney says: “The omission of the loophole legend suggests that the executives at Bear Stearns and JP Morgan weren't as comfortable telling that particular tale in a forum where they could be held to account for their veracity.”

Carney is suggesting that Pulitzer-seeking journalists are not similarly “held to account” in repeating without qualification off-the-record speculation for purposes of dramatising a story even after significant doubts about the speculation had developed. But at least in this web-enabled world we do end up with something like the whole story.

The marriage law market hits NY

Last week I wrote about the California marriage decision as an example of the market for law in action. I pointed out that now that California had joined Massachusetts, "[t]his puts economic pressure on other states (e.g., NY), which among other things risk losing productive taxpayers to competitive states."

Now the other shoe has dropped – NY has responded to this pressure by deciding to recognize foreign same-sex marriages, thus becoming the only state that recognizes foreign but not domestic same sex marriages.

Obviously this isn’t the end of the process – both the California and NY decisions will be challenged politically and legally. People and firms will participate in this process not only by voting but also by deciding where to locate. Note that the NY decision was precipitated by an issue of health care benefits -- something that is of more than passing interest not only to the couples but to their employers.

As I pointed out last week, the law market is a messy process. But it’s also arguably a better way to generate a social consensus on same sex marriage than to have the federal government abruptly declare a winner through a statute, constitutional amendment or Supreme Court decision.

New on SSRN: Uncorporating the Large Firm

This is a significant revision of a paper I’ve been talking about for awhile – the role of partnership governance in managing large firms. The previous version was The Rise of the Uncorporation, posted last summer (that’s now the working title of a book I’m working on that will cover the whole uncorporation area). Here’s the new abstract:

This article examines private equity firms as an example of partnership-type, or uncorporate, structures in the governance of large firms. Other examples include publicly traded partnerships, real estate investment trusts, hedge funds and venture capital funds. These firms can be seen as an alternative to the corporate form in dealing with the central problem of aligning managers` and owners` interests. In the standard corporate form, shareholders monitor powerful managers by voting on directors and corporate transactions, suing for breach of fiduciary duty and selling control. These mechanisms deal with managerial agency costs by relying on other agents, including auditors, class action lawyers, judges, independent directors and shareholder intermediaries such as mutual and pension funds. Uncorporations substitute other devices for corporate-type monitoring, including more closely tying managers` economic well-being to the firm`s fortunes and greater assurance of distributions to owners. Continued concerns with managerial agency costs, the inadequacy of regulatory responses such as the Sarbanes-Oxley Act, changing costs and benefits of public ownership, leverage and capital lock-in all contribute to the rise of uncorporate structures in large firms. Political considerations may, however, constrain these developments.

Bottom line: partnerships and the like are not just for closely held firms anymore.

Alternative bottom line: maybe it’s finally time to stop calling that course “corporations.”

Airlines still not hedging oil

Four years ago I started wondering why airlines weren’t hedging oil.

I noted that “[w]ithout hedging, the airlines are actually speculating on the price of oil, since they know they're going to be buyers. Since they probably don't have inside information on where oil prices are headed, this would seem to be questionable.”

A year later I was still wondering, noting that Southwest had saved $155 million by capping 86% of its fuel expenses at the equivalent of just $26 a barrel of crude oil. At that time, oil was around $50/barrel. I guessed it might have to do with the fact that “much of the industry is operating in bankruptcy?”

But the industry is out of bankruptcy, oil prices are still soaring, and Southwest is still the only hedger. Today the WSJ’s George Anders wonders,

With oil near $130 a barrel, why does Southwest Airlines stand alone in the airline industry in its aggressive use of hedging to keep fuel costs under control? Southwest has locked in more than 70% of its jet-fuel requirements this year at a price equivalent to $51 a barrel for crude oil. By contrast, other big carriers have hedged 30% or less of their fuel needs this year. Those carriers generally expect to pay the equivalent of $85 to $100 per barrel of oil under their hedging programs.

Anders cites some explanations by David Carter, who has studied hedging by Southwest (case study) and the US airline industry. The industry study, from back in 2002, concludes that hedging jet fuel can be valuable, but that non-hedgers may not be acting act suboptimally. That would seem to be harder to stomach six years later. 

For today's column, Carter suggests that it's "psychologically hard to switch strategies when prices are moving against you" and that airlines are stymied by frequent management changes.  Southwest's treasurer Scott Topping claims they're able to move decisively because they have a small group making decisions.

I have some other explanations:

• Fear of fiduciary liability for hedging mistakes. And it cuts both ways -- the "psychological" problem Carter refers to may be a fear of making their previous decision not to hedge look bad.
• Managers are paid and judged by what the rest of the industry is doing, so they stay in lock-step.
• Creditors may be wary about financing hedging only to see executives misspending hedging profits while they hold the bag for losses. See Tufano, Agency Costs of Corporate Risk Management.
• Derivatives can be scary because they reduce transparency (e.g., Enron).
• SOX could be rearing its ugly head. Hedging might entail extensive disclosures, and potentially huge individual liability for certifying financials that omit something. As I’ve argued often, SOX penalizes risk-taking. Of course it's also risky not to hedge in this environment, but at least managers won't go to jail or face personal liability for failing to hedge, particularly if they can point to competing executives doing the same thing.

Fear and group-think don’t make for lovely business strategy, but these seem to be the elements of our current business environment.

There may be a solution.  In my Rise of the Uncorporation (new version out shortly) I suggest that the tighter discipline of what I call “uncorporations” – firms that operate under partnership-type incentives and discipline – may help solve agency problems, including problems associated with using derivatives. These controls may make it easier for creditors and others to trust managers' decisions regarding derivatives.

Anders concludes his WSJ article by noting that "[hedging] has been a big enough boon [for Southwest] that other airlines should ask why they missed out." And we should ask what kind of institutional perversity might be causing this failure.

Discussing universal health care at shareholder meetings

Per the NYT, the SEC has decided that companies must allow shareholders to vote on a proposal for universal health insurance coverage – yet another shift in position on the types of shareholder proposals firms must allow.

This sort of proposal was allowed in NYCERS v. Dole Food Co., Inc. 795 F. Supp. 95 (SDNY), dismissed as moot, 969 F.2d 1430 (2d. Cir. 1992). The issue makes for a great law school hypothetical on the shareholder proposal rule. Health care is, of course, quite significant for most firms, so it’s arguably not just a matter of general social policy, one of the exclusions under the shareholder proposal rule. That would also take it out of “ordinary business.” Of course universal health care is beyond a company’s power to effectuate, but each company can take a lobbying position on this issue. But a company’s lobbying position would seem to get back to ordinary business. . . .

A better approach would seem to be common sense. Look, folks, this is no more a part of a shareholders’ meeting than the Iraq war, right? But the whole business of shareholder proposals doesn’t really lend itself to common sense.

Perhaps an even better approach is to eliminate the issue of whether a corporation needs to subsidize shareholder proposals by making them dirt cheap – e.g., through an internet chatroom type arrangement. The SEC is moving in this direction, but there are many logistical issues.

The best approach of all, which I’ve advocated all along, is simply to get the SEC out of the business of reviewing shareholder proposals. What gets discussed at a shareholder meeting should be a matter of state law and, if enabled by state law, the company’s charter. The domain of the securities laws stops at accurately disclosing the company’s rules.

Sure, this would mean that companies would have a selfish incentive not to allow discussion of socially important matters. But they are, after all, private companies, aren’t they?

Update: Bainbridge suggests that "[c]ourts should ask whether a reasonable shareholder of this issuer would regard the proposal as having material economic importance for the value of his shares.." Otherwise, he says, forcing the corporation to discuss this is

a species of private eminent domain by which the federal government allows a small minority to appropriate someone else’s property—the company is a legal person, after all, and it is the company’s proxy statement at issue—for use as a soap-box to disseminate their views.

I'm sympathetic with the conclusion, but if we're going to get all constitutional about it, I think the appropriate analysis is forced speech under the First/14th amendment, and I'm not sure reifying the corporation is the right approach. See my Corporate Governance Speech and the First Amendment, 43 U. Kans. L. Rev. 163 (1994) (with Butler), a chapter in our Constitution and the Corporation.

As for Steve's proposed rule, I wish it were that simple. Though I side with Steve, opponents would argue over what a "reasonable shareholder" would want. Since people are going to disagree, it's important to get the institutional framework right. As I've said, it's a state law issue.

Dealbreaker wisely comments:

The capture of so many arms of our government--party machinery, congressional committees, regulatory agencies--by lobbyists for special interests is well-known, and is viewed by many as a serious threat to democratic legitimacy. Probably the beset that can be said is that competition between special interests often act as a kind of check-and-balance mechanism. These shareholder proposals about universal health are also likely to be captured by special interests, especially labor unions acting through labor dominated pension funds. Handing control of corporate lobbying efforts over to these interests could remove the check-and-balance aspect of corporate lobbying.

John Cusack goes to War

John Cusack, who’s made some great movies, including the memorably funny Grosse Point Blank in which he played a hit man, plays another hit man in War, Inc. The big difference is that this time he has bigger ambitions than just being funny (HT Bainbridge):

“There’s a great tradition of films and filmmakers taking on aristocracies,” Cusack said. “There used to be kings and queens and presidents, and now there are CEOs and shareholders and board members.”

Rather than merely making art, Cusack “wants to start a conversation.”

To some extent, this is another in a very long line of films, chronicled in my Wall Street and Vine in which I said (as summarized last week):

film artists . . . are not so much anti-business as anti-capitalist. They have that attitude because they believe the capitalists constrain creative expression – particularly in film, in which expression takes wads of money. In other words, anti-capitalism in film is a product of artists' resentment.

But Cusack's film seems to be less than that, because it's not a conventional commercial film but rather a vanity film.  As the WSJ’s reliable Joe Morgenstern summarizes:

The setting is Turaqistan, a fictional stand-in for Iraq where the troops and military might of a vast corporation called Tamerlane -- read Halliburton -- are engaged, Hauser tells us, in "the first war ever to be 100-per-cent outsourced to private enterprise." While it might be a worthy subject for the Stanley Kubrick of "Dr. Strangelove," privatized war is too important to be left to the amateur absurdists at work here. . . . .Surrounded by sententiousness and self-preening, Marisa Tomei manages to play a skeptical journalist with easy charm, but her efforts are doomed by the movie's ceaseless barrage of dumb bombs.

Every artist seeks to connect with his or her audience (why else engage in expression rather than pure thought?). At its deepest level art brings out something that the viewer or listener didn’t know was there. At its shallowest level – the vanity level at which War, Inc. seems to have been created – the artist is playing to the audience’s attitude. The artist is hoping the audience will respond as to a warm bath, comforted by the fact that a famous filmmaker shares their views. Yes, this will “start a conversation,” because the legitimized and emboldened audience will shout at the similarly inclined: "see, I told you! War is all about capitalism!"

At least the anti-capitalist resentment of the typical screen artist has to please an audience. Here we seem to have the self-indulgent drivel of a former comedian who wants to make a point.

By the way, while the film tries to channel Dr. Strangelove, it might have done better to try to also be funny. That film (which admittedly doesn’t wear very well) at least kept war and capitalism almost separate. (You know, capitalists actually don’t like war – it gets in the way of business).

I say almost, because Dr. Strangelove did have something to say about capitalism:

Group Capt. Lionel Mandrake: Colonel... that Coca-Cola machine. I want you to shoot the lock off it. There may be some change in there.

Colonel "Bat" Guano: That's private property.

Group Capt. Lionel Mandrake: Colonel! Can you possibly imagine what is going to happen to you, your frame, outlook, way of life, and everything, when they learn that you have obstructed a telephone call to the President of the United States? Can you imagine? Shoot it off! Shoot! With a gun! That's what the bullets are for, you twit!

Colonel "Bat" Guano: Okay. I'm gonna get your money for ya. But if you don't get the President of the United States on that phone, you know what's gonna happen to you?

Group Capt. Lionel Mandrake: What?

Colonel "Bat" Guano: You're gonna have to answer to the Coca-Cola company.

Guano couldn't drop his petty obsession with capitalism even in the face of nuclear war. Apparently Cusack didn't get the joke.

Pileggi on uncorporations on the Harvard corporate blog

Francis Pileggi has added LLCs to the Harvard corporate blog's portfolio in a helpful post.  As he says:

The Delaware Chancery Court recently issued its opinion in Fisk Ventures, LLC v. Segal, which I predict will be cited often by scholars and practitioners alike as part of the ongoing discussion about the difference between applying fiduciary duty concepts to LLCs–or not–as compared with the conventional application of those duties in the corporate context.

I agree, in my own post on the case, in which I conclude that "Chancellor Chandler [has] made it clear that the contract controls uncorporations in Delaware."

I plan to add my own uncorporate post to the Harvard blog in the coming weeks. At some point maybe they'll have to change their name!

Hot off the press: Butler and Ribstein on insurance

Insurance is currently regulated by the states, and they've made a mess of it.  The federal government is closing in.  Henry Butler & I have an answer -- model insurance regulation on corporate governance.  The paper is A Single-License Approach to Regulating Insurance. Here's the abstract:

State regulation of insurance companies has been criticized for many years because of the burden imposed on insurers by having to comply with the laws of many jurisdictions. These higher costs are passed on to consumers. The problems with the current regulatory structure are prompting calls for increased federal regulation of insurance. However, all proposals to federalize insurance regulation create opportunities for abuse at the hands of the federal government and fail to utilize the benefits of a federal system. This article shows how many of the problems of the current system can be addressed without resorting to a large scale intrusion of federal regulators into insurance markets. The proposed solution calls for minimal federal intervention to provide for jurisdictional competition between states that would be allowed to charter insurers that could operate nationally with only the single license granted by the charter. This single-license approach addresses the most salient concerns of proponents of federal optional chartering. It also has the potential for triggering competition and innovation in insurance products and rates while preserving a meaningful role for state regulation.

And, yes, our proposal includes safeguards to deal with concerns about a potential "race to the bottom" in consumer protections and solvency regulation.   

Springer on corporate crime

Jerry Springer addressing Northwestern Law graduates:

Springer . . . . warned students they would face ethical dilemmas throughout their lives. "Think of the ethical questions you will have to deal with," he said. "Will you work with a corporate client who perhaps is polluting? Will you walk into a senior partner's office after having been asked to prepare a memorandum in support of this client's case and say, 'I'm sorry, sir or madam, I have to find another place to work?'"

I doubt he asked students whether they would consider representing individuals accused of crimes. Of course I'm talking about politically correct criminals such as rapists, murderers, as distinguished from really bad types like Lay and Skilling.

The efficiency of NY contract law and the puzzle of jurisdictional competition

Geoff Miller has posted Bargaining on the Red-Eye: New Light on Contract Theory. Here's the abstract:

Recent research has shown that large companies select New York law and New York courts to govern disputes under commercial contracts. Because these parties make choice-of-law and forum selection decisions before conflicts arise, there is reason to believe that their preference for New York reflects an effort to select efficient terms. This paper compares New York's contract law with that of its most natural competitor, California. It turns out that New York strictly enforces bargains and displays little tolerance for efforts to rewrite deals ex post. California, in contrast, is more willing to reform contracts for reasons of fairness, equity, morality or public policy. The revealed preferences of sophisticated parties support arguments by Schwartz, Scott and others that formalistic rules offer superior value for the interpretation and enforcement of commercial contracts.

This is obviously in the vein of using firms' choice of Delaware law to prove Delaware's superiority. And it's in sync with a lot of my work on the efficiency implications of choice of law, e.g., most recently in Corporations and the Market for Law and the forthcoming book, The Law Market, both with Erin O'Hara.

But I wonder about whether choice of law fully supports Miller's specific conclusions about the efficiency of NY's approach to contract law. Many more people choose to buy Hondas than Maybachs. Of course this doesn't mean that the former is more efficient than the latter. If you're worried about apples and oranges, does it at least mean that BMWs are more efficient than Maybachs because more people choose the former? In other words, there may be many different markets for contracts.

By analogy, in corporate law, there are really two markets – Delaware against everybody else, with Delaware a clear winner, and Delaware against each home state, with many firms choosing to stay at home. The same might be said for unincorporated firms, and across a wide variety of contexts in the market for law.

As summarized in my article with O'Hara linked above, there are several theories why firms choose particular incorporating states.  One possible theory is that there is an efficient market for corporate law.  Under this theory, Delaware corporation law is better for the firms that choose it, at least at the price Delaware chooses to charge. Same for Hondas and Maybachs.

Does this explain New York and California contract law? It doesn't cost anymore to insert "New York" than it does to insert "California" in the contract. However, a court may be more likely to enforce the NY clause for truly national or international contracts with NY contacts than for intra-California contracts. So California (or more accurately its lawyers, who tend to gain from indeterminacy) captures the less mobile contracts despite its inefficiency. However, under the standard rule for choice of law clauses, Restatement (Second) of Conflicts, Section 187, this is less likely to be the case for purely interpretation rules (like many Miller discusses) than for public policy rules relating to enforceability. So perhaps California, like Maybach, is just competing for a different market – that is, there's something inherently different about stay-at-home contracts.

Obviously I've just scratched the surface of these interesting but little-discussed issues covered in Miller's article and my recent work with O'Hara.