Ideoblog

Election oddities: The Obama same sex marriage effect, and Senator Palin

I don't normally do pure politics on this blog, but I can't resist noting a couple of odd fallouts from Tuesday's election.

I pointed out yesterday that “it's likely many people voted for Obama and against same sex marriage.” Indeed, today’s WSJ notes: "Clearly many of the voters who came out for Mr. Obama also voted for the gay marriage ban. The marriage amendments outperformed John McCain by 14 points in Florida and 15 in California.”

Add that to Nelson Lund’s comment noting Andrew Sullivan’s post that “African-Americans. . . voted overwhelmingly against extending to gay people the civil rights once denied them: a staggering 69 - 31 percent African-American margin against marriage equality.”

Of course the vast majority of the African-Americans at the polls Tuesday were there to vote for Obama. Moreover, many were brought there by Obama’s prodigious get-out-the-vote effort. 

So was the defeat of same sex marriage an inadvertent Obama effect?  In any event the vote shows that "change " may be more complex than we thought.

The other oddity is that if Stevens wins his election in Alaska but resigns or is expelled because of his conviction, the governor of Alaska appoints his successor, who then has to run 90 days later in a special election.  See the comments to today's WSJ Law Blog. Certainly likely that Alaska's governor would appoint the state's most prominent Republican -- herself.  This would give Palin a DC platform for a possible presidential run in 2012. 

The super-SEC

The WSJ writes today of a key item on Barney Frank's wish list -- a "systemic risk regulator," which Frank likens in scope and importance to the creation of the SEC.

I understand that right now nobody wants to hear stuff about markets correcting themselves, or about the costs of broad new financial regulation like SOX.

So I'll just focus on some other points that somebody might care about:  it won't work, and it might make things worse.

For starters, we already have the SEC.  Admittedly the SEC didn't regulate many of the new financial products that caused some troubles (that was another Congressional decision, eight years ago).  But some of those products were designed to skirt existing regulation.  Does anybody think that Congress will be able to outwit the collective genius of the financial markets?  Worse, this regulatory arbitrage might bring new and unpredictable risks.

Perhaps the law will be designed well and tightly enough that it manages to block most of the risks we know about now.  The problem is that the broader and tighter the law is, the more it might inhibit beneficial financial innovation.

More generally, the biggest problem we have seen in the recent meltdown is not with the instruments themselves, but how they were used.  At the heart of the now collapsing inverted pyramid of financial products was the notion that real estate prices would keep rising.  When they started south, default rates rose and mortgage-backed securities fell.  This is what started the collapse of securities values and the liquidity crunch that accompanied it. Remember that business people made the decisions to bet their companies on the dubious proposition of ever-rising real estate.  And that there was apparently nobody around to check these awful decisions.

This was a failure of governance.  How do we solve that?  Well, we supposedly already had the solution:  SOX.  Sarbanes-Oxley was to expose material weaknesses such as portfolios built on toxic securities.  Indeed, to some extent it did -- PW found in 2007 the material weakness in AIG's credit default swaps.  But clearly SOX did very little to stop the very sort of excessive risk that it had been passed only six years ago to deal with.

I have suggested, e.g., here, that the alternative governance models underlying private equity and hedge funds may be a way to deal with these governance problems. Yet I would not be surprised if misguided regulators see these firms as the problem rather than part of the solution. 

The worst case scenario is that we'll end up with more of the "good corporate governance" practices that did nothing to stop this crisis, yet with less of the market corrective provided by uncorporations.  Setting us up for the panic of 2015, or earlier. 

Voters reject same sex marriage. . .

. . . in California, Arizona and Florida. This despite the huge Obama victory, including in two of those states. As predicted here, this should lead in the near term to a federal move, particularly in the new Congress.  We might also see this issue get attention in the Supreme Court, and at hearings on nominees. But any such moves will have to account for the fact that voters turned out to oppose same sex marriage in the face of economic pressures to accept it and a general liberal onslaught at the polls. Among other things, Congressional action might expose a fissure in the Obama coalition:  it's likely many people voted for Obama and against same sex marriage.

Hedge funds: there's no success like failure

Dealbook, linking Financial Times, presents the latest gloom in the hedge fund world:  The “2 and 20″ fee structure may turn into 1 and 20; 80 percent of small hedge funds and 40% of mid-sized funds may fold.

Does this mean that the financial crisis has revealed some Achilles heel of hedge funds and private equity? 

I think the opposite:  the crisis is causing funds to modify their incentive structure, and quietly and swiftly driving the weaker funds out of business.  Hedge funds change or die because their investors are fickle and not stuck for the long term.  Meanwhile, corporations have "permanent" capital and depend on creaky and often inefficient governance structures to stay in shape.  Eventually the market has the last word, as Lehman and Bear can attest. 

Post-Obama law and economics

President Obama potentially can use his political skills, charisma, mandate and the large Democratic legislative majorities, to fulfill a long wish list. Clearly things are going to be different now. But how different?

Consider the constraints Obama and his party face: a plummeting economy, ongoing war and huge bailout debts sharply limit economic flexibility. Interest groups obviously haven’t gone away, particularly business, which has a lot at stake. And, most important, robust international competition limits the extent to which the US can protect American workers, investors and industry at the expense of the rest of the world.

As Hahn & Passell point out in a recent paper published pre-election:

In many ways, both candidates are defining themselves by how they would use regulation to cope with the great issues of the era – think energy security, climate change, housing finance, health care. Yet, the limits imposed by global integration, interest-group jockeying, budgetary constraints and even common sense suggest that, once in office, the policies of the two candidates would not be very different.

Those constraints alone can’t stop a president in Obama’s position. We’re likely to see strong moves toward regulating financial markets and health care, among other things. But in order to overcome the constraints, the president has to know exactly what he wants and be willing to target his power to get it done. Johnson pounded heads to get his civil rights legislation. What, exactly, does Obama want? Change?

The last election has revealed clearly the costs of economic cluelessness. McCain’s floundering in the face of financial panic likely turned the election definitively against him. It was enough then for candidate Obama to look cool and collected. It won’t be enough for President Obama.

Business could still provide a strong headwind against a regulatory revolution. But not if it remains divided. The Business Roundtable often supports federal regulation, even the likes of SOX, to hold off public criticism and, not so incidentally, beat down potential competitors. Big business thinks it can control the feds, but that’s less clear than ever with powerful forces lined up in favor of a bigger federal role. The Chamber of Commerce may not be able to hold off these moves toward regulation without something affirmative to offer politicians eager for “change.”

The point is that this both politicians and business have to figure out what regulation is really important and necessary. There is still, therefore, a role for well-reasoned moderation that uses the tools of economic analysis.

I think at least one fork of that path leads toward state regulation – not the kind of regulation states force on any firm selling locally, but regulation that firms can choose and avoid. Fears of a “race to the bottom” can be met by a well-fashioned, precisely targeted, federal backstop. That’s the message of my and O’Hara’s The Law Market, which is hitting the shelves just in time for the federal onslaught of the Obama administration.  Apart from the book's specific recommendation, its discussion of the economics of jurisdictional competition should be must reading for would-be regulators of a global economy.

Anyway, there is now a generational opportunity for meaningful (if not necessarily wise) regulation that business and others will have to meet with coherent arguments.   This could be a bull market for law and economics.

Don't vote

Here’s the basic instruction (stop after 1:22).

Dubner & Levitt giving the sober economics (of course it’s about social norms).

Gordon Tullock, in the inimitable style I recognize from being officed down the hall from him back at GMU (HT Café Hayek):

People are under delusions as to the importance of their vote. . . You’re more likely to be killed on the way to the polling booth than that you will change the outcome. . . . I don’t vote because I know there’s no likelihood my vote will affect the outcome. . . . If nobody else votes, I vote.

And last but certainly not least, George Carlin (surprise note: not family viewing):

On Election Day, I stay home. I firmly believe that if you vote, you have no right to complain. . . . . . . If you vote, and you elect dishonest, incompetent politicians, and they get into office and screw everything up, you are responsible for what they have done. You voted them in. You caused the problem. You have no right to complain. I, on the other hand, who did not vote -- who did not even leave the house on Election Day -- am in no way responsible for what these politicians have done and have every right to complain about the mess that you created.

What to watch on election night

Miss the election returns. Eschew the attempts to build drama, the endless talking heads, the false quest for meaning. 

Instead, watch The Candidate, the greatest political film. (You can insta-play it on Netflix.) 

Don't miss the end: "what do we do now?" Good question.

Do incentives matter?

From today's WSJ:

Even as Japan faces a sharp recession, civil servants are opting out of career-advancing exams and information-technology workers are flocking to headhunters to switch to less-demanding careers. A study this year by the consulting firm Towers Perrin found just 3% of Japanese workers say they're putting their full effort into their jobs -- the lowest of 18 countries surveyed. * * * Employment experts have begun to call these workers hodo-hodo zoku, or the "so-so folks." They say these workers, mostly in their 20s and early 30s, are sapping Japan's international competitiveness at a time when the aging country must raise its productivity to keep the economy growing.

The article doesn't offer much of an explanation for the phenomenon, except this:

getting a promotion no longer means getting such a big pay raise. The wage difference between managerial and rank-and-file positions has shrunk over the past decade as companies cut compensation amid restructuring. In 2005, division managers were paid about 2.2 times the rank-and-file worker, down from about 2.7 times in 1985.

Louis Terkel, Esq.

AKA Studs, died at 96, class of 1934, University of Chicago Law School.  By his account, he studied mainly phonograph records, then flunked the bar.  Perhaps not so unusual.  I suppose in these times it's nice to know that practicing law is not your only option with a law degree.

Oral LLC operating agreements

The Delaware chancery court has held that an oral LLC operating agreement is not enforceable under Delaware’s statute of frauds because it had a multi-year earnout provision that made the agreement non-performable in a year. The court therefore granted summary judgment as to a breach of contract claim based on the LLC operating agreement.

Here’s a note by Francis Pileggi, and a longer analysis by Peter Mahler. Mahler contrasts the NY rule requiring all LLC operating agreements to be in writing but not specifying the consequences of no writing. He notes that NY courts apply the statutory defaults rather than refusing any enforcement.

Here’s the relevant language of VC Lamb’s Delaware opinion (footnote omitted):

This court holds that if an LLC agreement contains a provision or multiple provisions which cannot possibly be performed within one year, such provision or provisions are unenforceable. The basis for this decision is in line with the policy for the enactment of the statute of frauds -- to protect defendants against unfounded or fraudulent claims that would require performance over an extended period of time. However, in keeping with the legislature's expressed intent "to give maximum effect . . . to the enforceability of limited liability companies," provisions of an oral LLC operating agreement that could possibly be performed within one year will not fall within the statute of frauds and will remain enforceable.

This is a seemingly technical but actually huge issue, and therefore a significant opinion. There is the general statute of frauds policy issue of whether to insist on formalities and hopefully reduce open-ended and costly disputes, or to avoid frustrating parties’ legitimate expectations. And there is also the question of whether LLC statutes should be designed to accommodate "default" informal entities or whether they should leave that task to the general partnership statutes.

Note that the Revised Uniform Limited Liability Company Act goes the opposite direction from a statute of frauds. Here’s my analysis of the relevant provision, from my article on RULLCA (footnotes omitted):

RULLCA section 102(13) very broadly defines the operating agreement as the “agreement, whether or not referred to as an operating agreement and whether oral, in a record, implied, or in any combination thereof, of all the members of a limited liability company.” This includes not only oral express contracts, but “any activity involving unanimous consent of the members,” and “a number of separate documents (or records), however denominated.” This may create significant uncertainty and invite litigation as to the terms of the operating agreement. The benefits of certainty must be balanced against the potential costs of frustrating the parties’ intent by refusing to enforce oral agreements, particularly in informal firms.

A specific effect of RULLCA’s open-ended approach to the operating agreement is that a person who joins an existing LLC may not easily be able to determine what she is agreeing to.RULLCA section 111(b) provides that “[a] person that becomes a member of a limited liability company is deemed to assent to the operating agreement.” The comment to this subsection notes that “a person becoming a member of an existing limited liability company should take precautions to ascertain fully the contents of the operating agreement.” This obviously presents problems where oral and implied-in-fact terms, and even the parties’ unanimous consent to a particular act, can be part of the operating agreement.

There’s no single answer to this debate. Perhaps the best solution is to offer parties to LLCs a choice of statutes providing a range of approaches. Or a statute could offer the parties the option of entering into a written agreement that requires all amendments to be in writing. Unfortunately, as discussed in my article, RULLCA does not clarify the enforceability of these agreements.

I discuss applying the statute of frauds in general partnerships in Bromberg & Ribstein, Section 2.13(c), and written vs. oral LLC operating agreements in Ribstein & Keatinge, Section 4.16.

Marriage, Prop 8 and the Law Market

A competition for same sex marriage law is rapidly emerging from what seemed like the graveyard created by the federal Defense of Marriage Act and the “little” state DOMAs adopted in the vast majority of states. Here's a summary of where things stood as of last August, and an update a couple of weeks ago when Connecticut joined California, Massachusetts and the big northern state of Canada in the legalization camp. Next week the competition pendulum might swing the other way with Proposition 8 in California.

Today’s WSJ discusses the situation of same sex couples under the current patchwork of state law. It seems the couples are legally maneuvering across the states to shore up their legality. They’re rushing to marry in California to get grandfathered in in case Prop 8 passes, and adding US marriage to their domestic partnerships, civil unions and Canadian marriages to get legal in states that recognize one or more but not all varieties. Advisers are telling couples “to have a belt and suspenders, and then another pair of belt and suspenders."

The jurisdictional competition dynamic is discussed in a chapter of my forthcoming book with Erin O’Hara, The Law Market. We discuss the commonalities among markets for various types of law, including marriage law. Those favoring a particular legal regime can further their interests not just by lobbying a particular legislature, but also by “shopping” for law in other jurisdictions, including by getting married in the relevant state. These other jurisdictions have an incentive to supply law to attract residents, ceremonies, legal work. Even non-supplier jurisdictions have an incentive to enforce the foreign law because the “shoppers” (including affluent and productive same sex couples) can avoid non-recognizing states. We’ve seen this competition play out, among other areas, in corporations and commercial contracts, and it is happening in Europe as well as the US.

The problem with the state competition is that chaos may reign until states widely enforce the parties' choice of law.  Returning to the marriage context, the interstate maneuvers described above are likely to increase the confusion that already exists.  If a couple adds a marriage to a civil union or domestic partnership do they lose their prior status? Which relationship’s rules apply in states that recognize both? What's the out of state validity of a "grandfathered" post-Prop 8 California marriage? During this unstable period, advocates and opponents of deregulation may take their case to the federal government.

Given the rising recognition of same sex marriage, the growing number of same sex couples clamboring for recognition, the increasing confusion, and the coming Democratic domination of Congress, I would expect significant pressure for federal authorization of same sex marriage. The passage of Proposition 8 may both increase pressure for a federal law and signal the opposition that such a law will face, and of course vice versa.

As noted above, same sex marriage is only one of the stages on which the jurisdictional competition drama will be playing out. The states' role in regulating international businesses in a world economy is also at stake. Read all about it in The Law Market.

Enron prosecutions: still wrong after all these years

I’ve been saying for a long time (see, e.g., my Corporate Crime and Enron archives) that the wave of corporate crime prosecutions following Enron, and particularly the Enron prosecution itself, were unfair, ineffective and counterproductive. The criminal law is wholly inappropriate for disciplining managerial agency costs, including disclosure violations. We’re likely to end up with some very close cases, pursued at enormous direct costs, and the even larger indirect cost of precluding a constructive effort to figure out what happened.

Dennis Berman makes these points in today’s WSJ:

Those looking for retribution against the executives of failed companies will quickly see that prosecutions won't come easy. The law gives executives wide latitude to run their business, no matter how terrible their decisions. And even convictions would seem an incomplete conclusion given that a system -- political and regulatory -- also failed the public.

Berman reviews potential criminal cases involving Lehman. As he quotes me in the article:

These are necessarily going to be very close cases," said University of Illinois law professor Larry Ribstein, a critic of some Enron prosecutions. Should Mr. Fuld "err on the side of panic, or state the risk pessimistically, he's got a full-scale bank run. If he gets optimistic, it's bordering on fraud."

Berman concludes:

It has been just 2,282 days since Sarbanes-Oxley was signed into law. Today, "we need to figure out root causes and get at them," Mr. Ribstein said. "We could go through all this and have no assurance the same thing won't happen again."

The question now: have we learned anything from Enron?

Was Greenspan wrong?

Alan Greenspan, according to the NYT, conceded his error on regulation. The NYT reporter claims that Greenspan has concluded he was mistaken in thinking that "free markets could regulate themselves without government oversight." So he should have advocated regulation of derivatives.

Actually, as Russell Roberts points out, what Greenspan actually said was

I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms.

Roberts explains that Greenspan was wrong in thinking banks wouldn’t take the risks they did.

So perhaps, this whole incentive thing that is at the root of capitalism, the profit and loss system that incentivizes firms is overrated.

Well, Greenspan’s not the first one to say that. Here's what another free market guy, Adam Smith, had to say:

The directors of . . . companies ... being the managers rather of other people's money rather than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which [they would] watch over their own. . . .Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company.

Smith was skeptical big firms would succeed. Of course he was wrong, because markets did find a way to deal with the “other people’s money” problem.

I suppose one could argue (and many have) that current events prove corporations need government to solve their incentive problem.  But while markets make mistakes, they also learn from their mistakes.  I've suggested that the solution to this bank governance problem may be for investment firms to jettison the corporate governance model in favor of partnerships, or what I call "uncorporations." Firms will find their way to this structure if it produces value for investors.

The alternative is to turn over control to the same people who thought until recently that Fannie and Freddie and easy mortgages were the way to go. 

The idea that incentives can get out of whack was not exactly invented by Alan Greenspan or Henry Waxman in Congress today.  The question has always been whether the market or government is better able to figure out incentives. 

So Greenspan had an Adam Smith Moment in Congress today. I think, even in light of current events, that he was right the first time.

Post-crisis federalism and insurance

David Zaring says

I'd guess that the crisis makes it more likely that there will be federal chartering of insurers, though I doubt Larry Ribstein will be pleased about it.

No, I wouldn’t, for the reasons Henry Butler and I give in our A Single-License Approach to Regulating Insurance.

Of course people are more worried than ever about financial safety, and are skeptical the states can provide it. But they may be thinking about the current “federalism” in which insurers operate in a chaotic environment of multiple regulators and states provide the only regulatory option. Butler and I argue for true insurance regulation competition via a choice of regulators, with the federal government playing a backstop role.

It seems to me that the current crisis strengthens rather than weakens our argument. After all, has federal regulation of banking has brought us such wonderful results? 

The Caymans, jurisdictional competition and the banking crisis

A report on Cayman Island banks suggests that the Caymans have not yet been hit by the financial crisis. Tyler Cowen, linking this report, says:

I've googled around and can't seem to find any reports worse than that one. It's fair enough to argue those banks are doing OK because bailouts from abroad have limited systematic risk in the world as a whole. But still Cayman Island banks don't seem to have gotten into trouble on their own, at least not so far. * * *

Cayman banking is not laissez-faire as is sometimes believed, but still it is relatively unregulated and measured in terms of liabilities it is the world's fifth largest banking center. And it's doing OK. . . .

Panama, by the way, also does not seem to be having major banking problems. The country has no central bank or lender of last resort, yet the banking system is highly liquid.

Cowen says this suggests deregulation may not be the cause of the crisis.

One might go further and suggest that “offshore” centers like the Caymans have kept the crisis from being even worse. As my colleague Andy Morriss argues in his recent The Role of Offshore Financial Centers in Regulatory Competition:

Offshore financial centers like the Cayman Islands and the Isle of Man exert an important discipline on democratically-constrained onshore jurisdictions by allowing firms and individuals to route around rent-seeking legislation and by innovating in the creation of legal rules to lower transactions costs. . . . .Fully understanding how offshore finance centers affect the global competition among states for economic activity is crucial for addressing current policy debates over measures like the European Union's Savings Directive and the proposed U.S. Stop Tax Haven Abuse Act.

This is yet another respect in which the urge to regulate in response to the crisis – in this case by shutting down offshore competition – may make things even worse.

Scheduling airplanes

You think you’ve got problems? Consider this WSJ story about how Southwest schedules 500 planes servicing 60 cities with 3400 daily departures. Of course you want the planes to run at high-traffic times. But there are a few other things you need to consider:

• Getting pilots, flight attendants, gates, baggage handlers and fuel trucks to the planes at the right time
• Ensuring the planes are at the right place for overnight maintenance
• Avoiding congestion at runways and TSA checkpoints.
• Allowing for seasonal wind differences, congestion and weather delays
• Making sure that at LAX you don’t depart within 20 minutes of an “Air New Zealand Boeing 747 that blocks an alley between two terminals when it pushes back” (Yikes)
• Competitors’ schedules
• Myriad consumer preferences: e.g., don’t arrive in Orlando too late for families.

Of course you can use computers, right? But the consultants and software were designed for hub-and-spokes systems, so “[n]one of the 20 companies Southwest talked to could produce a scheduling system to do the whole job." As a result,

until fairly recently Southwest's schedule planners penciled out routes for each aircraft for a seven-day week, with Monday-Friday usually identical, and some changes on the weekend. Schedules were hand-written on sheets of paper that were taped together in scrolls reaching as long as 30 feet.

Standardized schedules created both inconveniences and opportunities for customers, and lost profits for airlines, as the firms had to get customers to fly when the planes were there and ready to go.

But then a Southwest employee on his home computer figured out a scheduling formula that could optimize Southwest’s schedule. Now Southwest can do the same service with fewer planes. Soon airlines may have different schedules for every day of the week.

Somehow this makes me more optimistic about the economy.

Pondering the mortgage deduction

Why is Canada not crashing like the US?  Here's WaPo (HT MR):

Another difference is that in Canada, mortgage interest is not tax-deductible, making it harder to buy a house. As a result, Canada did not have as strong a construction surge as the United States did during the boom years, and thus does not now have a big oversupply.

I've always questioned the mortgage deduction.  Maybe now I'll get some company.

Calling for Mitt

During this financial crisis, it's been weird to watch the presidential candidates be almost a sideshow to the dominant crisis of the day on election eve, as all eyes turn to Bernanke and Paulson. And so I wonder (and I'm not alone), what if McCain had picked as his running mate somebody who actually knew something about business – i.e., Mitt Romney? In any event, hopefully this election teaches a lesson about the importance of real business expertise these days.

Who will defend markets?

Henry Manne comments in Forbes, "A Voice From The Friedmanite Wilderness."

The political direction of the country is now determined for a long time to come, and it is inevitably leftward. Politicians would never resist a popular but massive demand for more government regulation . . . The business community has never been a strong supporter of free market capitalism, and it certainly cannot be counted on to change its stance this time around. The media, the various leftist trend-setting elites and university faculties have been waiting a long time for an opportunity just like this, and we can be sure that they won't squander it. The shrillness of their attacks on free markets will reach new heights of righteous indignation and assumed moral and intellectual superiority.

But still, Henry sees "a glimmer of hope": 

This time around, unlike during the New Deal, there is a substantial intellectual establishment to ride herd on leftist proclivities. There are numerous free market blog sites, which, for instance, can be properly credited with forcing modification of the recent short-sale ban. There are countless free market think tanks in Washington and all around the country exerting considerable influence on government policies. Libertarians are a small but growing political factor, and there are even a few university economics departments and law schools where sanity prevails or is at least occasionally evident. Like it or not, these few intellectual bastions of freedom philosophy will be about the only thing that keeps these ideals alive in the coming years.

And, as I've discussed, Henry Manne himself can claim some of the credit for these "intellectual bastions."

The bailout: Hayek's revenge

Markets are bigger and more complex than any one set of regulators can comprehend, even Henry Paulson, as this WSJ story makes clear:

• Fannie/Freddie bonds are selling off because the bank guarantee is better, which of course undercuts the Fannie/Freddie rescue.
• The bailout increases government debt, also increasing interest rates, which makes mortgages harder to get, which was the problem that drove all this.
• Government backing for short-term debt pulled money away from corporations and European banks. . . .
• So the government had to loan directly to corporations and overseas banks with US branches. . .
• Which further increases government debt, further raising interest (including mortgage) rates, leading again back to square one.
• And increased bank deposit insurance may lure funds there, away from money market funds, which will then buy less short term debt, undercutting government relief of that market.

All this is well summarized by one person quoted in the article:

"You have unintended consequences that spark government actions, that create other unintended consequences," said David Kotok, chairman at money managers Cumberland Advisors.