Ideoblog

Shareholder power vs. mandatory securities laws

About a month ago I suggested making SOX optional.  Now Henry Butler and I have an article on this subject forthcoming in the December 22 Forbes.

Butler and I argue that the recent financial “crisis shows that SOX did not have the advertised payoff of flushing Enronesque risk out of the market.” So it’s not clear what shareholders got for all that money their firms spent on SOX. We suggest that it’s time to try an alternative: “SOX would remain, but firms could have their shareholders vote to opt out of some or all of its provisions. Or firms going public could opt out of SOX and let potential investors decide whether to buy their shares.”

We also make the connection with “say on pay:”

If shareholders should vote on pay, then why not on something that can have even more effect on profits. How about "Say on SOX"? 

Our proposal meshes with another one that’s getting some recent play: Adam Pritchard’s idea to let shareholders vote to amend the charter to modify the application of the fraud on the market theory, an important underpinning of federal securities class actions. Pritchard’s idea has now turned into a shareholder proposal at Alaska Air (here's an article, discussed in PoL).

Shareholder proposals could be the mechanism for adopting SOX opt-outs, too.  Of course SOX would have to be amended before such proposals would have an effect. 

So there you have it: shareholder choice vs mandatory federal protection. Using the corporate governance provisions of the securities laws (14a-8)  to opt out of the anti-fraud provisions of the securities laws.  As Henry and I concluded, “[i]t's time for the corporate governance reformers to decide what they really believe.”

The bailout and the anti-uncorporation bias

John Carney thinks “[t]he idea that Chrysler should not get a bailout because it is owned by the private equity firm Cerberus Capital Management” is "dangerous nonsense.”

Carney notes that the logic underlying this position is rather muddled.  Any profits from the bailout will not actually go the current private equity owners, and in any event these are the same institutional investors who own the other carmakers. Indeed, private equity has, until lately, been a gravy train for these institutions and those who depend on them.

But Carney recognizes that the anti-Chrysler argument isn’t about the specific investors, but rather against privately held, and in favor of publicly held firms. He correctly observes that this is precisely backward, and cites my work (here’s the paper and a recent application to the current mess). Quoting Carney:

we should be suspicious of adopting a government that thwarts innovations in corporate ownership. The publicly held corporation has been the dominant form of business ownership for quite some time. But it has widely known weaknesses, including the difficulty it has with controlling agency costs. This is one reason alternative forms have been emerging.

Carney’s not sure he agrees with my view “that we're seeing the beginning of an epochal shakeout that will mark the end of the corporate era." But we agree that, as Carney says,

having the government declare that alternative forms are somehow less worthy of survival than the traditional public corporation is simply wrong-headed government planning.

As a clear indication of the wrongheadedness of this anti-uncorporation bias, consider that the automakers may end up post-bailout with federal oversight boards (WSJ).  So we’re going to solve the incentive problem in corporations by putting politicians in charge? There must be a better way.

Is Fuld the next loser of the corporate crime lottery?

I’ve been saying that the Enronesque criminal prosecutions of meltdown figures is probably looming, beginning with Lehman’s Fuld, though this would be a mistake. This NY Mag article brings Fuld’s prosecution closer. Here's Carney's summary:

The article makes clear that while Lehman Brothers chief executive Dick Fuld was using his powers of intimidation and influence with the Treasury Department to quiet “rumor mongers,” he was running a firm in a financial condition that was even worse than critics suspected. Even while he and his deputies sought to assure investors and counterparties that all was well aboard the good ship Lehman, the firm’s own executives were discovering that the balance sheet told a very different tale.

The criminal laws will hit those who lied (maybe Fuld) and not those who merely screwed up (e.g., Bob Rubin). It’s the sort of distinction we're used to with the corporate crime lottery. I'm not comfortable with putting anybody in jail for this type of mistake.

Multitasking at the Times

Clark Hoyt, the NYT’s public editor, writes today about “the question of how much people who report the news should also tell you what they think about it.” The specific issue is whether reporters should cross the line into analysis and opinion.

I have discussed this problem before with reference to the NYT’s most prominent reporter/opinion-monger Gretchen Morgenson. As I wrote a couple of years ago about a Morgenson report/opinion on executive pay:

is this commentary, like the executive pay rants Morgenson does every Sunday, or is it news? Or is the Times' point that we're not supposed to get that straight?

Morgenson is still at it. As Hoyt says:

Last month, Morgenson covered Congressional hearings on the role that credit rating agencies played in the financial crisis. * * * Three days later, she wrote a column that said the testimony of one executive “was a lot for my malarkey meter to absorb.” When I asked Morgenson why it was O.K. to write a straight news article about the hearings and then give her personal opinion about them in a column, she said, “I do not pull my opinions out of thin air.”

Well, that last point is a matter of opinion, as I’ve shown in my detailed examination of a large number of Morgenson columns. Hoyt says that Morgenson could show “internal e-mail and documents” that contradicted the ratings executives. And Executive Editor Keller claims that Morgenson is “remarkably adept” at both reporting and opinionating. But even if those statements are true, they're beside the point. One would hope that at least Morgenson’s reporting has support. The problem is her off-the-wall opinions.

Morgenson says “I think it would be unfortunate indeed if staffers who can both report news stories fairly and write columns that are well-argued are forced to do one or the other but not both.” I don't agree that Morgenson is able to “write columns that are well-argued.” But that’s not my point either. The point is that, whatever the value of Morgenson's opinions, a responsible newspaper would not seek to give them a head start in credibility by mingling them in the reader’s mind with what is passing as reporting of fact. This applies not only to Morgenson, but to the other, more competent, writers Hoyt discusses, including Sorkin and Nocera.

Keller would draw the line at a writer doing a news story and a column about that story on the same day and page. So he recognizes the problem. The idea that the same-day rule solves the problem is simply a joke. Busy readers confronting a multitude of sources do not have these neat categories in their brains, and he knows it. As Hoyt says:

if it isn’t all right to have a reporter write a column about a news article he or she is covering on the same day, why is it all right three days later? * * * As business issues, public policy and politics merge in the current crisis, I think the risk only increases as reporters and news columnists slide from analysis to outright opinion. * * * I would not have reporters writing opinion about the subjects they cover.

Hoyt concludes that his battle to separate news and opinion “appears lost to two stronger influences:

the Internet, which puts a premium on opinion and voice, and economics, which keeps the business staff from having columnists who don’t also carry reporting duty. “We don’t have the resources to do that,” (business editor Larry) Ingrassia said.

So the Times wants its readers to believe that it can't afford to do the news right anymore.  But the Times' biggest competitor, the WSJ, still maintains the reporting-opinion separation. Apparently, even post-Murdoch the Journal thinks it’s worthwhile to play straight with readers. 

Finally, Hoyt says “no reader has complained to me about bias on the business pages.”

Well here’s one. I’m sending this to Hoyt, and will report on the response, or lack thereof.

Rubin and Citi

I noted last week in discussing a NYT article about Citi's downfall:

There will be a temptation to blame the individuals. I suspect, for example, that this will kill a major role for [Citi board member Robert] Rubin in the Obama administration.

But I also said that we should resist the temptation to scapegoat Rubin and focus on the deeper governance failures.

A WSJ article today spotlights Rubin's role.  The article basically wonders how Rubin could take home $115 million in pay in nine years excluding options while claiming that he had no operating responsibility, and therefore can't be blamed for the $20 billion in recent losses and the 70% stock price decline during his tenure.

Rubin is quoted as saying:

The board can't run the risk book of a company. The board as a whole is not going to have a granular knowledge" of operations.

I'm tempted to see Rubin as the Clinton-Obama version of the Enron board. Didn't Lay and Skilling also say they lacked "granular" knowledge of what was happening at Enron? Wasn't the Enron board faulted for being similarly non-granular? 

The difference is that Rubin can't even claim ignorance. The article reports that Rubin "was deeply involved in a decision in late 2004 and early 2005 to take on more risk to boost flagging profit growth." He understood the financial instruments, and was making speeches to the effect that assets were overvalued and there was a lot of risk. Indeed, Rubin insists that

I've been a very constructive part of the Citigroup environment. That has become particularly manifest since August '07. I have been very involved.

So why didn't he advise the Citi board to avoid the risks that almost brought down the bank? He says: "I wouldn't run a financial institution based on someone's view about what markets would do." He figured the potential losses were less than what the bank was making. He just didn't realize that the problem was "not only a cyclical undervaluing of risk [but also] a housing bubble, and triple-A ratings were misguided. There was virtually nobody who saw that low-probability event as a possibility." The collapse "was a systemic problem of which Citi was a piece." And, of course, the article says Rubin blames "short sellers ganging up on the stock."

In a nutshell, Rubin was involved and knowledgeable, so he deserved his $12 million or so a year, but he couldn't be expected to know what was going on.

There's a lot of nonsense here apart from the anomalies in Rubin's description of his role at Citi. Most importantly, it's now obvious that the meltdown did not result from a "low-probability event," but rather from a core design problem that somebody like Rubin surely knew: the assumption built into the valuation model that real estate prices would keep going up. This wasn't a systemic problem that swept over Citi like a hurricane. Citi wasn't New Orleans. Citi and the others who participated in the market while ignoring the manifest risks were the hurricane.

Rubin correctly points out that there was no telling how soon the market would catch on. When will there be no more "greater fools" to buy the junk? But nobody's saying Rubin should have bet against the market. Rather, he shouldn't have advised Citi to bet the pot on drawing four aces.

Henry Blodget has similar thoughts.

But as I said at the beginning, I want to focus on the broader governance issue. As I've said repeatedly, the meltdown was symptomatic of a deep-seated governance problem. If even having somebody with Rubin's sophistication on the board couldn't protect Citi, then you have to wonder about the whole concept of the board of directors and the rest of the corporate governance paraphernalia.  

Rubin was a typical part of the modern corporate governance structure. He had all the information and sophistication he needed to find out what was really happening. What he lacked was the incentive – the skin in the game that would have impelled him to get to the bottom of Citi's risk profile. 

Finally, it's worth pointing out that Rubin was in fact doing his job and earning every penny of his pay. As he pointed out in the WSJ article, it's not like he lacked other equally lucrative opportunities. He doesn't need to say that he commanded this kind of money for a non-operational advisory role not for his expertise, but as a former Treasury Secretary. In other words, you can't neatly separate politics and government from the market.  Might Rubin have something to do with the fact that, despite its huge mistakes, Citi is still standing? If so, he deserves a bonus.

The India attacks and the information age

From the WSJ:

Since Danish Khan started "tweeting" about the attacks, the software engineer has 30 to 35 new people subscribing to his Twitter updates. Twitter is helping "those who are away from Mumbai who want to know about this," after some television channels stopped broadcasting on-the-ground live updates, he said. * * *

Users posted phone numbers for hospitals, besieged hotels and volunteered to help people outside Mumbai text-message their missing friends and family, when phone lines were jammed.

Soon after the attacks, a user using the name John Kenny started the first Wikipedia entry on the subject * * * After 15 hours, various users had expanded and updated the entry to include a chart detailing the location and type of attacks (grenades/ shooting/hostages), reactions from a number of embassies, names of some prominent casualties -- and even the news that the English cricket team had postponed a planned tour to India.

[One Twitterer said] "I had an information advantage of at least 10 minutes before the news guys actually reported it. I think it's [social media is] going in the right [direction] * * * We are reaching a stage now where information is disseminated by a lot of people, it's accurate and reaching you in a timely fashion."

One question. Where was Twitter in "Cloverfield"?  Looks like Hollywood will have to update.

Tina Turner

Do you remember where you were 39 years ago? I do (with some help from Wikipedia).  I was at the International Amphitheater in Chicago watching Ike and Tina Turner.

This comes to mind because of a WaPo story about the now 69 year old Ms Turner’s show at Verizon Center last night. She did the encore of her three-hour show walking on the hydraulic arm of a cherry picker two stories above the stage. In spike heels.

So what else happened that night 39 years ago? I remember my 8-track was stolen from my car. And, oh yes. The Rolling Stones played the second act.

Music and the markets

In Music and the Market: Song and Stock Volatility Philip Maymin writes:

I compare the annual average beat variance of the songs in the US Billboard Top 100 since its inception in 1958 through 2007 to the standard deviation of returns of the S&P 500 for the same year and find that they are significantly negatively correlated. With the recent high stock volatility, people should now prefer less volatile music. Furthermore, the beat variance appears able to predict future market volatility, producing 2.5 volatility points of profit per year on average.

Now, you might think this is a completely novel idea.  The author says that "the finance literature contains no references to any articles linking music and the financial markets."

But that's not quite true, proving that there's nothing new under the sun. See Crain & Tollison, Economics and the Architecture of Popular Music, 32 Journal of Economic Behavior & Organization 185 (1997):

A simple supply and demand framework is developed to study the time-series pattern of music. Changes in the internal structure of successful songs, it will be argued, are tied to market forces. An extensive data set has been developed to enable the investigation of a large number of issues in this spirit. The analysis proceeds by first asking a basic question: Has the structure of music changed in these 50 years? We discover major regime changes in the mid 1950s and again in the mid 1960s that generally conform to intuition. The analysis then turns to specify a system of demand and supply equations to explain the patterns in popular music over the sample period.

Update:  Maymin responds in the comments, distinguishing Crain & Tollison.

Another attack on lawyer blogging and speech

This time in Louisiana, per ABA Journal:

A law firm contends new Louisiana lawyer advertising rules slated to take effect in April will restrict its right to comment on Twitter, Facebook, online bulletin boards and blogs. The Wolfe Law Group filed a federal suit today challenging the rules, claiming they would subject each of the firm’s online posts to an evaluation and a $175 fee, according to a press release. The construction law firm says in the suit that its own blog may qualify for an exemption for law firm websites, but its comments on other blogs would not. The firm claims the rules would restrict its First Amendment right to speak freely about its trade.

Here’s the complaint, and the Wolfe Law Group blog on the case.

I wrote a couple of years ago about a similar move to shut down lawyer blogging in NY.  I noted that the question, still not determined, is what is considered “mere” commercial speech. Under Florida Bar v. Went For It, Inc., 515 U.S. 618 (1995) the Court, applying the commercial speech test, held that an interest in maintaining the professionalism of the bar was enough to support regulation of lawyer advertising.

What about lawyer blogs?  As I noted in my lawyer blogging paper:

[E]ven the most blatantly self-promoting weblog may include both important ideas and valuable information about legal services that deserve constitutional protection. Blogs therefore illustrate the close connection between the "market for goods and the market for ideas" that led Nobel Prize-winning economist Ronald Coase to question limiting constitutional protection for commercial speech (Advertising and Free Speech, 6 J. Legal Stud. 1 (1977); The Market for Goods and the Market for Ideas, 64 Am. Econ. Rev. 384 (1974)). Indeed, the Court has observed in Virginia State Board of Pharmacy v. Virginia Citizens Consumer Council, 425 U.S. 748 (1976) that in a free enterprise economy "the free flow of commercial information is indispensable."

As a matter of policy, I’ve argued, in From Bricks to Pajamas: The Law and Economics of Amateur Journalism, 48 William & Mary Law Review 185 (2006), that the Web itself, fueled by Google searches, provides an easy way to check false claims. As I noted in my paper on lawyer blogging:

Scrutiny by millions of eyes on the Internet serves as a more powerful constraint on misleading information than an overworked bar committee's sorting through a mountain of filed blog posts. Moreover, regulation could discourage the most responsible, and therefore risk-averse, lawyers, thereby opening the field for the unscrupulous.

I suggested the following test if the Court decides to distinguish which lawyer communications get full First Amendment protection:

[T]he Court should consider the degree of interactivity the blog invites (for example, does it permit comments and trackbacks?), and the extent to which the lawyer uses the blog to express judgments and opinions.

But I also noted that:

[T]he issue of whether to apply the First Amendment to blogs might finally persuade the Court of the futility of trying to distinguish commercial and non-commercial speech for First Amendment purposes, and to abandon the "commercial speech" doctrine. Such a move could have significant implications in many areas of business, particularly including securities regulation.

As to securities regulation, see my and Butler’s, Corporate Governance Speech and the First Amendment, 43 U. KANS. L. REV. 163 (1994), a chapter in our Corporation and The Constitution.

So while regulatory moves like the one in Louisiana are a troubling nuisance, as an academic looking for clarification on commercial speech generally, and professional and securities regulation in particular, I say to these aggressive speech regulators, go ahead, make my day.

The meltdown and the end of the corporate era

I have previously noted Michael Lewis’s useful Portfolio article. There’s a lot of wisdom in the piece that’s relevant to today’s Citi bailouts, and all the bailouts, prosecutions and regulation to come.

Lewis chronicles how all that toxic paper choked Wall Street. As I’ve noted, Lewis sees the original sin as the incorporation of the old Wall Street partnerships, led by Salomon’s John Gutfreund (I still marvel at that name) whose interview climaxes Lewis's article.

This is part of a theme that pervades the piece, and with which I agree. Although the article details the absurd premises of the CDOs and other derivatives that Wall Street and sucker investors swallowed whole, Lewis notes (quoting a friend) that “The problem isn’t the tools. It’s who is using the tools. Derivatives are like guns.”

Nor is the problem “greed.” Gutfreund thought it was “greed on both sides—greed of investors and the greed of the bankers.” But Lewis “thought it was more complicated. Greed on Wall Street was a given—almost an obligation. The problem was the system of incentives that channeled the greed.”

The incentives came from the corporate form. As Lewis points out, “Lehman Brothers circa 2008 more closely resembled a normal corporation with solid American values than did any Wall Street firm circa 1985.”

But what was it, exactly, about the corporation that was so bad for Wall Street? Here Lewis is less clear. He blames Gutfreund for transferring

the ultimate financial risk from themselves to their shareholders. * * * From that moment . . . the Wall Street firm became a black box. The shareholders who financed the risks had no real understanding of what the risk takers were doing, and as the risk-taking grew ever more complex, their understanding diminished. The moment Salomon Brothers demonstrated the potential gains to be had by the investment bank as public corporation, the psychological foundations of Wall Street shifted from trust to blind faith.

That quote questions the entire fundamental logic underlying the corporate form which is, after all, precisely this transfer of risk. Or to put it more precisely, the specialization of risk-bearing and management functions. This specalization enables risk diversification. Instead of a “black box,” it's supposed to produce the trading of the securities on an efficient market.

So what went wrong? My Uncorporating the Large Firm describes a true alternative to the corporation – the "uncorporation." I emphasize incentives and discipline. The managers need to be compensated like partners, with both upside and downside risk. The investors have to have access to the cash through distribution and liquidity events, which forces managers to face the judgment of the capital markets.

I suspect that this is the long-term future of Wall Street and many other industries – that we’re seeing the beginning of an epochal shakeout that will mark the end of the corporate era.

I’m not sure, however, where the overall equilibrium will settle. There’s clearly a role for the corporate form. That role has been exaggerated by the tax laws, which impose an extra tax on distributions by most publicly held firms. But even without the corporate tax, some firms likely would be structured along what are now recognized as corporate lines.

Even so, even firms that continue to look like conventional corporations will need uncorporations to keep their governance on track– venture capital to incubate, hedge funds to uncover information, and private equity as the foundation of the new takeover market.

Karen Wruck has a recent useful summary of the role of private equity in the takeover market (though she forgets that Henry Manne, not Michael Jensen, originally conceived of the market for control). Wruck says that concentrated ownership, and therefore leverage, is essential to private equity governance. I wonder, though, whether what I’ve called “privlic equity” – public ownership combined with private equity governance – might represent an emerging convergence of forms.

In the short term, the current panic, like others, likely will spawn a lot of scapegoating and show trials. Lewis recalls that in the late 80s

Anti-Wall Street feeling ran high * * * but the result felt more like a witch hunt than an honest reappraisal of the financial order. The public lynchings of Gutfreund and junk-bond king Michael Milken were excuses not to deal with the disturbing forces underpinning their rise. Ditto the cleaning up of Wall Street’s trading culture. The surface rippled, but down below, in the depths, the bonus pool remained undisturbed. * * * The changes were camouflage. They helped distract outsiders from the truly profane event: the growing misalignment of interests between the people who trafficked in financial risk and the wider culture.

In short, one of the many bad effects of criminalizing corporate behavior is that it prevents a productive search for answers. The criminal show trials seek to preserve the status quo by putting all the problems on a few bad apples and distracting attention from the real problems.

This time, though, I think the problems have become too obvious to hide or ignore.

Lessons from Citi

So Citi basically got the troubled asset protection it sought from the government in the Wachovia deal. Here’s Zaring and Carney and the government statement.

Yesterday’s Times did a pretty good job of describing how Citi went off the rails. Among other things, a dysfunctional risk management system (the risk officer went fishing with the head of the bond business he was supposed to be supervising); a CEO (Prince) who “didn’t know a C.D.O. from a grocery list"); advised by Robert Rubin, who pushed for more risk.

How bad was it? “Citigroup’s risk models never accounted for the possibility of a national housing downturn.” That ridiculous notion, as I've said, was at the heart of AIG and many other companies, which I've described as "living in a child's world in which real estate prices always go up."

Citi was bolstered in its absurd assumption by the bond raters. The Times quoted John Dugan, head of Comptroller of the Currency, as saying: “There is really no excuse for institutions that specialize in credit risk assessment, like large commercial banks, to rely solely on credit ratings in assessing credit risk.”

No excuse, but why did it happen? There will be a temptation to blame the individuals. I suspect, for example, that this will kill a major role for Rubin in the Obama administration.

But I’ve been saying for awhile that the problem is in the structure. We have seen in the current meltdown and in Enron that conventional corporate governance has not been able to handle the opaque complexity. As I've pointed out:

These firms apparently did not have a governance model suited to investing in an increasingly complex world. The regulators (SEC) couldn’t be expected to fill the gap. I have already discussed where this is headed: nimble, highly incentivized partnerships such as hedge funds, private equity, venture capital.

Markets will produce this result on the off-chance we're prepared to let them. I fear that we’re more likely to see regulation that shores up the status quo – the continued dominance of giant corporations that mucked up the banking system.

Gretchen Morgenson: journalism's stopped clock

Joe Weisenthal writes about the latest Morgenscreed in today’s NYT – financial institutions aren’t lending their TARP money the way they’re supposed to. Gretchen closes by favorably quoting a Dallas money-manager, Fred Rowe, as saying the banks “are acting like war profiteers. If I were in charge, I would haul them all down to Gitmo, put them in a room and say, ‘You have used the taxpayer’s money to pervert our objectives. It is morally wrong and we are not going to stand for it.’”

As Weisenthal points out, this seems at odds with Morgenscreed’s earlier complaint that bank lending policies were too lax. He gives her credit for being right then. Readers of this blog’s detailed analyses of Morgenscreed’s columns know that she’s not right very often, so I suppose I should give her credit. Let’s say the best case for Morgenscreed is that a stopped clock is right twice a day.

But like the banks I’m not in much of a credit-giving mood. To begin with, Morgenscreed wasn’t quite right back in 2007 when she was complaining about lax lending. Like many others, she saw cracks in the subprime market. But she cited little support for her cries about a coming disaster, as I pointed out back then.

Moreover, Morgenscreed’s idea of a disaster back then was that

If home prices do not appreciate or if they fall, defaults will rise, and pension funds and others that embraced the mortgage securities market will have to record losses. And they will likely retreat from the market, analysts said, affecting consumers and the overall economy.

In other words, she was worried then, as now, about a normal market adjustment to the defaults – a pullback of credit. Give her no kudos for seeing the disaster that has unfolded.

Morgenscreed also had a concern back in spring 07 with subprime lenders purportedly hiding defaults by rolling over loans. She pointed out that "it is worth remembering that the rollover of nonperforming loans was central to what made the savings and loan mess of the early 1990s so disastrous,"

Well, now, the big problem is that banks are not rolling over loans. She writes: 

There is an ugly precedent for banks refusing to renew loans during a time of crisis, said Frederick E. Rowe, a money manager at Greenbrier Partners in Dallas. That is what Texas institutions did during the savings and loan crisis in the late 1980s. The consequences were disastrous.

It’s great that Morgenscreed can pull the savings and loan crisis out of her little bag to support whatever she wants to preach at the moment. And convenient that she once again could find Frederick E. Rowe to give her a nice quote.

More Gretchenomics: Gretchen also has some interesting criticism of the Treasury: 

And the Treasury’s decision not to buy toxic mortgage assets with TARP money after it said it would do so has produced paper losses for the banks that hold these securities. The value of those securities rose when TARP was announced but fell significantly when the mortgage purchase program was abandoned."

If I'm understanding this, the "paper losses" were the gain the banks momentarily thought they would get by the government's overpaying for the assets.  

Further note: Well, now it looks like the government will buy the assets.  So I guess the shorts will have the "paper losses." 

The effects of the financial crisis on corporate governance

The massive realignment that’s occurring in the financial markets must be affecting the mechanisms of governance. Our assumptions about governance have to change accordingly, particularly if we’re going to impose massive new regulation. Consider these two quotes from this morning:

FT (HT Elfenbein and Cowen): 

What's really going on is another effect of the disappearance of dealer and arbitrageur capital. The dealers can't afford to make efficient markets, given their decapitalisation, downsizing, and outright disappearance. That means anomalies sit there for weeks and months, where they would have disappeared in minutes or seconds.

And from WSJ:

So far this year, 46 outside directors who are CEOs or chief financial officers left the boards of 42 companies in three struggling industries -- financial services, retail and residential construction -- concludes an analysis for The Wall Street Journal by Corporate Library in Portland, Maine. * * *George Davis, co-head of the global board practice at recruiters Egon Zehnder International, said about a half-dozen CEOs he had been wooing for board seats withdrew their names after investment bank Lehman Brothers Holdings Inc. collapsed in September. Their own boards told them, "Keep your hand on the tiller," the recruiter remembers. * * *

We should keep these effects in mind before we impose regulation that could exacerbate the strains – e.g., short-selling bans that further weaken market efficiency; and imposing additional pressures and monitoring burdens on outside directors.

The Electronic Arts decision: 14a-8 and preemption

Gordon Smith analyzes the transcript of the federal district court decision (supplied courtesy of Lawyer Links) in Bebchuk v. Electronic Arts. 

Cutting to the chase, here's the critical passage from the opinion:

I would hold that the SEC has been very careful not to trammel on the -- except to the extent that it thinks it appropriate -- on the normal discretion of the board of directors..., and the proxy rules honor that. And these 13 provisions for the exclusion, express the different views of different instances. And this particular instance requiring the company to put a proposal that could eliminate the discretion of directors would be * * * contradictory, to what the SEC has done * * *

In short, as Gordon summarizes:

Judge Hellerstein believes that Rule 14a-8 -- and only Rule 14a-8 -- defines the scope of director discretion with respect to a company's proxy ballot. This is the essence of the argument * * * that Rule 14a-8 preempts state law on the issue of access to the issuer’s proxy statement.

Gordon also has observed that "[p]reemption doesn't seem like a serious argument to me."

But I agree with the judge -- preemption is precisely the problem.  My earlier analysis of this case is strikingly consistent with the judge's reasoning:

Even if the proposal is not within a specific 14a-8 exclusion it would essentially undermine the careful limitations on mandated proposals under 14a-8. This strikes me as really an argument that the proposal is substantially inconsistent with 14a-8 even if it doesn’t fall within a specific exclusion category. And that argument makes some sense.* * *

I understand that the argument seems odd.  But that oddness result from a clash inherent in the excessive federalization of corporate governance.  As I wrote in my earlier post:

Bebchuk's proposal exposes [14a-8’s] basic ambiguity: where in the complex realm of corporate internal governance does the federal regime end and the state regime begin? * * *

I have consistently recommended that the SEC solve the problem by revising the rule

so that it just requires disclosure of agenda items permitted by state law. That would eliminate the ambiguity that gives rise to this case.

My fondest hope, as I concluded, is to "let firms choose their disclosure laws." That, of course, ain't going to happen, with the result that we're going to continue to get cases like this about the borderline between federal and state law.

Cuban and insider trading

Bainbridge discusses the charges. Here and here I discuss an earlier Cuban project to ferret out fraud by buying nonpublic information. The differences have a lot to do with illegality, but little to do with why we have a federal law to deal with what's essentially just a breach of fiduciary duty.

What to do about the auto industry

Allowing GM to fail might threaten a million jobs, counting the domino effect (see this WSJ article). However, as Bruce MacEwen among others has said:

If the Big Three have demonstrated anything over the past 30 years, it is their unrivalled managerial genius at misallocating productive assets and falling ever further behind their rivals. Time, one might think, to give someone else a chance to deploy those assets.

Maybe. I’ve thought until recently that it was basically a governance problem. Maybe bankruptcy would solve that by getting the assets into, say, private equity's hands. But, then, Cerberus hasn’t made a go of it either. So who would buy GM in bankruptcy? The Japanese? Why should they do a better job? 

Maybe, as David Yermack suggests, cars are just a bad investment. But, then, why are the Japanese companies at least surviving? And if cars are a bad investment, then the auto workers would be out of work and not just redeployed, which is probably not politically acceptable.

Of course you can’t ignore the huge elephant in the room of the legacy labor costs. And there’s also the CAFÉ fuel economy standards, which have forced US companies out of their main competence – building big, fuel-inefficient but heavy-hauling vehicles. Holman Jenkins would attack both problems by getting rid of the CAFÉ two-fleet rule and letting GM make the lower-margin small cars in low-wage factories overseas. That sounds promising. But if you just did that, you’d still have the governance problems.

What seems clear is that we’d be better off burning the money, as Yermack suggests, than just giving it to the existing GM management/labor structure. If the only reason for doing that is to save the jobs, then here’s an idea that would at least be better than burning the money: put the same money into a huge public works/job training program for auto industry workers. Maybe they could build public transit systems.

Now you might find it strange that somebody who’s argued for free markets would advocate a huge government program. However, giving the money to GM right now is basically the same as a government jobs program only worse managed, if you could imagine that.

Market discipline is what makes firms work. But massive government subsidies and the lock-in of overpriced labor short-circuit markets in this case. Without markets, we can't expect shareholder voting, independent directors or takeovers to do the job.  It follows that a huge bailout now would make GM the old-economy version of Fannie and Freddie.

Bottom line:  if government is going to spend a huge wad of money, why not at least ensure that the politicians are responsible for it?  I know it's hardly an ideal outcome.  But anybody got a better idea?

Spitzer on the financial crisis

Acknowledging that "mistakes I made in my private life now prevent me from participating in these issues as I have in the past," Eliot's peeking out into the world, and making it clear he still has his opinions.  The first of these is that

no major market problem has been resolved through self-regulation, because individual competitive behavior doesn't concern itself with the larger market.

Spitzer sort of misses the basic idea behind the invisible hand thing -- self-interest and competitive behavior is what makes the "larger market" work. 

Sure regulation is sometimes necessary.  But Spitzer's examples of regulatory brilliance show why we should at least presume in favor of markets. He brags about his office’s investigations of AIG reinsurance transactions and subprime lending. But neither hit the real problems that caused the system to temporarily implode. Moreover, one can still wonder whether AIG might have avoided at least some of its problems if Spitzer hadn't removed Hank Greenberg. 

But then Spitzer starts making sense.  He points out that the conventional corporate governance mechanisms – institutional shareholders, independent directors – did little good, and that

arguably the sole challenge to corporate mismanagement and poor corporate strategies has come from private-equity firms or activist hedge funds. These firms were among the few shareholders or pools of capital willing to purchase and revamp encrusted corporate machines. So it shouldn't be surprising that the corporate world has taken a skeptical view of them -- especially short-selling hedge funds, which have often been a rare voice raising the alarm.

Hey, that's what I've been saying. This is an example of what Spitzer says doesn't happen -- the market taking care of its own problems.

Spitzer adds that

we will have to step back from the current environment in which government has become a guarantor of all major risk. The so-called moral hazard will serve to devalue risk in the market, and this too will have a debilitating long-term effect on capital flows. Only if private actors have to bear the real risks they incur will the market function properly.

I’m not exactly a fan of Spitzer’s. But it’s hard to deny that the guy would have had some credibility. He would be saying "I told you so" (though he really didn't).  He could be the tough cop people seem to want.  He could pass himself off as an expert on financial markets, and as a friend of capitalism of the bridled variety.  One wonders where he’d be today if he'd kept his pants zipped.

Today in Congress: Houman Shadab at the hedge fund hearing

In the midst of all the big names facing Congress today at the hedge fund hearing (here's the WSJ story) was a young scholar (just entering the law teaching market this year) named Houman Shadab, now at GMU's Mercatus Center.  He did a great job presenting the real story on hedge funds, as he did in this paper, which Houman presented in my Illinois Corporate Colloquium earlier this fall. 

Here's Houman's testimony today. And here's the emailed comment on the hearing I solicited from him:

Congress seemed to understand that the credit crisis was not instigated by hedge funds, and the members seemed to show a genuine interest in how exactly was it that the fund mangers actually preserved their investors' wealth while the economy was doing so poorly. However, there seemed to be a consensus, not shared by me, that hedge funds were part of the so-called "shadow" banking system consisting of securitized products backed by mortgages, credit derivatives, and excessive leverage, such that increased transparency was necessary to bring the allegedly hidden risks in our economy to light. My prediction is that some type of direct monitoring over hedge funds will become authorized by law, as well as mandatory clearing, if not full-blown exchange-trading, of credit default swaps.

Michael Lewis on the uncorporation

A couple of months ago I described the current financial crisis as "the wake up call for corporate governance," predicting that "the financial industry will return, in a way, to its partnership roots."  The longer reasoning is in my Uncorporating the Large Firm. 

So I read with interest Michael Lewis' words of wisdom in Portfolio:

No investment bank owned by its employees would have levered itself 35 to 1 or bought and held $50 billion in mezzanine C.D.O.’s. I doubt any partnership would have sought to game the rating agencies or leap into bed with loan sharks or even allow mezzanine C.D.O.’s to be sold to its customers. The hoped-for short-term gain would not have justified the long-term hit.

It's about what happened when Wall Street abandoned the partnership model. Read the whole thing.

The financial panic and the (near) future of the legal profession

The NY Times scarily summarizes what’s happening in the legal world: firms collapsing, laying off partners and associates, hurting their future recruitment efforts; a downturn in supposedly recession-proof litigation because of clients’ problems financing it; firms with too many people doing the wrong things (real estate, corporate finance); clients, looking for ways to cut costs, insisting on flat, fixed or contingent fees.

These events are going to force major changes in legal services sooner rather than later. As I said last April in commenting on a major Georgetown symposium on law firms:

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 particular, rules mandating worker (i.e., lawyer) ownership constrain mechanisms for binding lawyers to firms, and business diversification and integration that could make firms more robust and able to withstand downturns. This structure also locks in place an unsustainable system in which partner compensation depends on leveraging associate hours, all teetering on the increasingly shaky foundation of the billable hour.

I hypothesized last April that the result of all these developments may be

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 [whose law firm economics blog is must reading now] aptly referred to the coming "Cambrian explosion" in the legal business, in which evolution is unprecedented and rapid.

And I pointed out that this has important implications for legal education:

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. * * * Surely in this world we can't expect to be selling all law students the same $100,000 education.

People have been talking about these developments for awhile as if they’re way in the future. It looks like the current financial crisis may bring the "Cambrian explosion" sooner than we may have expected.