John Carney is not sold on the endowment effect, and he has put together an entertaining 16-part post to convince you that "the Endowment Effect may really be a response to the counterparty risk faced by early humans."

I think John Carney is one of the most interesting business bloggers around, but I am not buying this. Why does he have to bring "early humans" into this story anyway? Why not just test people in a context with counter-party risk and compare them to a control group tested without counter-party risk?

The problem for John is that the experiments on the Endowment Effect do not create counter-party risk. The Endowment Effect appears in the lab even when counter-party risk is absent. And that is improper because ...?

According to John, these experiments erred by testing "subjects who had deeply ingrained, hard-wired counter-party risk discounting built into their behavior." As Brian Regan said about the Pop Tart directions, "I see where you're going with this ..."

So I will play along ... how do we know that people are hard-wired for counter-party risk, even when the transaction doesn't involve counter-party risk? At this point, John's version of evolutionary psychology looks a lot like religion, making assertions about human nature that are not susceptible to falsification. Of course, I have nothing against religion, as a general matter, but pardon me if I choose not to worship at this particular altar.

I thought John was going to take on behavioral economists for finding irrationality where none existed, but instead what I found is that he doesn't like the particular brand of irrationality manifested in the Endowment Effect. He prefers a different sort of irrationality that is deeply ingrained and hard-wired by evolution.

At the end of the post, I was still wondering: does it matter which form of irrationality we choose to believe? I don't think so. Slide 14 is entitled, "The Meltdown Shows The Endowment Effect Might Not Be Irrational At All." Nevertheless, two slides later, on the last slide, John is warning us against behavioral economists, and that's a message that resonates with Larry Ribstein.

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My co-author and deal professor par excellence Steven Davidoff is out with his first book this week.  Gods at War is about the transformation (continuation?) of dealmaking into something quite personality driven, with troublesome results.  But, in being an account of the latest boom and bust in M&A, it is about much more than that, with meaty takes on the material adverse change clause, the fall of private equity, and, not least, the importation of the deal perspective into the financial crisis. 

 

As Steve observes:

Highly recommended, and there's much more here.  I've seen the book in previews, my published copy is already on its way.  Indeed, I'd say that it's your top holiday choice.  At least, it certainly is one of them, but there are other candidates too, more about them to come.

While I'm at it, you should be looking at the DealBook crisis conference, in which Steve and I will be participating, along with luminaries like Gary Gorton, Lucian Bebchuk, Leo Strine, David Skeel, Lynn Stout, and a host of other luminaries.

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My friend Mitu Gulati, along with co-authors Stephen Choi, Mirya Holman, and Eric Posner, has posted a piece on SSRN that's generating some buzz, including a front page article on Slate (quotes are from the Slate piece--it's Monday, I know you need some punch).

Controversial point number one: "On average, female judges are less qualified, based on traditional metrics, than male judges. They have attended lower-ranked colleges and lower-ranked law schools, they are less likely to have had judicial clerkships (a prestigious job often taken by top law school graduates), and they have less experience in private practice before becoming judges."  

Still the sub-par performance as measured by traditional metrics didn't affect the female judges' performance: "Yet when it comes to performance rather than qualifications, we find no statistically significant differences between the decision-making ability of male and female judges in any of our data sets. Female judges are cited just as often as male judges; they write as many opinions; and they are just as likely to dissent, and to dissent from opinions written by judges who belong to their party." 

So the authors say female judges do the same work even if they're less qualified by traditional measures, from which they conclude that 1) women are, innately or by virtue of their experience, better judgers than men, 2) that the legal hierarchy's traditional measures of success don't work, or 3) that the study's empirics are off because it's not measuring judicial quality correctly. 

It's obligatory to attack the empirical methodology; I'll leave others to do that.  While the first explanation has obvious personal appeal for me, it's the second that I see as potentially more unsettling.  Law is a hierarchical world.  From the time an aspiring law student applies to a school to the day she retires, she's awash in a sea of rankings: how good a school did you go to?  What was your class rank?  Did you make law review?  Were you on the managing board?  Did you make Order of the Coif?  How good a clerkship did you get?  How prestigious is the law firm?  How long did it take you to make partner?  How much did you make?  How much did you bill?  What GS level are you? 

What if none of it really means anything?  Where are we then?

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Last Friday Rob Daines presented his paper (with Ian Gow and David Larcker) entitled Rating the Ratings: How Good are Commercial Governance Ratings? at the BYU Finance Department. I had seen this paper floating around, but I hadn't taken the time to read it until the seminar.

Wow! This paper is terrific.

The authors examine Audit Integrity, RiskMetrics (previously Institutional Shareholder Services), GovernanceMetrics International, and The Corporate Library and find little support for claims that these ratings can accurately predict future performance, risk, and undesirable outcomes such as accounting restatements and shareholder litigation.

In one sense, this is not surprising, given that the agencies generate dramatically different ratings for many firms. On the other hand, you might wonder, as I did, why firms buy these ratings. According to Rob, the answer seems to be twofold: the ratings can serve as a form of insurance in litigation (providing evidence of diligent investigation) and purchasing the ratings gives firms access to the underlying data, which may be valuable.

Highly recommended.

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This past summer, I went on a three-day backpacking trip to Yellowstone Backcountry with my three sons. For Yellowstone aficionados, we were on the Hellroaring Creek Trail. As we set out, we were all excited to see some wildlife, but I was not at all interested in seeing a bear. I have seen bears in the wild, and they scare me.

On our second day, a group of hikers on the other side of Hellroaring Creek motioned to us. They were yelling "Bear!" while pointing in the direction we were headed and making claw motions with their hands. The creek made verbal communication spotty, but they managed to communicate that the bear was near a bridge that we were planning to cross.

Hmm. What to do with this information? We were heading to a reserved campsite, and we needed to cross that bridge at some point. Do bears move a lot? Do they move quickly (when they are not trying to eat you)? How would we know when the bear was gone?

We decided to take a break and ponder our next move. Within about 15 minutes, more hikers came from the direction of the bridge, and we asked if they had seen the bear. They hadn't, and they seemed a little  disappointed that they missed it. They had just crossed the bridge, so we decided to proceed with our hike. In retrospect, that doesn't seem too bright, but how do you avoid bears in the middle of the wilderness anyway? I figured we could have a bear in any direction, so why not go in the direction where hikers had just passed? (We later heard that the rangers had evacuated campers from this part of Yellowstone the day before because of a bear kill. Gulp!)

As we approached the bridge, I was scanning both sides of the trail ... and making plenty of noise. Just before we reached the bridge, I spotted the bear about 20 yards to my left. As soon as I said, "there's a bear!" my sons wanted in on the action.

"Get across that bridge!" I urged.

Ok, I realize that bears can cross bridges, too, but I liked the idea of having a creek in between us. When we got to the other side, we found five or six employees of the Forest Service having a picnic.

"Did you see the bear?" we asked.

"What bear?"

They couldn't believe that they were having a picnic right across the creek from a black bear. Fortunately for us, the bear was sitting next to a deer carcass, so he (she?) had no interest in getting to know us better.

The battery in my son's camera had died early in our trip, but one of the Forest Service employees had a camera and agreed to send me some pictures. (Thanks, Sam!) They arrived today:

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The IMF is supposed to do two things in the new international financial architecture regime.  It is supposed to be the eyes and ears of the G-20 on matters of systemic instability.  And it is supposed to serve as a lender of last resort - admittedly a penurious one - for countries on the brink of default. 

The problem is that these jobs have always, in theory, been duties the IMF has had.  So financial reform for that particular international institution is not about making it different, but rather about making it better (and possibly about tying it to the G-20 a bit more closely than it was tied to the G-7).  Part of that is about giving it a dollop more money - not enough to make it a real backstop, but maybe enough to deal with Pakistan, Iceland, and someone else at once.

So, of course, there's talk of a reorg, perhaps a richly deserved reorg, but one that, in Tim Geithner's view, should always be paired with commensurate reevaluation of the contributions of the emerging markets.  Hence, I think, this part of his speech for the big IMF meeting in Istanbul:

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You know that the prospects for financial reform are not terrible by the amount of new initiatives being churned out by agencies that hope to survive the process.  E.g., the recent efforts by the CFTC and SEC to forestall consolidation by working together a bit more now than they used to do in the past.  Here's the announcement of ... further announcements in the coming weeks.  It's reasonably interesting:

The chairmen of the Securities and Exchange Commission and the Commodity Futures Trading Commission announced today that they anticipate, in two weeks, the two agencies will issue a report that will address key areas in which their regulatory schemes are different. The chairmen also expect the report will recommend legislative and regulatory actions to address those differences where appropriate.

Subject to consideration of the Commissions, a report is expected to be issued on October 15 to address harmonization of futures and securities regulation. It is anticipated that the report will include discussion of the following issues:

Product listing and approval
Exchange/clearinghouse rule approval under rules- versus principles-based approaches
Risk-based portfolio margining and bankruptcy/insolvency regimes
Linked national market and common clearing versus separate markets and exchange-directed clearing
Market manipulation and insider trading rules
Customer protection standards applicable to broker-dealers, investment advisors and commodity trading advisors
Cross-border regulatory matters

HT: Securities Mosaic

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Whenever I fly, at some point I generally find myself flipping through the airline's in-flight magazine.  During my last flight, the Southwest magazine had an "entrepreneur handbook", featuring a variety of stories and statistics about entrepreneurs that provide some important perspective about how we think about (and teach) business associations. 

As an initial matter, the handbook included some contrarian advice from founders, some of which challenged the profit-maximization norm, such as that from the Container store founder who said to forget the Milton Friedman notion that the only reason a corporation exists is to "maximize the return of the shareholder."  Instead, "Put the employee first, and that employee will take better care of the customer than anyone else."

Then too, the magazine had a host of statistics underscoring the fact that many American businesses are small.  Accordingly, one set of data revealed that small businesses represent 99.7 % of employers, and that there are an estimated 7 million new ventures each year.  These statistics suggest that to the extent our focus in corporations and business association is on the large public corporation, we may be missing the mark.  Or at the very least, that focus may leave many students ill-equipped to deal with the type of businesses that they are likely to create, advise, or otherwise interact with on a daily basis.  One interesting data point--apparently self-employed workers out-earn the rest of the population by 6%.  And yet, the number of uncompensated hours that entrepreneurs collectively spend on their businesses a year: 10,000,000,000. 

On a related note, some of the statistics illuminate the risky and short-term nature of small businesses.  Thus, less than 1% of small businesses receive venture capital, while some 46% of small businesses are financed with personal credit cards.  Then too, the average small business survives 11.2 years, and only 1/3 of entrepreneurs will still run their businesses in six years.  To be sure, the risky nature of a small business may be an obvious point. Moreover, as the current crisis painfully highlights, risk is not limited to small businesses. 

However, these kind of statistics remind us that many business issues, including those involving  risk, dissolution, personal liability, and financial responsibility, may be distinct and more acute in the small business setting.  To the extent discussions about businesses and corporations get dominated by large public corporations, we may overlook or otherwise fail to appreciate these distinctions--along with the very important fact that small businesses play a significant role in the American economy.

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Hello!  I am back from Malawi, and my head is still spinning.  After spending a week or so in a country where 2% of residents have running water, I have to say that I doubt I'll look at most of our luxuries the same.  I'm sure those of you who have traveled in developing countries have already experienced this strange re-entry, but I'm processing. . . .

Anyway, for two days in Malawi my group shadowed employees from Opportunity International in an effort to understand its microfinance operations "on the ground."  This experience was very beneficial in beginning to understand why microfinance can work and why it sometimes doesn't.  The operations that we observed begin and end with monitoring.  As far as underwriting criteria go, the one thing that gets the loan officers comfortable with the borrower is monitoring.  This is a country where few borrowers have access to paper, and no one I saw had electricity in their house, so no one had an in-home computer.  Never mind the Internet.  Documentation on business revenues, cost, and profits is probably nonexistent before the first loan.  So, loans begin very small -- about $100-150.  The timeline to repay is short -- a month or two.  The interest rate is not nominal -- 2.5% a month.  If the first loan is repaid, then the borrower may get a second loan.  There are no refinancings of unpaid loans.  And, borrowers must have an "exit plan" -- a plan to build up savings so as to quit borrowing at some point.  To get there, borrowers are required to deposit weekly into a security account with their trust group (more about that in a minute) and into a savings account.  Borrowers are also taught how to keep business records and calculate profits.

But wait, there's more.  The loan officers are titled "Transformation Officers," and this is no joke.  To borrower from Opportunity International, borrowers must attend Transformation Meetings.  I attended one (in Chichewa, a language I do not speak), and it was like attending church.  The officer gave a sermon about reinvesting one's profits into one's business.  Two analogies that stuck out -- Opportunity International was like your friends helping you jump start a car with a bad starter.  They arent' going to push you your entire journey, just at the beginning.  Another analogy about reinvesting profits involved a farmer eating his seedlings.  These meetings are monthly.  In addition, each borrower is part of a "trust group" from her/his village.  Trust groups are generally 7-10 people, who guarantee each other's loans.  Each trust group is instructed to write a "constitution," which is basically a partnership agreement detailing what to do with defaulters.  Because citizens of Malawi feel deep ties to their villages, these trust groups are powerful forces.  Defaulting and having fellow villagers pay your debt would create grave reputational consequences.  Once a borrower has 5 or 6 successful borrowings, they may "graduate" and become an individual borrower.

Opportunity International also provides the great service of banking.  For the villages that we visited, there are no banks.  So, Opportunity Bank has a mobile bank (like a Brinks armored car) that goes to each village once a week.  (The week we were in the Mulanje district, Monday was a holiday in honor of the last day of Ramadan, and people were very upset that the mobile bank hadn't come!)  This allows people to save each week and to also make payments on their loans.  These businesses are cash businesses.  I saw no checks in Malawi.  A few places (our hotel, etc.) would take credit cards, but the fee was as high as 10%.  So, people get cash every day and have no place to put it.  At one trust meeting, a female client urged Opportunity Bank to open a physical building in Mulanje (they plan to) because, as she put it, she is tempted to misuse her profits when she has to wait a week to deposit them.  At the same trust meeting, a male client challenged Opportunity's policy of requiring savings account deposits during the term of the loan.  If he was getting loans to grow his business to provide for his family, then shouldn't he be able to use the profits for things in his house?  The answer from the trust officer was simple:  Sure.  After you repay your loan, you can use profits for whatever you want. 

There have been reports about a possible microfinance "bubble" -- private equity firms coming in, doing "no document" loans, refinacing microloans, borrowers with huge microdebt and no business to generate profits.  There is more competition in the microfinance industry.  The borrower who wanted to spend his profits made clear that other microfinance outfits were offering loans with no such strings.  The more sound way to run a microfinance organization in developing countries seems to be the Opportunity International way -- transforming the borrower, training the borrower, monitoring the borrower.  OI also employed Malawians, who were familiar with the villages and the marketplaces.

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A few weeks ago, I posted an unbalanced, but funny, video on health care from the right. Here is one from the left. The woman with the Wisconsin accent made me chuckle, but the guy who speaks of his fear of living in a "communist gulag like Canada" put me over the edge.

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Utah is awash in fruit juice. Tahitian Noni. Xango. MonaVie. Synaura.

But the spotlight today is on Zrii:

Zrii is a Sanskrit word that means light, luster, splendor and prosperity. As a company, as a brand and as a product, Zrii was born iconic. Bill Farley, one of the true icons of American business, realized that his years of experience and wealth of connections had prepared him to embark on an incredible journey. And that journey is Zrii.

That's just a sampling of what you get on these websites. You cannot really appreciate this industry without at least visiting some of the websites. Watch the video at Zrii ... "Deepak Chopra! Deepak Chopra! Deepak Chopra!"

But I digress. The reason I am writing about Zrii is that the Delaware Court of Chancery (VC Parsons) just issued an opinion involving the company. (Thanks, Francis!) The facts are full of intrigue revolving around an attempted coup: a covert conclave, computer sabotage, an employee walkout.

The coup was directed at Zrii founder and CEO, William Farley. Like the other companies listed above, Zrii is a multi-level marketing (MLM) business, and the main participants in the attempted coup were either officers of the company or high-level distributors. The distributors had all signed contracts in which they agreed not to solicit other Zrii distributors for six months after ending a distributor relationship with Zrii.

By the way, here is a description of one of the defendants, just so you know what we are dealing with:

Jason Domingo is a resident of California. Domingo, called the “Master Distributor,” was the senior-most Zrii [Independent Executive or "IE"] and a Ten Star IE, the highest level attainable by an IE. As the Master Distributor, Defendant Domingo’s downline [the people below him in the pyramid of distributors] included every IE and every customer of the entire company – somewhere around 70,000 people, by Domingo’s estimate. In this capacity in 2008, his first full year with Zrii, Domingo earned approximately $600,000.

Well, the coup didn't work, so the insurgents left Zrii for LifeVantage, another MLM company that sells anti-aging products. Then they proceeded to tell other Zrii distributors to follow them.

The case was before Chancery on a preliminary injunction motion, and the issues revolved around a claim of civil conspiracy, which would be governed by Utah law, though one of the elements of the claim was "one or more unlawful, overt acts," and the plaintiffs wanted to satisfy this element by reference to, among other things, a breach of fiduciary duty.

Is there any doubt that the defendants breached their duties to Zrii? Not really.

But they did it with such a flair! It's unusual to see such shamelessness and lack of nuance outside the movie theater.

Oh, and they (probably) breached their non-solicitation agreements, too.

Motion granted. The remedy? A three-month injunction.

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If I haven't flogged his work before, I'd like to draw your attention to the erudite anonymous investment banker The Epicurean Dealmaker, who, if you are a fan of RSS, is perfect - one or two meaty posts per week.  Anyway, TED is in the middle of a great guide for the perplexed on how investment banks operate, with an eye, I think, to explaining how the compensation is awarded in terms clear enough to permit the government to take it all away.

It is good stuff, and for one thing, it provides a bit of an answer to a question I asked earlier, about why investment banks decided to stuff themselves with dodgy paper, to no good end.  Here's the question:

They may have kept the assets because they were the de facto buyer of last resort for them, and they may have been misvaluing the assets they bought back because they created them (and their good name means that the assets couldn't be worthless, right?).  TED observes that

Good stuff.  As is the series, which is clearly explained.  May not be news to you, well-read readers of this blog, but I learned something.

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We are in the process of reevaluating our first-year curriculum, and one of the compelling proposals on the table is to include a course on legislation and regulation. Willard Hurst joined the faculty of the University of Wisconsin Law School in 1937 and developed with Dean Lloyd Garrison a course called "Law in Society":

We decided we wanted a course which would expose students to a much broader range of legal agencies than just courts. We wanted something that would involve the development of legislation and administrative law particularly.

Last year at the AALS Annual Meeting in San Diego, Jim Brudney acknowledged the debt of modern LegReg courses to Garrison and Hurst's early effort. After Hurst's death, William Eskridge offered the following tribute to their materials:

The most striking thing about the Garrison and Hurst materials was their post-formalist and post-realist exploration of the relationship between law and society. On the one hand, they flatly rejected traditional views of law and society as separate, and did not view society as routinely following the rule of law as it was laid down. The materials were, after all, called “Law in Society,” and they emphasized how the law's force is limited by social mores and structures and how lay people and private institutions are themselves sources of law. On the other hand, the materials revealed the many ways in which law helps shape social experience, by valorizing one norm over another and by channeling the thoughts and efforts of the citizenry and its groups.

In examining Hurst's work for a recent project, I have been continually amazed at his sophisticated understanding of law, even at the distance of many years. In his later years, Hurst noted that the students did not like "Law in Society" -- which is true -- but since when did that stop us from teaching something?

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Earlier this evening, counsel for petitioners in Jones v. Harris filed their reply brief (Download 08-586rb-1), bringing the substantial array of briefing in this case to a close.  Counting amicus filings, the case's Supreme Court docket includes approximately two dozen briefs.  The next step will be oral argument on Monday, November 2, at which the Solicitor General has requested leave to participate by using ten minutes of the petitioners' half hour.

Perhaps the most interesting new argument in today's brief is the petitioners' contention that "[n]either Harris nor its industry amici attempt to defend the Seventh Circuit's analysis."  Indeed, many of those briefs argued instead for a continuation of the Gartenberg precedent, leaving Judge Easterbrook's lower court opinion in a curious limbo.  If neither side supports it, one wonders whether the Supreme Court will attempt by itself to carry the load of upholding that decision.

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