Ideoblog

Time for a federal snow commission?

Snow resorts lie about snow, according to Zinman and Zitzewitz, Snowed: Deceptive Advertising by Ski Resorts. Here's the abstract:

Casual empiricism suggests that deceptive advertising is prevalent, and several classes of theories explore its causes and consequences. We provide some unusually sharp empirical evidence on the extent, mechanics, and dynamics of deceptive advertising. Ski resorts self-report 23 percent more snowfall on weekends; there is no such weekend effect in government precipitation data. Resorts that plausibly reap greater benefits from exaggerating do it more. We find little evidence that competition restrains or encourages exaggeration. Near the end of our sample period, we observe a shock to the information environment: a new iPhone application feature makes it easier for skiers to comment on resort ski conditions in real time. Exaggeration falls sharply, especially at resorts where iPhones can get reception.

The authors suggest that this is just one example of how "deceptive advertising can prevail when consumer search or switching costs are high."

Fortunately these conditions don't prevail in liquid securities markets, where many devices serve the purpose of the iPhone app in reporting on ski conditions. So maybe the SEC's efforts can be redirected.

Elois and Morlocks

The juxtaposition here is great.

Yesterday the WSJ Law Blog asked What Can Law Firms Do To Make Everyone Happy? A: Read This. What ensued was a discussion of Larry Cunningham's suggestion on Concurring Opinions that law firms offer partner sabbaticals. Cunningham says:

Firms adopting such policies would instantly win the affection of the many younger associates now concerned, by associate-targeted firm policies, about their own job prospects and security. * * * Instead of running a firm like a business, riveted only on bottom line and promoting cut-throat cultures, the practice of law could return to its erstwhile professionalism, characterized by thoughtful advice to clients, service to the public weal, collegial support among firm members, and cultivation and training of the next generation's legal professionals.

At around the same time, Above the Law had a post about contract attorneys, with quotes from Big Debts Small Law about a piece of the real world of modern law practice. I've been discussing the bigger picture in my Lawyers archive.

I wonder whether Cunningham's suggestion doesn't fit at all in the real future of Big Law, or whether the future will be H.G. Wells's bifurcated world.

Methodist ministers are paid like CEOs

So says David Yermack in Is a Higher Calling Enough? Incentive Compensation in the Church. Here's the abstract:

We study the compensation and productivity of more than 2,000 Methodist ministers in a 43-year panel data set. The church appears to use pay-for-performance incentives for its clergy, as their compensation follows a sharing rule by which pastors receive approximately 3 percent of the incremental revenue from membership increases. The elasticity between ministers pay and parish size is similar to the firm size elasticity of compensation for public company CEOs. Among a range of possible performance measures, those with the greatest informativeness about pastoral effort are linked most closely to compensation.

Studies on backdating and "say on pay" to follow.

Michigan State Business Law and Narrative Conference

Here are details with complete links for this conference to be held September 10-11 at the MSU College of Law.

The lineup starts with my keynote address on September 10, now titled "How movies created the financial crisis." The next day are talks by, among many others, Geoff Miller, David Skeel, Frank Partnoy (lunch talk on his book, The Match King), Lyman Johnson, Don Langevoort, and my colleague, Christine Hurt, all organized by Mae Kuykendall.

More later!

Backdating prosecution bites the dust

It's ironic, as the WSJ Law Blog notes, that on a day that the WSJ chose to revisit backdating with a story implying that not enough is being done about it (see my earlier post), the key backdating prosecution of Greg Reyes, former Brocade CEO, the case that was the veritable criminal law poster child of backdating, the vindication of the WSJ's Pulitzer-hounding on this subject, has been reversed.

I've been covering this case, e.g. here and here, as part of my effort to highlight the ambiguities inherent in prosecuting backdating, and therefore why these cases are inappropriate for criminal treatment.

Although the case could have gone down on a number of grounds, e.g., materiality, the court chose to focus on the prosecutorial misconduct of "culpably" misrepresenting the state of the evidence during closing argument.

As the Ninth Circuit opinion emphasizes, this was no minor technicality:

At trial, an issue as to Reyes' criminal state of mind was whether Reyes knew the corporate records falsely stated the company's financial condition by under-reporting the company's expenses. Reyes' defense was that he thought the transactions were properly accounted for, in reliance on the Finance Department's expertise to comply with accounting principles and SEC regulations. The government, however, argued that the Finance Department was unaware of the backdating, and thus powerless to get the accounting right. A key question therefore became whether the Finance Department knew that the backdating scheme was taking place.

And this is a central problem with backdating cases generally: should the CEOs, unschooled in accounting technicalities, be held criminally responsible for the way compensation was set forth on the company's books? This is why, for example, it has been so difficult to distinguish Reyes from Steve Jobs, who unlike Reyes benefited from the Apple backdating. Why should the CEO be held criminally responsible for the way the company's experts were handling the accounting?

Well, there was lots of evidence that responsible people in the Brocade Finance Department did know. Yet, as the court said

the prosecutor asserted to the jury in closing that the entire Finance Department did not know about the backdating, and further that the government's theory of the case was that "finance did not know anything." "Our theory is that those people didn't know anything . . . . Elizabeth Moore says finance didn't know. Did you need everybody in the finance department to come and tell you that they didn't know?" The government even displayed for the jury a diagram explaining the prosecutor's position that the Finance Department did not know of the backdating. The prosecutor asked the jury to assume other employees of the Finance Department would testify that they did not know about Reyes' backdating procedure when the prosecutor knew they did. * * *

The record demonstrates that the prosecution argued to the jury material facts that the prosecution knew were false, or at the very least had strong reason to doubt.* *

Moreover, these facts were critical:

Although the government's case was relatively strong, the jury took seven days to deliberate, and the case was complex and technical. Moreover, the prosecutor's statements were particularly prejudicial given that Reyes' defense rested on his delegating his responsibilities to others and reliance on them. At the end there was considerable focus on the issue of what the Finance Department knew. The prosecutor's false statements went directly to this issue. Moreover, the statements were made during closing arguments, both orally and visually, and closing statements from the prosecution "matter a great deal." * * * Deliberate false statements by those privileged to represent the United States harm the trial process and the integrity of our prosecutorial system. We do not lightly tolerate a prosecutor asserting as a fact to the jury something known to be untrue or, at the very least, that the prosecution had very strong reason to doubt. * * *There is no reason to tolerate such misconduct here.

The court nevertheless refused to dismiss the indictment. Now the government has to decide whether to spend millions more to retry this case. Doing so would be incredibly irresponsible. How could the government justify a retrial of a case that, in the court's view, rested so fundamentally on the prosecutor's lie to the jury?

This case illustrates not only a central legal ambiguity in backdating cases, but the extent to which corporate crime cases have been marred by excessive prosecutorial zeal. This botched case crowns the illegitimacy of the whole fiasco of criminalizing backdating.

Update: Business Week's Peter Burrows, whose coverage of this case has been on target from the beginning, has similar sentiments.

Backdating is back

The WSJ is back on the backdating beat, noting today that a new academic study has revealed that backdating was even more widespread than previously revealed, despite the glare of attention the WSJ helped cast on the practice.

Interestingly, the article notes that one of the study's authors

briefed the SEC on the research a year ago, providing a preliminary list of suspected companies. An SEC spokesman said the agency "appreciated the input" but wouldn't confirm or deny whether it sparked any enforcement actions.

Stephen J. Crimmins, a securities lawyer at K&L Gates LLP in Washington, said the SEC devoted lots of resources to backdating cases but now is looking to other problems. "They came down like a ton of bricks on options backdating, and they believe the message has been sent and received," he said.

So I guess that, in addition to the Steve Jobs exception, we now have a "message sent and received" exception. If backdating was criminal activity then, why not now? The corporate crime lottery strikes again.

As I've argued numerous times (see my executive compensation archive), e.g., in the Steve Jobs post linked above, "backdating is not a business scandal.  It is a scandal of credulous (or worse) business journalism."

But for the WSJ, backdating is the gift that keeps on giving. Maybe this will help the Journal forget about the story that got away.

Mutual funds and the new paternalism

Professor Bainbridge, the NYT and Dale Oesterle discuss the forthcoming Supreme Court opinion in Jones v. Harris, 527 F.3d 627 (7th Cir. 2008), a suit by Oakmark fund investors that the funds had overpaid their investment adviser. Dale says "This case will reaffirm or change existing practice and either result will have ripples across the governance of companies countrywide."

Prof B doubts the ripple effect, citing Langevoort, Private Litigation to Enforce Fiduciary Duties in Mutual Funds: Derivative Suits, Disinterested Directors and the Ideology of Investor Sovereignty, 83 Wash. U. L.Q. 1017, 1019 (2005), for the proposition that the two contexts differ because the efficient capital markets and the a market for control, the major constraints in the corporate world, do not

arguably operate[] with any power in the world of mutual funds. Because mutual funds are not traded in an organized market, arbitrage opportunities cannot work to keep prices in line with rational expectations. Mutual fund prices are simply the product of net asset value at the time of purchase or redemption. Insider compensation is largely based on assets as well, which creates the conflict rather than aligns insider-shareholder interests, and directors are typically paid all or mostly in cash. Institutional shareholder voice does not exist in the fund area, and there is no external market for corporate control at all because shareholders can only sell their shares back to the fund. Thinking about mutual funds by imagining them simply as a species of "corporations" in a way that is directly informed by contemporary corporate law theory is completely misguided.

The NYT highlights Posner's dissent in Jones, in which he noted that "executive compensation in large publicly traded firms often is excessive * * * because of the feeble incentives of boards of directors to police compensation" – despite the fact that Posner is "a conservative with libertarian leanings, and he is a leader of the law and economics movement associated with the University of Chicago." [I question the "libertarian leanings" part, but that's a subject for another post.]

But Judge Easterbrook dismissed the suit. He reasoned:

Today thousands of mutual funds compete. The pages of the Wall Street Journal teem with listings. People can search for and trade funds over the Internet, with negligible transactions costs. * * * Mutual funds rarely fire their investment advisers, but investors can and do "fire" advisers cheaply and easily by moving their money elsewhere. Investors do this not when the advisers' fees are "too high" in the abstract, but when they are excessive in relation to the results-and what is "excessive" depends on the results available from other investment vehicles, rather than any absolute level of compensation.

* * * New entry is common, and funds can attract money only by offering a combination of service and management that investors value, at a price they are willing to pay. Mutual funds come much closer to the model of atomistic competition than do most other markets. Judges would not dream of regulating the price of automobiles, which are produced by roughly a dozen large firms; why then should 8,000 mutual funds seem "too few" to put competitive pressure on advisory fees? A recent, careful study concludes that thousands of mutual funds are plenty, that investors can and do protect their interests by shopping, and that regulating advisory fees through litigation is unlikely to do more good than harm. See John C. Coates & R. Glenn Hubbard, Competition in the Mutual Fund Industry: Evidence and Implications for Policy, 33 Iowa J. Corp. L. 151 (2007) [see my discussion of this paper]

It won't do to reply that most investors are unsophisticated and don't compare prices. The sophisticated investors who do shop create a competitive pressure that protects the rest. See Alan Schwartz & Louis Wilde, Imperfect Information in Markets for Contract Terms, 69 Va. L.Rev. 1387 (1983). As it happens, the most substantial and sophisticated investors choose to pay substantially more for investment advice than advisers subject to § 36(b) receive. * * * When persons who have the most to invest, and who act through professional advisers, place their assets in pools whose managers receive more than Harris Associates, it is hard to conclude that Harris's fees must be excessive.

Harris Associates charges a lower percentage of assets to other clients, but this does not imply that it must be charging too much to the Oakmark funds. Different clients call for different commitments of time. Pension funds have low (and predictable) turnover of assets. Mutual funds may grow or shrink quickly and must hold some assets in high-liquidity instruments to facilitate redemptions. That complicates an adviser's task. Joint costs likewise make it hard to draw inferences from fee levels. Some tasks in research, valuation, and portfolio design will have benefits for several clients. In competition those joint costs are apportioned among paying customers according to their elasticity of demand, not according to any rule of equal treatment.

Federal securities laws, of which the Investment Company Act is one component, work largely by requiring disclosure and then allowing price to be set by competition in which investors make their own choices. Plaintiffs do not contend that Harris Associates pulled the wool over the eyes of the disinterested trustees or otherwise hindered their ability to negotiate a favorable price for advisory services. The fees are not hidden from investors-and the Oakmark funds' net return has attracted new investment rather than driving investors away. As § 36(b) does not make the federal judiciary a rate regulator, after the fashion of the Federal Energy Regulatory Commission, the judgment of the district court is affirmed.

In 2004 I took a position like the one Easterbrook later took in Jones in discussing the mutual fund scandal du jour. See Do the Mutuals Need More Law? Regulation Magazine, Spring, 2004 at 14:

Mutual funds have won trillions of dollars in investments from consumers who chose funds over competing banks, insurers, and other financial service providers. Any problems came despite, or perhaps because of, 60 years of pervasive federal regulation. The first question we ought to ask, then, is do we really need more mutual fund laws — or just better enforcement of the ones we already have?

See also, to the same effect, Henry Manne, What Mutual Fund Scandal?, Wall St. J., Jan. 8, 2004, at A22.

So did Paula Tkac, writing in the WSJ. As I noted at the time:

Paula Tkac writing in today's WSJ that the follies with the SEC's mutual fund independent director rule * * *make this a good time to recognize that open-end mutual funds don't need such directors anymore than do "service-providers such as lawyers or automotive technicians."

Tkac notes that, since customers can withdraw funds at current net asset value, "mutual fund advisers have fewer opportunities to harm fund investors, and investors can do much more to protect themselves and discipline management than in a typical corporation." Also, mutual fund investors easily can "compare the services they receive, net of the fee paid, with those offered by other funds or alternative investment vehicles."

Nor are individual investors unsophisticated. After all, they promptly sold the funds like Putnam, Janus and Invesco that were involved in the mutual fund scandals and bought funds in families that had clean records." Tkac concludes that "there is reason to consider removing board oversight of fees. We might even contemplate eliminating the legal mandate to have mutual fund boards at all."

And even Don Langevoort was on board in the article discussed earlier, which I discussed at the time. Langevoort noted:

Mutual fund investments are products – no different, really, from health care, insurance, bank deposits, residential real estate and other important settings where consumers are often less than diligent. In fact, because of securities regulation and the sophistication of the financial media, the transparency in the mutual fund area is probably superior to that for most of those other important household decisions.

Langevoort argued that the fiduciary and consumer characterizations were inconsistent. But I was skeptical:

why not have state competition as to mutual fund governance, as we do about corporate law, with federal regulation limited to disclosure. The states could recognize the differences between corporations and mutual funds and legislate accordingly, including as to rules for dismissal of derivative suits. Mutual funds would still be products, but the product would include these state governance rules.

The NYT article makes much of briefs filed by Ayres, Litan, and Mason, and by the federal government, highlighting investors' judgment errors and lack of information, and the difference between the deal ordinary investors get and what investment advisors charge pension funds. But as Easterbrook's opinion quoted above noted: "Different clients call for different commitments of time. Pension funds have low (and predictable) turnover of assets."

The NYT article concludes:

When public sentiment, economic research and even Judge Posner argue for more vigorous judicial examination of whether compensation is fair, the Supreme Court may just agree.

The ramifications of this case potentially extend well beyond the Court's holding, whichever way it goes. If consumers of mutual funds can be counted on to judge these products, why not other, less sophisticated products? Or why not corporations, as I asked in my post on the Langevoort article:

Next question: how is this different from corporate law? Not because of investor judgment biases, because surely investors in corporate stock suffer from analogous defects – indeed, probably more, because they're investing in individual stocks rather than rationally buying the market. The difference goes to the redemption mechanism, but this is an endogenous governance rule – one of the many variations one might expect among different investments.

Bottom line: Mutual funds are like corporations.  They are both products.  And they are both fiduciary relationships.  Neither should be subject to federal regulation of internal governance.

On the other hand, I suspect that in this day and age the Supreme Court will side with Posner. Such a decision would be a symptom and signal of our sharp turn toward paternalism in everything from complex finance to corporate governance to the simplest products.

Update:  William Birdthistle, who's been leading the charge for reversal in Jones, responds.

Mad Men

The new season starts tonight, but I won't be watching. I came late to the series and immediately got addicted. Since we've only made it halfway through season 2, I'll have to put a few episodes in the bank and wait for Netflix to catch up.

In the meantime, I have a few thoughts. In brief, although the nostalgia is interesting (hey, I actually lived through this era) the writers' take on business interests me more.

Readers will recall that I have an interest in how business is portrayed in film (here's the long recently updated version). My theory is based on film and doesn't deal in detail with television or other art forms. But Mad Men has gotten me thinking about artists in general. In general, artists are allergic to business. But why? Isn't there a kind of art in what businesspeople do?

My nascent theory is that artists are inclined to view business as not just different from but antithetical to what they do. Artists (at least modern artists) are into self-expression. In other words, they're inherently selfish. Business people, on the other hand, are into selling. This means they have to discern other people's wants and cater to them. Artists call that selling out.

Now, one might also call the business perspective the opposite of selfish – say, altruistic. Of course artists don't see themselves that way. Modern artists – at least the sort that are inclined to write for television – are inclined toward Herbert Marcuse's neo-Marxian view in One-Dimensional Man (1964) that business, rather than catering to people's real needs, creates fake ones.

Which brings me to Mad Men. The show is set in the early 60s, just when Marcuse's theories were coming into vogue. People were questioning the 50s consumer culture. There's a scene that forces the main Mad Man (Don Draper) to deal with a bunch of Marcusian beatniks who challenge him to defend his life.

Most interesting (for me) are the scenes that show Draper doing his job. Draper's artistic crew tend to have a pedestrian approach to selling – figure out what the consumer wants, and promote that. What makes Draper seem brilliant is that he's always a step ahead: figure out what people want to want – that is, their dreams about themselves – and sell that. For example, to sell an airline, Draper's guys figure that men fly, men like sex in the sky, so show them stewardesses' short skirts. Draper says men want to think of themselves as family guys. So show the little girl asking, "what did you bring me daddy." Draper sells Kodak's Carousel the same way -- as a device for showing a gauzy version of the lives men would like to think they're living with their families.

Of course there's some truth to this view of advertising, but is it really so bad? Advertising increases aggregate demand, so we're all richer. Isn't it great that somebody's helping us figure out what to want? And Draper, at least, often shows us a better version of ourselves – sort of like religion.

But I suspect this isn't the intended message. What we're supposed to take away from this show – one of the most well-made and popular television shows that is really about business – is that business is about manipulation.

And of course there are policy implications. Given this "inside view" of what business is doing, shouldn't we regulate it?

The irony, of course, is that Mad Men is selling us a dream – a dream about business.

The post-Madoff SEC

A couple of weeks ago I explained the SEC's sudden decision to go after non-fraudulent executives of firms that had restated earnings by noting:

One may wonder why this provision hasn’t been used until now. One possible reason is that new SEC Chair Mary Schapiro wants to show that the agency that could ignore Madoff should not be shuffled out of existence in the looming reorganization of financial agencies. At least it has some teeth, even if they get sunk into a wholly innocent executive (or Mark Cuban).

Well, today we learn from the WSJ:

The Securities and Exchange Commission is reeling off a string of enforcement moves against high-profile companies and individuals as it tries to establish what its new enforcement chief calls a "sense of urgency." * * * SEC Chairman Mary Schapiro and enforcement director Robert Khuzami are trying to repair the agency's reputation, which has been battered in recent years. The agency was taking a longer time to bring cases and failed to stop the multibillion-dollar investment scheme pulled off by Bernard Madoff before he confessed in December.* * *The changes come a few weeks before the SEC's inspector general is expected to release a critical report on the SEC's handling of the Madoff matter.

The Inquirer on law firms

I’ve been writing for awhile (e.g., here) on the big problems of Big Law.  Today some of my ideas got into this article in the Philadelphia Inquirer.

Class action avenger: a good idea from Ted Frank

ATL has a cool interview with Ted Frank about his cool new public interest law firm that is planning to represent consumers unhappy with class action settlements.
Of course the problem with contesting these settlements is that nobody has the economic incentive to do so.  But Ted has been

approaching a variety of philanthropists and philanthropic organizations, and I so far have received a very generous grant that should provide funding for the first few months. Of course, I'm happy to hear from anyone wanting to make a tax-deductible contribution.

It would be nice if there were enough money in this good work to attract private investors.  The problem is that the suits with the bad settlements may not have been any good in the first place.  Take away the excessive fees, as Ted is trying to do, and you decrease the incentive to bring the cases in the first place.  But if nobody can easily internalize the benefits, you need to have some kind of charitable or public financing.

So here's to Ted, and the people who fund him.

Decoupling: a good idea from the UK

Lord Myners, the U.K. minister overseeing London's financial center has suggested that shareholders should be able to buy and sell their voting rights:

"Some shareholders who never vote could sell their voting rights to others who do want to vote," he said in an interview last week. "That would introduce some market discipline into voting. It would have to be limited -- voting could not go beyond two votes per share, say.

There's some disagreement, of course:

Of Lord Myners's proposal to buy and sell voting rights, Alain Grisay, chief executive of U.K. fund manager F&C Asset Management, said: "Renting the right to vote would potentially open the floodgates to all sorts of trouble. That sort of practice is no longer tolerated in the public life of any functioning modern democracy, so I suspect most people would be deeply uncomfortable with it being introduced into the business world."

For an economic rationale favoring decoupling of ownership and vote, see my article with Bruce Kobayashi.

I don't understand why the proposal "would have to be limited."  Bruce and my rationale for decoupling is that in some situations enabling a bidder for control to amass voting rights without buying the underlying stock can facilitate efficient transactions.  But this can happen only if the vote buyer can aggregate significant rights.

And of course the criticism that this is "undemocratic" is nonsense.  Voters in a democracy have stakes in their countries that corporate voters do not have.  A business is not a political entity.  At least not yet.

Report on Illinois admissions

The Mikva Commission report is out.  Brian Leiter has an excellent analysis.

John Hughes: the man who put Shermer, Ill. on the map

He died of a heart attack yesterday in NYC.  That will teach him for leaving Chicago, where he lived and made his movies.  He made one great film (in my opinion) -- Home Alone. 

I mention him here for two reasons.  First, he was the greatest filmmaker ever to work in the north suburbs of Chicago, which is where I'm from.  My old high school, New Trier, even made it into some of his films. 

Second, he has some relevance to my theory of capitalism in film.  The bottom line is that you don't find the standard anti-capitalist theme in his movies.  I've wondered whether that was because Hughes managed to keep himself out of Hollywood -- and therefore whether the So-Cal mindset has something to do with that pervasive theme in film. 

Hughes' films may have been escapist fantasies, but they were grounded in the midwest, not the closed world of movieland.  In other words, they were more real than most of what comes out of Hollywood, even if they were set in a fictional place. 

Spitzer, AIG and the crash

The WSJ puts yesterday’s $15 million SEC settlement with AIG’s Hank Greenberg into perspective:

More than four years later [after Eliot Spitzer filed fraud charges against Greenberg], the federal government has decided that it cannot even make a civil case for fraud against Mr. Greenberg, never mind a criminal one. The SEC has essentially settled with Mr. Greenberg on the charge that he was the CEO at the time that “material misstatements” in earnings occurred. As the WSJ notes, the mistatements “add up to less than 1% of AIG’s net income during the period at issue. . . [and] represent less than 10% of the restatement AIG filed to justify the Greenberg firing demanded by Mr. Spitzer. The impact on retained earnings was roughly $250 million, when AIG’s total retained earnings at the time were approaching $70 billion.”

On the other hand, consider the costs of this prosecution.  As the WSJ notes, the charges led to Greenberg’s removal from AIG, which led directly to loss of its AAA credit-rating, a foundation of its financial business. It also left the company Greenberg had built without his firm hand or a competent successor. The result was AIG’s disastrously increased bets on the housing market. As I noted (discussing Michael Lewis’s recent article on AIG):

Lewis’s article does break new ground in explaining in more detail why this happened. Lewis blames everything on Joe Cassano, head of AIG Financial Products, whom Lewis dubs “the man who crashed the world.” According to Lewis, Cassano was not a financial wizard – just a back office guy with “a real talent for bullying people who doubted him.” He became ascendant when the man who put him in power, and who could control him (Hank Greenberg), was forced to resign by Eliot Spitzer (so, hey, let's blame all this on Spitzer).

The bottom line:  if Joe Cassano was the "man who crashed the world," Spitzer was the guy who gave him the keys to the car. And all this for his supposed non-fraudulent responsibility for a barely material (if that) accounting mistake, plus, of course, the boost to Spitzer's then career. 

Specter tries to resurrect Stoneridge and himself

Arlen Specter, the Democrat-Republican-Democrat who wants desperately to keep eating in the Senate dining room at least until he’s 85, has introduced a bill to reverse Stoneridge and expand the parties shareholders can sue for securities fraud. The Glom has a discussion and useful links, including to Steve Bainbridge's useful analysis.

I’m no fan of aiding and abetting liability. However, as I wrote at the time of the decision, I didn’t like Stoneridge because of its misguided reliance on the reliance requirement rather than delineating the “conduct gives rise to a 10b-5 cause of action, and how that conduct must be connected to the deception of investors.” I also criticized the Court for straying too far into the policy arguments on the appropriate scope of liability rather sticking to interpreting the statute. Thus, I concluded:

Legal niceties aside, the Court has managed to send the issue of secondary liability to Congress, which is where it belongs.

So now the issue is in Congress.  But let’s hope this particular bill ends up just being grandstanding by Specter, who is finding that even being a Democrat is no sure path to political salvation.

Dean Hurd's statement on Illinois admissions

Apropos of my post last month on the Tribune’s coverage of the admissions flap at Illinois, Heidi Hurd has posted a statement that provides a much-needed perspective. Read the whole thing.

The SEC, Congress and SOX 304

There seems to be an emerging consensus to go after the SEC for going after Maynard Jenkins under SOX 304 even though he’s not accused of misconduct. The latest example is former SEC enforcement lawyer Russell Ryan, writing in today's WSJ, who says the SEC is “push[ing] the envelope" of the provision.

Frankly, I don't get it. Here, again, from my post a couple of weeks ago, is the language of SOX 404:

SEC. 304. FORFEITURE OF CERTAIN BONUSES AND PROFITS. (a) ADDITIONAL COMPENSATION PRIOR TO NONCOMPLIANCE WITH COMMISSION FINANCIAL REPORTING REQUIREMENTS.--If an issuer is required to prepare an accounting restatement due to the material noncompliance of the issuer, as a result of misconduct, with any financial reporting requirement under the securities laws, the chief executive officer and chief financial officer of the issuer shall reimburse the issuer for-- (1) any bonus or other incentive-based or equity-based compensation received by that person from the issuer during the 12-month period following the first public issuance or filing with the Commission (whichever first occurs) of the financial document embodying such financial reporting requirement; and (2) any profits realized from the sale of securities of the issuer during that 12-month period.

The only reference to “misconduct” is clearly that of the issuer, not of the reimbursing executive. One could argue that the SEC should not use the authority it clearly has. But how can the SEC’s position in this case be viewed as “pushing the envelope” of the statute?

As I made clear in my last post, I don’t like this provision. But let’s put the blame where it belongs: on Congress, which enacted this misbegotten statute.

This is important because Congress is being asked to address another financial crisis. We shouldn’t assume that any Congressional errors will and ought to be corrected by the enforcing agency, and then blame that agency when it uses the authority Congress gave it. We should ask and expect Congress not to blow it again.

Two briefs arguing unconstitutionality of PCAOB

From Cato, Henry Butler and me . . . and from some other law professors. 

Tales of Hoffmann

Gordon Smith has an interesting post on an article by Whitford and Macaulay on the famous contract law case of Hoffman v. Red Owl Stores.

As Gordon says, the case is “usually credited both with expanding the reach of the promissory estoppel doctrine and with opening up the issue of liability for precontractual reliance.” Bob Scott characterizes the case as an “outlier” in his Hoffman v. Red Owl Stores and the Myth of Precontractual Reliance, 68 Ohio St. L. J. 71, 101 (2007).

Whitford & Macaulay have found the plaintiff and gotten from him a story of a promise made by Red Owl in addition to those the court relied on. They say:

[i]f a jury believed Hoffmann's [correct spelling] testimony that Lukowitz [Red Owl’s district manager] said that the people at the home office had told him that the "only hitch" to Joe being granted a franchise was the sale of the bakery, we think the jury could reasonably find the statement to be a promise.

Gordon finds particularly interesting the agency issue:

Although Red Owl is treated as a single person for purposes of this lawsuit, it's worth remembering that Red Owl has multiple decision makers in the hierarchy. My guess is that none of them had a strong incentive to approve this deal. Certainly, we wouldn't expect anyone above Lukowitz to get a commission (and Whitford and Macaulay note that even Lukowitz may not have had that sort of incentive). While these middle managers have some incentive to grow the company, they often have a bigger incentive to avoid mistakes than to pursue gains. Think of it this way: if the store failed, the obvious question for HQ would be, "who authorized this?" If, on the other hand, the store succeeded, HQ would be less likely to focus on who authorized the store and more likely to focus on who found Hoffmann (i.e., Lukowitz). Thus, the middle managers and Lukowitz have asymmetric incentives, and I suspect that these incentives account for Lukowitz's excess zeal and HQ's excess caution.

With that background, I want to focus on two important problems raised by the Whitford/Macaulay article.

First, why should we care about the newly discovered facts? This is a big problem with the current infatuation with storytelling – the frequent failure to articulate why these stories matter. Whitford & Macaulay assert that the new facts support the result in the case. Even if that's true (as I note below, I doubt it), so what? As legal analysts, the case matters to us because it’s law. What makes it law is the court's holding, which turns on the facts the court articulates rather than on the additional facts Whitford & Macaulay discover. We might now rest easier that justice was done in the actual facts of the case. But Hoffman (or Hoffmann, or whatever) warrants discussion only because of its role as law, and the new story is completely irrelevant to that.

Indeed, W & M note that

it is usual to interpret a precedent as though the facts of the case are those stated in the opinion. * * * We agree that because the Court does not explain why Lukowitz’ statements about the $18,000 should be considered a promise rather than a mere opinion or enthusiastic encouragement, the opinion does not help explain the limits on precontractual reliance.

That's right.  So why, then are the additional facts helpful in analyzing the case?

The second problem concerns agency law. The basic question for agency law is whether the principal or the third party is in the best position to protect against the type of agency costs Gordon discusses. In Hoffman(n) it was likely the third party. By the time Whitford & Macaulay say the newly uncovered representation was made (October), Scott points out that “Hoffman knew well that their approval and not Lukowitz's was the key to securing the franchise.”  It would follow that the question is whether Lukowitz had the authority to represent the HQ managers’ statements.

Indeed, Scott points out (at 96) that one of the central problems with Red Owl’s attorneys’ defense of the case is that they failed to raise the issue of Lukowitz’s authority. Scott notes (n. 103):

Restatement (Second) of Agency § 136(1) (1958) provides that an agent's apparent authority is terminated “(a) when the principal states such a fact to the third person.” Thus, the key question was whether Hall and Carlson indicated directly or indirectly to Hoffman that Lukowitz had no authority to make financial representations on behalf of Red Owl. Clearly, Hoffman had reason to know that this was so.

I haven’t researched that question here. My point is that the issue is both important and neglected in Whitford and Macaulay’s account. More importantly, I think that neglect of agency law issues is a general problem with modern legal analysis.