Ideoblog

The SEC’s Madoff report

The executive summary of the report is one of the more remarkable government documents I've ever read. Anybody even slightly interested in the question of whether the government is an effective fraud regulator needs to read this document – and the longer report when it comes out. In the meantime, I can't help sharing

First, the bottom line:

The OIG found that between June 1992 and December 2008 when Madoff confessed, the SEC received six substantive complaints that raised significant red flags concerning Madoffs hedge fund operations and should have led to questions about whether Madoff was actually engaged in trading. Finally, the SEC was also aware of two articles regarding Madoff's investment operations that appeared in reputable publications in 2001 and questioned Madoff's unusually consistent returns.

The OIG also found that numerous private entities conducted basic due diligence of Madoff's operations and, without regulatory authority to compel information, came to the conclusion that an investment with Madoffwas unwise.

Apropos of my post in January that the SEC was essentially an unwitting accessory to the Madoff fraud, consider this:

We also found that investors who may have been uncertain about whether to invest with Madoff were reassured by the fact that the SEC had investigated and/or examined Madoff, or entities that did business with Madoff, and found no evidence of fraud. Moreover, we found that Madoff proactively informed potential investors that the SEC had examined his operations. When potential investors expressed hesitation about investing with Madoff, he cited the prior SEC examinations to establish credibility and allay suspicions or investor doubts that may have arisen while due diligence was being conducted. Thus, the fact the SEC had conducted examinations and investigations and did not detect the fraud, lent credibility to Madoffs operations and had the effect of encouraging additional individuals and entities to invest with him.

Madoff had a field day with the woefully ignorant and inexperienced investigators the SEC sent to deal with him, "captivating" them with wonderful stories and name-dropping. (One key investigator "had been involved in very few investigations overall. The Madoff assignment was also her first real exposure to broker-dealer issues.") When investigators did act astutely and responsibly they were pushed back by their superiors.

Although the NERO examiners determined Madoff was not engaged in frontrunning, they were concerned about issues relating to the operation of his hedge fund business, and sought permission to continue the examination and expand its scope. Their Assistant Regional Director denied their request, telling them to "keep their eyes on the prize," referring to the front-running issue.

For the SEC, of course, the "prize" is any hint of unfairness or advantage, akin to the agency's obsession with insider trading. Massive fraud apparently isn't their concern.

So ignorant of finance were the SEC's investigators that they bought the most amazing explanation for how he made his profits:

Essentially, Madoff claimed his remarkable returns were due to his personal "feel" for when to get in and out of the market, stating, "Some people feel the market. Some people just understand how to analyze the numbers that they're looking at." Because of the Enforcement staff's inexperience and lack of understanding of equity and options trading, they did not appreciate that Madoff was unable to provide a logical explanation for his incredibly consistent returns. Each member of the Enforcement staff accepted as plausible Madoffs claim that his returns were due to his perfect "gut feel" for when the market would go up or down.

How negligent was the SEC? Try this:

During his testimony, Madoff also told the Enforcement investigators that the trades for all of his advisory accounts were cleared through his account at DTC. He testified further that his advisory account positions were segregated at DTC and gave the Enforcement staff his DTC account number. During an interview with the OIG, Madoff stated that he had thought he was caught after his testimony about the DTC account, noting that when they asked for the DTC account number, "I thought it was the end game, over. Monday morning they'll call DTC and this will be over ... and it never happened." Madoff further said that when Enforcement did not follow up with DTC, he "was astonished."

This was perhaps the most egregious failure in the Enforcement investigation of Madoff; that they never verified Madoffs purported trading with any independent third parties. * * *

A simple inquiry to one of several third parties could have immediately revealed the fact that Madoff was not trading in the volume he was claiming. The OIG made inquiries with DTC as part of our investigation. We reviewed a January 2005 statement for one Madoff feeder fund account, which alone indicated that it held approximately $2.5 billion of S&P 100 equities as of January 31, 2005. On the contrary, on January 31, 2005, DTC records show that Madoff held less than $18 million worth of S&P 100 equities in his DTC account. Similarly, on May 19, 2006, the day of Madoff's testimony with the Enforcement staff, DTC records show that Madoff held less than $24 million worth of S&P 100 equities in his DTC account and on August 10, 2006, the day Madoff agreed to register as an investment adviser and the Enforcement staff effectively ended the Madoff investigation, DTC records showed the Madoff account held less than $28 million worth of S&P 100 equities in his DTC account. Had the Enforcement staff learned this information during the course of their investigation, they would have immediately realized that Madoff was not trading in anywhere near the volume that he was showing on the customer statements. When Madoff's Ponzi scheme finally collapsed in 2008, an SEC Enforcement attorney testified that it took only "a few days" and "a phone call ... to DTC" to confirm that Madoff had not placed any trades with his investors' funds.

The summary concludes

As the foregoing demonstrates, despite numerous credible and detailed complaints, the SEC never properly examined or investigated Madofi's trading and never took the necessary, but basic, steps to determine if Madoff was operating a Ponzi scheme. Had these efforts been made with appropriate follow-up at any time beginning in June of 1992 until December 2008, the SEC could have uncovered the Ponzi scheme well before Madoff confessed.

Update: The full report is out (at the beginning of Labor Day weekend). Some highlights reported by the WSJ:

25 people, including some who reinvested directly with Mr. Madoff after the SEC action against the accountants, "knew of and relied upon the SEC's 1992 public statement that there was nothing to indicate fraud" in deciding to invest with Mr. Madoff.

Senior examiner John McCarthy told the inspector general that it wasn't a mistake to focus solely on front-running "because that's where my area, my team's area of expertise led," according to the report.

One anonymous complaint directed the SEC to a "scandal of major proportion" by the Madoff firm and said assets of a specific investor "have been 'co-mingled' with funds controlled by the Madoff firm. The SEC called Mr. Madoff's lawyer and had him ask Mr. Madoff if he managed money for that investor. When the lawyer said Madoff didn't, the complaint wasn't pursued further. The IG report concludes that "accepting the word of a registrant who is alleged to be engaged in a specific instance of fraud is an inadequate investigation."

I may have more when I've had a chance to read the report.

The demand for law school

The carnage at law firms over the last several months suggests to many that something's got to give at law schools.

• Dan Slater says that "many law schools appear to profit from what may charitably be called an inefficient distribution of market information." He thinks they're misleading students about the prospects for high paying Big Law jobs, leading them to borrow big.
• David Lat, discussing changes in the law market, suggests making law school cheaper, fewer law schools, more field training.
• Bill Henderson criticizes law schools' high-cost business model in the face of clients "fundamentally changing how they value and buy outside legal services." He attributes market blindness to law student "overconfidence and the reflexive desire to impress others through the acquisition of positional goods;" banks ignoring repayment risk; law schools' misguided concern about US News rank; and the ABA's failure to ensure dissemination of proper employment data.
• Steve Bainbridge says that law schools have to adjust to the fact that law is a "mature business" whose growth rate will decline. As a result, "we have to reduce the number of law schools." But, unlike Slater and Henderson, Professor B trusts the market: "Once word filters out to pre-law students about the state of the job market, maybe they'll start looking elsewhere."

There's obviously a problem here, but I don't think this punditry quite captures it. Law students are not misguided or irrational. Law schools may not be giving them the full scoop, but I think students are seeing through these stories and making pretty sophisticated judgments about the costs (including opportunity costs) and benefits of legal education.

Look at it this way: Assume for illustration purposes that a legal education buys you an annuity of $25,000 (over and above wages without legal training) which can be expected to grow over a lifetime at .5% a year, with a 3% discount rate. Under these assumptions, a legal education has a present value of $1,000,000. At $50,000/year tuition plus career opportunity costs, this looks like a decent investment regardless of assumptions about the future of law.

To be sure, law students have to borrow a lot and may be in trouble repaying if that big law job doesn't materialize after law school. But the law students who made the choice over the last year or so couldn't know the problems they would be facing. The law students who are making the choice now might reasonably assume that the economy, and therefore the law market, will improve by the time they get out. Moreover, the bad economy reduces the opportunity costs of a legal education. Legal education always has been counter-cyclical.

In fact, one might go further and say that if law students are getting themselves in over their head, the problem is with too few financing opportunities, not too many as some have suggested. In a perfect market, if a legal education is a positive net present value investment, law students should be able to finance it.

Thus, legal education is not a bad investment. Nor is law a mature industry as Bainbridge argues. To the contrary, it is a growth industry. Think about the exponential growth of the regulatory state, important new technologies that challenge the frontiers of property rights, increasingly sophisticated financial markets and business devices, among many other things, that cry out for law-trained people. As Bainbridge says, "[s]ociety still needs lawyers and we still need law schools." But contrary his statement that "[w]e just don't need as many as the American legal academy now produces," I would say we need more.

The problem is not with law generally, but with existing mechanisms for delivering legal services. This includes, among other things, the basic model of one-on-one legal advice and the big law-only firm, all locked in place by outmoded ethical rules. I discuss the problems with these legal services models and propose new models in my recently posted Death of Big Law.

New ways to deliver legal services obviously require new approaches to legal education. As discussed in my article just referred to, this includes better integrating law with other fields, including business, technology and other fields.

Here Bill Henderson's post has it right:

To my mind, the proper response is for law schools to really think through how they can maximally enhance the human capital of law school graduates.  * * ** * *[W]hat type of law school curriculum and teaching methods are really worth the price paid by today's students?  * * *

I also agree with him that "[t]he schools that rise to this challenge are, in the long run, going to fare better."

However, I disagree with Henderson's argument that the winning model of legal education is to separate itself from the academy and more closely align with the profession. Rather, the tradition-bound profession needs intellectual leadership to bring it into the new era of law practice that it is not currently getting from legal educators. We need deep thinking now more than ever. But we also need a different type of deep thinking that does not take for granted that our students will be doing the same things they always have. The schools that see this will be the ones that survive the current upheaval.

The Death of Big Law: Hot off the press

I've posted a draft of the work in process I've been referring to over the last few months, The Death of Big Law. Here's the abstract:

Large law firms face unprecedented stress. Many have dissolved, gone bankrupt or significantly downsized in recent years. These events reflect more than just a shrinking economy: the basic business model of the large U.S. law firm is failing and needs fundamental restructuring. There are at least three prerequisites to establishing the viable large legal services firm of the future. First, the firm must own a core of durable, firm-specific property. Second, the firm must be able to secure non-lawyer financing in a variety of forms. Third, coherent legal structures must evolve that are suitable for large law firms. Big Law's ability to meet these conditions is contingent on significant changes in the regulation of law practice. The article discusses the current stresses on Big Law, potential business models for legal services, and the forces that may usher in the introduction of these models.

I'll be presenting this paper at various venues and discussing here over the next few months. Comments welcome.

Update:  For a comment on the paper see Bruce MacEwen (Adam Smith, Esq.)'s newsletter.

Corporate speech in the Supreme Court

The WSJ has a timely article on the case about the Hillary movie (Citizens United v. FEC) which will be argued at the Supreme Court next week. So did the NYT last week. The Supreme Court ordered the case reargued after the ramifications of the government's argument became evident at oral argument. Basically, the government seemed to be arguing that McCain-Feingold could be applied to criminalize corporate financing of a political book.

I have not yet had a chance to delve deeply into this case, though I plan to. Here I just want to call attention to my article, Corporate Political Speech, 49 Wash. & Lee L. Rev. 109 (1992), which focused on the 1990 Austin case that the Court is now considering overruling. I argued 16 years ago that that case was totally misguided, and I continue to believe that.

My article addresses all of the arguments for stifling corporate speech and finds them all wanting under the balancing the First Amendment requires. It should be obvious, for example, that we do not need campaign finance laws to protect corporate shareholders from managers.

The critical question is whether enabling corporate political speech would give too much power to corporations. The Austin Court accepted the proposition that the mere possibility some speakers will speak louder than others does not justify a restriction on political speech. The question boils down to whether some special problem with corporate speakers justifies this restriction. Here's what I had to say on that issue in my 1992 article (49 Wash. & Lee, 147-50, footnotes omitted):

[T]here is no reason to believe that unrestricted corporate speech would lead to massive wealth transfers to for-profit firms. In the first place, the "by-product" theory of collective action, in which firms use surplus from noncollective activity to support political action, applies to both for-profit and "ideological" firms. Many ideological firms grow large and powerful by combining selective incentives and political goals, such as the outdoor activities offered by the Sierra Club. Labor unions and farm groups in particular have amassed considerable membership by offering economic benefits, such as insurance, that are separate from the organizations' political goals. In fact, it is often difficult to determine whether membership in such groups is motivated primarily by selective incentives, ideology or other considerations.

Moreover, even if for-profit firms have more surplus potentially available for political activity than do nonprofit firms, the former's political advantage cannot be determined without comparing the firms' opportunity costs for their surplus. Corporate managers who are acting in their principals' interests will invest the firm's surplus in nonpolitical activities if its risk-adjusted return from doing so exceeds that from investing in political activities. For-profit firms that extensively engage in productive activities probably face significantly higher opportunity costs for their surplus than do nonprofit firms that engage primarily in political activities.

Imperfectly disciplined managers may invest surplus in political activities if they will personally gain from doing so, even if the firm does not. But there is no reason to believe that even imperfectly disciplined for-profit managers will systematically gain more from political investments than from nonpolitical investments given their ability to divert financial gain from nonpolitical investments to themselves through excessive compensation and the like. Indeed, managers in for-profit firms are less likely to prefer political investments for selfish reasons than those in ideological firms given the for-profit managers' significant opportunities for financial gain.

Even if for-profit firms have some advantage under the "by-product" theory in generating surplus for collective action, ideological groups may be able to overcome this advantage by organizing at lower cost because of forceful leaders who serve as "political entrepreneurs" out of initial commitment to a cause; because many members have sufficient moral or political commitment to the cause or group that they are willing to incur the costs of membership without being offered selective incentives; because geographical proximity of members makes the group relatively easy to organize; or because interest groups offer social or relational incentives to join or provide "prominent" rallying points for people with shared ideologies. Moreover, interest groups' ability to compete in political markets does not depend solely on financial resources. First, some organizations, such as civil rights groups, have had a significant impact primarily because their members contribute time to such activities as marches and vote drives.

Second, groups may be strong simply because politicians realize that a comparatively small membership may, precisely because of the difficulty of collective action, represent a much larger supply of votes. Third, groups' influence depends partly on their ability to coordinate their activities. Accordingly, labor PACs may be able to compete effectively with corporate PACs because, like a cartel, they are better able to concentrate their resources on, and therefore control, particular politicians. To illustrate, suppose an ideological firm has only $.50 of surplus that is potentially available for political activity, while a potential transferee for- profit firm has $.60. The ideological firm may be able to outbid the for- profit firm where, for example: (1) the for-profit firm has a much higher- value use for $.10 of its surplus; (2) the ideological firm can cheaply raise an additional $.10 of political capital; and (3) the ideological firm can bid nonfinancial resources to offset the remaining $.10 difference.

In light of the significant power of noncorporate interest groups, restricting corporate speech may upset or prevent a desirable equilibrium among competing interest groups that otherwise would exist. Madison recognized at the time of the drafting of the Constitution not only the inevitability of "factions," but also that in a large republic no single faction could dominate.

Gary Becker has shown that interest group competition may cause laws to be Kaldor-Hicks efficient because some interest groups offset the influence of others. As government subsidies rise, so do benefits to transferors from resisting the subsidies. At the same time, transferees' benefits decline because they share the increasing dead- weight costs from the subsidies. Thus, unless a particular group is very effective at seeking influence, the competition among groups tends to produce laws whose benefits outweigh their costs. For example, law efficiency may have increased as environmentalists and customers became more organized, and therefore more able to counteract the power of polluters and producers. Conversely, there may be significant efficiency benefits from allowing corporations to act as a counterforce against other interest groups and political agents.

Even if corporations' political strength is somewhat disproportionate to their popular support, this is a long way from showing that full participation of corporations would dominate other views. Rather, the argument reduces to one that corporate power should be distributed to other groups.

Obviously the winners will prefer this outcome, but that alone does not make the laws restricting corporate speech constitutional.

I expect to have more to say as this interesting case goes through oral reargument to decision.

State competition for health insurance

Last week the Wall Street Journal suggested state competition as a possible alternative to the public option for reducing health care costs. The Journal quoted a recent exchange between the AARP's John Rother and Fox's Chris Wallace.

Mr. Wallace: "If you really want competition why not remove the restriction which now says that if I live in Washington, D.C. I've got to buy a D.C. health plan, and instead create a national market for health insurance, so that if there's a cheaper plan in Pennsylvania, I could buy in Pennsylvania?"

Mr. Rother: "There are states and localities where health care is much less expensive than others, and if we allow people to buy all their insurance from those places, it will raise the rates there. And it's called risk selection. It's a real problem, given the fact that health care costs can vary substantially from one place to another. So I think while the idea sounds appealing, the consequence would be it would make health care more expensive for those people who live in those low-cost areas."

The Journal responded to Rother that the high price of NJ insurance comes from NJ regulation. State competition would mitigate these regulatory costs and let consumers decide what they want to pay for. Arizona Rep. Shadegg, who initially proposed this idea in 2005, would protect high risk insureds with government funded risk pools. Rother's "risk selection" problem would be addressed by eliminating mandates that cause healthy people to opt out of health insurance.

The article concluded:

Interstate competition made the U.S. one of the world's most efficient, consumer driven markets. But health insurance is a glaring exception. When the competition caucus in Team Obama has to look for Plan B, this is it.

A letter to the WSJ published today responds:

That solution is unworkable. It would require enacting legislation repealing or modifying the McCarran-Ferguson Act, which allows states to regulate the "business of insurance"—a daunting task that would depend on overcoming the objections of those who champion states' rights, among others.

Yes, that's true – the solution would require dealing with McCarran-Ferguson. But that doesn't lead inexorably to federal regulation. Henry Butler and I have proposed in a working paper and shorter version in last winter's Regulation how to reform insurance regulation so as to get to state competition for insurance. Here's the abstract for the longer paper:

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

Note that we don't propose to eliminate individual states' power to regulate the sale of insurance in their states, but rather to set ground rules on how states regulate. The goal is to balance states' power to regulate against the significant benefits of creating state competition and a national market.

Although our proposal does not deal with health insurance, its underlying reasoning applies in this context. It would be necessary to decide what states should be able to mandate in their states – in other words, to set federal maximum standards for state regulation. And even if states do retain some regulatory power, our proposal would emphasize competition and tend to erode inefficient regulation over time.

The issues are not simple. But our proposal provides a template for thinking through them that is more promising than any other approach out there.

Rise of the Uncorporation: Chapter 1

Chapter 1 of my book, Rise of the Uncorporation, is now available on SSRN. The book is expected out from Oxford University Press in about two months. Here's the abstract:

The analysis of business associations largely has been limited to corporations. Yet unincorporated firms, including general and limited partnerships and limited liability companies, comprise about a third of the firms in the US, and even larger percentages elsewhere in the world. The Rise of the Uncorporation covers the history, law, and finance of unincorporated firms. These "uncorporations" are now the dominant business form for non-publicly-traded firms. Moreover, through private equity, hedge funds, and publicly traded partnerships, uncorporations have emerged as a significant force in the governance of a wide range of large firms. The Rise of the Uncorporation is the first general theoretical and practical overview of the alternatives to incorporation. The book seeks to bring uncorporations into popular and academic debates that have previously focused only on corporations. This book also covers the ancillary concepts connected with the evolution of these uncorporations, and analyzes likely future trends in business organization.

The second coming of Hank Greenberg

More than four years ago Eliot Spitzer was responsible for Hank Greenberg's departure from AIG. As I said In August 2005, reporting on the decline in AIG's stock price since then, "history will probably demonstrate that AIG was better off with him in charge, or trusting to corporate governance processes to replace him, than with Spitzer's political maneuvering."

I followed up here, and more recently suggested that Spitzer's improvident action may have helped trigger AIG's collapse, which figured prominently in the crash.

Today we learn via Dealbook:

Shares of the troubled insurance giant American International Group soared Thursday following a report that its new chief executive, Robert H. Benmosche, had sought a reconciliation with his estranged longtime predecessor, Maurice R. Greenberg. * * *Bill Bergman, a senior analyst at Morningstar, attributed Thursday's gains in the stock to "the notion that there's a reconciliation under way between Greenberg and the company." Mr. Bergman told Reuters that Mr. Greenberg could help attract new private capital investment to the company.

The rough beast of proxy access slouches toward Washington

Unfortunately, its hour seems to be come at last. Its opponents lack conviction (or at least votes), while its supporters (e.g., labor unions) are full of passionate intensity.

According to today's WSJ, "the measure [Rule 14a-11] looks like it will be passed by the Securities and Exchange Commission in November." It will allow mere 1% stockholders to put director candidates into corporate proxy materials, at the company's expense. SEC Chair Schapiro, who evidently holds the deciding vote with the Democrats and Republicans split 2-2, thinks this will bring more accountability, in the wake of the financial crisis.

John Carney once again disagrees:

Far from increasing the power of ordinary investors the move would have left them vulnerable to exploitation by special interests, especially union dominated pension funds. Shareholders don't really have an interest in companies being more democratic. * * * Proxy access dresses itself in the name of shareholder rights but it is really inimical to shareholder interests

I would add, as I said a couple of years ago:

the reason why the SEC should keep its hands-off here has more to do with the appropriate limits of SEC power than with the substance of the proposal. This is a matter of internal corporate governance which should be for the states. There is no justification for making this a federal matter unless you buy in to the shareholder democracy myth.

But there's hope. We saw when listings fled to London and elsewhere to escape SOX that even the federal government faces competition.

Moreover, these rules necessarily apply most directly to corporations. How do you regulate proxy access in uncorporations that don't have boards and don't have proxies? At some point tinkering with corporate governance will get so expensive that competitive capital markets and creative lawyers will find and exploit contractual alternative. The great thing is that these moves to the uncorporation could increase rather than decrease accountability. All this is laid out in The Rise of the Uncorporation, my book forthcoming from Oxford U Press in a couple of months.

So the headlong move to mess with corporate governance could have some positive effects. Things will fall apart, the center not hold, and anarchy will be loosed upon the world. I hope.

The death of hourly billing

The WSJ has an interesting article on the state of the billable hour. It confirms what most people suspect – it's declining – but has some notable details.

The article notes that clients spent $13.1 billion this year on alternative billing, vs. $8.6 billion last year, with a reported average cost savings of 15%.

The article suggests it's the current economy. The chairman of the Association of Corporate Counsel says "[l]aw firms are more receptive to change because they are in the business of needing legal work." Saul Ewing's managing partner says "[j]ust like the tech and housing bubbles, there was a legal-profession bubble, and now we are experiencing a correction."

But the decline of the billable hour is not just about the recession. After all, if demand goes down you cut your prices, meaning in this case hourly rates. But clients are demanding a change in the pricing method, away from the billable hour.

The billable hour has worked well for law firms. They just count lawyer hours and slap a profit on them. Historically, clients haven't been in a position to question that profit, because they haven't had a better way to control costs. But now with beefed up in house counsel offices, increased sophistication about what lawyers do, and competition from outsourcers, among others, clients are in that position, and there's no reason to think they'll revert to old practices when the economy improves.

The article suggests some implications for the lawyer market:

• Orrick "is employing some college graduates who can perform routine tasks at a lower cost."
• Orrick is "focusing less exclusively on hiring graduates from elite law schools, who can command starting pay of $160,000."
• A Sidley Austin partner told the reporters that Pfizer's switch from hourly to fixed fees meant they could assign more efficient senior associates rather than having to use juniors because Pfizer restricted hourly rates to no higher than those of second-year associates.

Doesn't sound too good for the entry level lawyer market.

How far will this go? According to the article, "[a]ttorneys say it is doubtful flat fees could ever supplant hourly billing for the most complicated and high-stakes matters, such as an antitrust fight with the government or a particularly tricky corporate merger, where it's too hard to estimate how much effort it will consume." But we're in early days for alternative billing. Certainly aspects of even the most complex litigation can be charged on a fixed basis, perhaps with bonuses.

The implications for Big Law are substantial. Fixed fee and other alternative billing make legal work more like a commodity and less like a specialized one-on-one service.

Even more importantly, hourly billing has been Big Law's profit engine for decades. If it ends, Big Law will have to adapt or give way to new kinds of firms.

What kinds of firms? I'm working on a paper tentatively titled "The Death of Big Law." Watch this space.

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.