Ideoblog

A standard forms approach to mutual funds regulation

That's my take on Jones v. Harris for the Conglomerate Masters forum.  Tune in!

Update:  Here's William Birdthistle's ringside view of the oral argument.

Jones v. Harris at the Glom

Usha Rodrigues has the background.  Tune in there and here for more on Sunday, in preparation for Monday's Scotus argument.

The unconstitutionality of the pay czar

Former judge Michael McConnell writes in today's WSJ regarding "Pay Czar" Kenneth Feinberg's fixing of compensation for executives at large financial firms:

Mr. Feinberg's ukase is the most prominent example (and not just by the Obama administration) of the exercise of power by an individual unilaterally appointed by the executive branch without Senate confirmation—and thus outside the ordinary channels of Congressional oversight. * * *

The Appointments clause of the Constitution, Article II, section 2, provides that all "Officers of the United States" must be appointed by the president "by and with the Advice and Consent of the Senate." * * *

There is no doubt that Mr. Feinberg is an "officer" of the United States. * * * [His] orders setting pay levels * * * have the force of law and are surely an exercise of "significant authority" pursuant to an Act of Congress. * * * That means his office is subject to the requirements of the Appointments Clause. * * *

[P]rovisions governing appointments * * * embody the Founders' conviction that all power under U.S. laws must be exercised by officers with constitutional authority.

The Founders * * * required Senate confirmation as what the Federalist Papers call "an excellent check" on abuse or favoritism by the president. * * *

The power to set compensation at large American businesses is especially subject to potential abuse, favoritism, arbitrariness, or political manipulation. * * * Because he is not a properly appointed officer of the United States, Mr. Feinberg's executive compensation decisions were unconstitutional.

Earlier this month I expressed similar sentiments about Geithner's pay czar:

Perhaps the worst aspect of this whole thing is the Obama administration's attempt to avoid political accountability by creating a "czar." Process is supposed to matter in a democratic system. This is, in fact, what's at stake in the PCAOB case. I wonder if the Supreme Court will have in mind the current administration's approach to governance when considering the constitutionality of a past effort to create an agency with executive power but not executive accountability.

Big Law tries to get bigger

If, as I've argued, Big Law is dying, then what explains Hogan & Hartson and Lovells's plan to create a US/UK megafirm?

Got me.

The WSJ explains that the merger would create "one of the world's largest law firms, with about 2,500 attorneys and $2 billion in annual revenue." I've argued that Big Law lacks a business model that binds property to the firm. If that's true of large law firms generally, then it would seem that it's likely to be even truer of a transatlantic firm with clashing cultures, notably including eat-what-you-kill vs. seniority-based compensation.

My guess is that the consultants think clients will pay premium prices to a firm that can provide integrated advice on global regulatory and antitrust issues. But in order for that to work, the firm has to keep all those lawyers working for the firm. The WSJ quotes Peter Kalis, chairman of K&L Gates LLP, as saying that the obstacles to the merger "boil down to . . . [n]ame, power and money."

Oh, is that all?

Think about what happened to other firms that have grown rapidly to become one-stop-shopping behemoths. Remember Brobeck?

So good luck to Sterling Cooper Hogan Hartson Lovells (or whatever the new firm will be called).

Notes from the nationalization of GM

Last June I talked about the nationalization of GM.

Today's WSJ has a progress report on the government's role in GM's recent business decisions:

• Reinstatement of a mining contract advocated by local politicians.
• Decisions as which dealerships to close.
• Dropping plans to produce a new subcompact car in China.
• Whether to give hauling work to nonunion contractors.
• Getting GM to participate in an environmental program that removes mercury from scrapped cars.

A GM spokesman says "being responsive to members of Congress while moving forward on our business plan is the best way to repay the nation's support." I suppose that's one way of putting it.

I'm shocked – shocked! – that the government would buy a company and then attempt to manage it. And I almost had a heart attack on learning that politics would play a role in these management decisions. Oh well, you live and learn.

 

Are law professors necessary?

Mathias Siems imagines A World Without Law Professors. Here's the abstract:

Inspired by Alan Weisman's book "The World Without Us" (2007) I analyse the thought experiment of a world in which law professors suddenly vanished. First, without academic teachers legal training would shift back to the legal professions. Purely professional law schools would provide legal training for future lawyers. This is feasible in both Common Law and Civil Law jurisdictions. These professional law schools can also be involved in a more general provision of legal education. In addition, non-law faculties of universities can take responsibility for teaching on law-related subjects. Secondly, I analyse the impact on legal research. Self-referential research would diminish. Doctrinal research would persist but it would be done by practitioners and the current oversupply would melt down. At universities legal research would continue but it would shift to related fields of social sciences and humanities. Thus, the threshold would be an "academic dinner party test": legal research would have to show that it is of interest for other academic disciplines. Overall, I would therefore expect some changes; however, legal education and research would not disappear. In some respects, one could even argue that without law professors the quality of both teaching and research may improve. The paper finishes with the implications for the current system.

Siems' thought experiment is no trivial exercise. I've argued that a key part of the law student job market – big law firms – is dying. Obviously this suggests that law schools need to fundamentally rethink their mission. Siems' idea of legal education melting into the universities they are only loosely connected with now is one possible future I also imagine in my article. What's really dying is the idea of law as an autonomous profession. The law-only school is going to go the way of the law-only firm.

US News impoverishes law students

Believe it or not, that's what the GAO says (HT ATL). According to a couple of the GAO's slides (printed in the ATL post), US News rankings, by emphasizing costly inputs rather than educational outputs, have forced law schools into a costly competition that raises costs for students.

As I've pointed out,

The US News survey is done by a private business. No law gives it monopoly power. It gets attention because it's earned it in the market. There's room in the market for multiple surveys of law schools * * *

So we should focus on flaws in the survey. * * *

More fundamentally, US News stresses inputs (resources) over outputs (success of students, faculty scholarship). This is particularly bad since academic institutions are notoriously bad at using resources. On the other hand, we can have some sympathy with measuring the measurable. And what should be the output measure? Counting faculty publications, or citations of these publications, or graduates' salaries?

Of course we don't know what the perfect measure is, which is why we have markets to sort this out. * * *

Saul Levmore has another take:

[The GAO Report] concludes that although some critics had claimed that accreditation standards were a major factor in the cost of law schools, "officials for more than half of the ABA-accredited schools we spoke with stated that they would meet or exceed some ABA accreditation standards even if they were not required." The report and the conclusion miss the point.

When we say, for example, that obesity is the cause of higher medical costs, we do not mean that with no obesity there would be no visits to the doctor. Rather, we mean that it is an important explanation for varying costs, or that it is a controllable cause of higher costs. * * *

[T]he costs that can be traced to competition * * * are there, for the most part, in the absence of regulation. If a school competes by exceeding 80% of the accreditation requirements, it might still object to having bookshelves that are not needed, assistant deans who fill out required reports, and faculty or non-faculty who are tenured not because the school thinks that tenure is the right way to attract talent but rather because tenure was required by the regulators. In this as in so many other things, it is marginal analysis that matters. On the margin, ABA regulations might raise costs; evidence that something else, like rankings or competition, matters more, is a bit beside the point.

In other words, we have two problems that are driving up costs: problems in the market for which there is no obvious solution, and for which it's dumb to blame US News; and ABA regulation that we can do something about. The GAO report, like a bullfighter or a pitcher with a crazy windup, wants to take our eyes off the ball. Let's not get distracted.

Anyway, this is all a short-term problem. Once the problems in the market for lawyers hit law schools, US News will be the least of their worries.

The costs of Geithner’s shell game

John Carney discusses the little matter of Tim Geithner's $13 billion mistake of judgment in the AIG bailout. The problem is that the bailout protected AIG's counterparties at par rather than at the substantial discount AIG had already substantially negotiated.

Carney figures the rationale was that the government

feared making banks take a haircut on the AIG swaps would leave them with insufficient capital. In short, it was a covert bailout of the banks. The biggest winners here include Goldman Sachs, which got $14 billion, as well as Societe Generale and Deutsche Bank.

Carney says it would have been better to "transparently bailout firms that needed the additional capital instead of doing it in an under-handed way."

Indeed, I've described Geithner's lack of transparency as a "shell game" where "the government subsidizes private equity companies to buy the assets at inflated values."

Moreover, there was good evidence at the time that the assets the taxpayers were paying for were, indeed, crap.

In the post just linked, I had a better idea:

Mark to market plus relief from capital requirements, as I've said. Either the capital requirements are of little use (my view) as long as the market knows the actual values, or rules that enabled the banks to game the capital requirements helped create this mess. Either way, we're better off suspending those requirements than helping the banks evade accurate valuation of the assets.

Unfortunately, Geithner decided that political expediency trumped honesty. What do you think the government would do to a private firm that made the same judgment?

Self-protecting from insider trading

John Carney has some advice for investors. My favorite:

The playing field in the market is never level. Investor confidence built on the idea that regulators can create a level playing field is no better than a con game. Instead of trying to foster investor confidence around this phony notion, the SEC should sanction anyone they find fooling investors into believing it. The truth is that the ordinary, retail investor is like the high school JV team playing against the New York Giants. You don't stand a chance if you try to beat them at their game of stock picking, forecasting and market timing.

The lesson: If someone tells you the playing field is level, get off their field and play somewhere else.

The (market) rise of the uncorporation

The WSJ has an investment recommendation:

Worried about a depreciating dollar, rising taxes and stingy investment yields? Try Master Limited Partnerships. MLPs are listed partnerships that typically invest in hard assets like oil and natural-gas pipelines. They pay no corporate tax and offer investors high cash distributions, most of which is tax-deferred. And their recent performance is hard to beat.

Yes, distributions are nice, for these and other reasons. See my Rise of the Uncorporation, particularly Chapter 8, which discusses publicly traded partnerships.

The trouble with criminalizing outsider trading

Gordon Crovitz, writing in today's WSJ, says that

the Galleon case is about what might be called "outsider trading"—trading by people who gathered information from insiders about company performance or operations, not trading by the insiders themselves.

The reason the U.S. government should tread carefully in criminalizing outsider trading is that markets run on information, analysis and the connecting of dots to determine when prices are too high or too low. * * *

Until recently, the vagueness of the insider-trading laws were more of an academic topic than a core issue for how markets operate day to day. In today's world of immediate, global flows of information, markets need greater clarity about how information can be gathered and used. The lesson so far is that knowing when insiders violate their duty is easier than knowing when outsiders go too far in bringing accurate information to markets.

Crovitz credits a particular academic, Steve Bainbridge, with this insight. I also pointed out last week that "[c]riminalizing insider trading doesn't just punish the bad guys who are caught, but deters perfectly legal and socially beneficial trading."

We keep hearing about how all the risk in markets demands more disclosure. Surely we cannot afford to clamp down on information. The government therefore better have some hot smoking guns that point to a clear roadmap of wrongdoing in the Galleon case, or drop it.

Hootie and Coase

From yesterday's WSJ comes a story about how one cranky guy shut down a garage band haven in Columbia, South Carolina called the "Sheds," once home to Hootie and the Blowfish. The storage units that housed the music were, according to the story, "far from residences, on an industrial strip bordered by two sets of railroad tracks and near fields used by the USC's athletic teams."

Clif Judy lived a half mile from the Sheds and preferred to listen to unadulterated crickets. "I don't like Hootie & the Blowfish," he says. "When they play, it sounds like they broke something." In fact, Mr. Judy's "tastes tend toward Bach and Christmas carols." He writes a lot of letters to newspapers and hands out rewards to people with neat yards. Mr. Judy called it "an issue of an old fella getting tired of listening to them, with their tattoos, down there having a good time."

There was no problem with a noise ordinance. Mr. Judy found only one other person who was bothered. She said: "I tell him I hear [the bands], but I can't say I really do." She "asked not to be identified for fear of antagonizing Mr. Judy." But Mr. Judy used his expertise from sitting on a zoning board and owning a strip mall to lodge a complaint based on inadequate wiring for electric guitars. As a result, the Sheds were shut to music.

At the same time I was reading the WSJ story, I was also reading Terry Anderson's excellent article, Donning Coase-Coloured Glasses: A Property Rights View of Natural Resource Economics. I met Terry last summer during my stimulating two week stint at PERC in Bozeman, Montana last summer.

From Terry's article:

Suppose there is an apartment building with two apartments. In one apartment lives a person who enjoys music and values louder and louder music * * *. [A]dditional decibels provide more value to the music lover, but the marginal value of decibels declines until it reaches zero at the maximum number of decibels that can be produced by his equipment. In the other apartment lives a person who values quiet such that fewer decibels of noise are worth more with the marginal value of quiet declining until it reaches zero with no noise.  * * *

Consider a case where there are no rules regarding noise in the apartment building and where the quiet lover moves in first. When the music lover moves in and turns his stereo up to full volume, the quiet lover will clearly have reduced value of quiet. He is likely to respond by knocking on the door of the music lover asserting a first possession right to be free of noise [citation omitted]. Assuming that he can defend this right both morally and legally and sell it, the costs are fully accounted for when the music lover compensates the quiet lover for the costs he bears or ceases producing music.

If the quiet lover cannot defend his right to quiet, there will be too much noise because the music lover is not bearing the cost of lost quiet. But * * * even this discussion requires considering Coasean transaction costs associated with defining and enforcing property rights relative to the value of the rights.

Now reverse the arrival of the dwellers so that the music lover is the first possessor of an apartment. When the quiet lover moves in, he might again knock on the door of the music lover and assert that a cost has been imposed on him. But in this case the music lover is likely to assert a right to play his music as loudly as he likes based on first possession. Assuming he can defend his right, the costs will again be fully accounted for when the quiet lover compensates the music lover for his reduced decibels or puts up with the music. If the quiet lover could force the music lover to reduce the volume without compensation; that is, the music lover cannot defend his rights, there will be too much quiet because the quiet lover is not bearing the cost of reduced decibels.

This example illustrates Coase's important realization that social costs are reciprocal. If the quiet lover has the right to be free of noise, the music lover will bear the cost of scarcity, and if the music lover has the right to music, the quiet lover will bear the cost of scarcity. How the rights are assigned will affect who bears the costs and, depending on transaction costs, may affect resource allocation and certainly will affect wealth distribution.

Even in the absence of property rights, reciprocal costs remain, but without property rights there is no way to say who is imposing costs on whom and no way to say there is an externality.

Note that in the Sheds case, both the Sheds and Mr. Judy had been there for a long time, and that the Sheds were not obviously out of place, noise-wise. It seems that property rights were unclear.

Anderson's article discusses various ways to develop the appropriate property rights, including contracting among the affected parties. He does not discuss electric codes, which clearly were not designed to deal with this problem. But of course we live in a world where regulations are so pervasive that we can expect them to create de facto property rights, intended or not.

Fall in Champaign

Insider trading and efficient markets

Don Boudreaux has an important take on the recent big insider trading case in today's WSJ:

Federal agents are wasting their time slapping handcuffs on hedge fund traders like Raj Rajaratnam, the financier charged last week with trading on nonpublic information involving IBM, Google and other big companies. * * * Far from being so injurious to the economy that its practice must be criminalized, insiders buying and selling stocks based on their knowledge play a critical role in keeping asset prices honest—in keeping prices from lying to the public about corporate realities.

* * *Capital that would otherwise have been invested in firms more productive than Acme Inc. never gets to those firms. So compared with what would have happened had people not been misled by Acme's deceitfully high share price, those better-run firms don't enhance their efficiencies as much. They don't expand their operations as much. They don't create as many good jobs. Consumers don't enjoy the increased outputs, improved product qualities and lower prices that would otherwise have resulted.

What about the problem of scaring investors out of a "rigged" market?

Another potential benefit of lifting the ban on insider trading is explained by Harvard University economist Jeffrey Miron: "In a world with no ban, small investors might fear to trade individual stocks and would face a greater incentive to diversify; that is also a good thing."

Moreover, the laws are unevenly applied to exclude, e.g., purchases of related companies and non-sales. In other words, the insider trading laws do not prevent insider trading – they just decide which insiders can trade.

And to the extent that insider trading interferes with property rights, let the property owners themselves – the corporations whose shares are traded – decide how to protect these rights. They clearly have an incentive to do so.

Read the whole thing.

A court makes LLCs criminals

In People v. Highgate LTC Management, LLC, 2009 WL 3380029 (N.Y.A.D., October 22, 2009) the NY Appellate Division held that an LLC could be criminally liable for willfully violating health laws in operating a nursing home, resulting in a one-year prohibition on operating nursing homes and a $15,000 fine.

NY common law holds against criminal responsibility for acts of agents in crimes requiring intent. NY Penal Law Section 20.20(2) provides an exception relating to criminal liability of corporations:

§ 20.20 Criminal liability of corporations.

1. As used in this section: (a) "Agent" means any director, officer or employee of a corporation, or any other person who is authorized to act in behalf of the corporation. (b) "High managerial agent" means an officer of a corporation or any other agent in a position of comparable authority with respect to the formulation of corporate policy or the supervision in a managerial capacity of subordinate employees.

2. A corporation is guilty of an offense when: (a) The conduct constituting the offense consists of an omission to discharge a specific duty of affirmative performance imposed on corporations by law; or (b) The conduct constituting the offense is engaged in, authorized, solicited, requested, commanded, or recklessly tolerated by the board of directors or by a high managerial agent acting within the scope of his employment and in behalf of the corporation; or (c) The conduct constituting the offense is engaged in by an agent of the corporation while acting within the scope of his employment and in behalf of the corporation, and the offense is (i) a misdemeanor or a violation, (ii) one defined by a statute which clearly indicates a legislative intent to impose such criminal liability on a corporation, or (iii) any offense set forth in title twenty-seven of article seventy-one of the environmental conservation law.

This section explicitly applies only to "corporations." It is also obviously designed for the particular governance structure of corporations.

The court wasn't troubled by these details. It held that it was enough that the LLC was a "hybrid," an "entity" and a "person" to drag it into this criminal statute. The court reasoned that corporations had been held criminally liable for agents' acts, and that any reluctance to base criminal liability on respondeat superior does not apply in this situation because

[u]nlike the imputation of the conduct of one natural person to another, the corporation 'is, in reality, being made to answer for its own acts. Such a theory of liability is a far cry from one involving true vicarious liability'" [citations omitted].

Yes, but what about that little detail that this isn't a corporation? The court held that "the long-standing analogous principles that have evolved through case law remain dispositive," reasoning that "given the important public interest at issue and the regulatory nature of the crimes committed by defendant's employees * * * there is no rational basis to exempt defendant from criminal liability under these circumstances, when a corporate nursing home operator would be held accountable. . . ."

The basic problem here is that legislatures still haven't gotten around to fixing their large masses of statutes and regulations for the new era in which LLCs are doing a lot of what corporations used to do. Maybe the courts should help them out to some extent. But surely we ought to be careful about giving too much help in applying criminal sanctions.

Yes, it's true, as the court notes, that the LLC is commonly viewed as a "person" or legal "entity." But as discussed in Ribstein & Keatinge on LLCs, Section 3.08, there are still lingering questions about what this means in particular contexts and under particular statutory language.

The Mississippi Supreme Court was more careful than the NY court. It held in Champluvier v. State, 942 So. 2d 145 (Miss. 2006) that the fact that the LLC was a legal person did not justify applying to an LLC a statute criminalizing embezzlement in an ''incorporated company." The court reasoned that if the legislature had intended LLCs to be covered it could have amended the statute to take account of more modern business entities. The legislature later amended the statute to substitute "person," which Cater v. State, 2009 WL 707638 (Miss., March 19, 2009) held covered LLCs.

But the New York courts have a history in the LLC area of treating statutes more cavalierly. The classic example is Tzolis v. Wolff, 10 N.Y.3d 100, 855 N.Y.S.2d 6, 884 N.E.2d 1005 (2008), which held over a vigorous dissent for a common law right to sue derivatively in LLCs. The court wasn't troubled by the legislature's deliberate omission of the derivative remedy because it said it's possible some legislators figured the courts would "follow the established case law" permitting derivative suits. This is a rather questionable approach to legislative intent. I sharply criticized the opinion, noting the dissent's statement that "the modern Legislature reasonably expects the judiciary to respect its policy choices."

As with Tzolis, there are good reasons for not extending the statute to cover LLCs. As discussed extensively in my Rise of the Uncorporation, the differences between business associations are not mere technicalities. Rather, the standard forms are designed to guide courts toward filling statutory gaps in particular ways. These differences reflect parties' deliberate choices of form, particularly now that these choices have been liberated by the development of alternative standard forms and the tax "check the box" rule.

In particular, when parties choose the corporate form, they are choosing a hierarchical structure in which control over the assets is locked in managers and the managers' decisions can realistically be considered those of the firm. This is less true of unincorporated firms, whose structures are more flexible and in which managerial control is compromised by the members' greater access to the assets through dissolution and dissociation.

These considerations point to significant predictability problems in applying the court's decision, a level of unpredictability that should be intolerable in a criminal statute. For example, are members of a member-managed LLC "high managerial agents"? Does the criminal statute follow the LLC statutes in distinguishing between member-managed firms and manager-managed firms in which members nevertheless have agency power? Does the statute apply to partnerships? Limited partnerships? LLPs? Does it apply to all crimes, or only those involving an "important public interest" and crimes like the one in this case?

Legislatures are supposed to fill in these spaces in criminal statutes. Even if the conduct here arguably deserves criminal sanction, it is at least as important to be careful in applying the criminal laws. Isn't it enough that legislatures are criminalizing everything without the courts stretching these statutes to create even more crimes?

E-marriage!

I have long argued for jurisdictional competition for marriage law. See my articles Calling a Truce in the Marriage Wars (with Buckley) and A Standard Form Approach to Same-Sex Marriage, and Chapter 8 of my book with O'Hara, The Law Market, which puts the idea in the general context of a theory of jurisdictional competition.

Now Adam Candeub and Mae Kuykendall have taken the concept a couple of steps further. Here's the abstract of their article, E-Marriage: Breaking the Marriage Monopoly:

This Article advocates updating the law governing marriage formation to recognize the shift in social interactions from real to virtual life. We argue that couples can use internet communications not only to marry when separated by great distance but also to choose which state's laws will authorize their marriage. In particular, same sex couples could marry under the laws of a state that permit such unions, regardless of where they exchange vows.

States inadvertently have created geographic monopolies, requiring each marriage receiving the benefits of their licensing laws to be performed within their borders. This Article's model builds upon established precedents, such as proxy marriage and choice of law for multi-jurisdictional and internet contracts. Using the power of internet communications, our proposal allows states to compete over marriage's procedures and substance. Depending on a couple's preferences for "e-ritual" and a state's desired level of regulatory control, couples could consume the trappings of a traditional ceremony before their friends and family, without travelling to another jurisdiction, perhaps with an officiant presiding on-line from a remote location. More simply, couples could have a complete marriage ceremony in the location of their choice, but would receive a license and file necessary papers with a distant state jurisdiction.

Some states do not recognize types of marriages that other states authorize, i.e., Massachusetts same sex marriage or Louisiana covenant marriage. Every type of e-marriage will not be enforceable everywhere. We argue, however, that marriage satisfies a unique human need for socially sanctioned commitment, which a simple contract cannot satisfy, a point ignored by those who argue for a purely private, contractual approach to marriage. E-marriage can more efficiently distribute the "status good" of marriage-even if it cannot provide a legally enforceable relationship in every state. Finally, our proposal encourages a legal cosmopolitanism as individuals witness a variety of sanctioned relationships within their own places of worship and communities, defusing protracted political struggles at the state level over substantive marriage rules.

And they also have a website to act as a "clearinghouse for legislative proposals to institute "e-marriage," potentially altering the landscape of the marriage culture wars and solving the problems that arise when a great distance separates couples who wish to marry." Here's the press-release for the whole project, which notes:

The proposal would allow same sex couples to marry in California under the laws of Massachusetts or Vermont, if those states enacted e-marriage provisions. Even though the couple's home state would not be required to recognize the marriage, the couple could celebrate their marriage at home in front of friends at their setting of choice. The same is true for couples who'd like to enter a covenant marriage, in which the couple can express a higher degree of commitment by agreeing to more onerous divorce procedures. Covenant marriages are only offered by Louisiana and Arizona. With a state e-marriage enactment, these states could offer the symbolic extra dimension to marriages that take place outside their borders.

The professors offer their proposal as a way to soften the culture wars over marriage and to refute suggestions the state should get out of the marriage business.

I'll be watching with interest how this plays out in the Law Market.

Gerding on Disclosure 2.0

This week in the Illinois Corporate Colloquium Erik Gerding presented his early draft paper, Disclosure 2.0: Leveraging Technology to Address "Complexity" and Information Failures in the Financial Crisis. This was the latest in several interesting papers we've had in the Colloquium addressing possible causes and cures of the crisis.

As Eric summarizes in his abstract:

This article advocates leveraging advances in computer software, information systems, and the Open Source movement to enhance securities disclosure and remedy some of the information asymmetries that exacerbated the current financial crisis. This article responds to a critique of mandatory securities disclosure by several legal scholars (Troy Paredes and Steven Schwarcz) that disclosure overloads investors with too much information and fails to help investors analyze the complexity of modern financial instruments and markets.

However, because the financial crisis stemmed in large measure from information failures, it would be counterproductive to dilute securities disclosure for failing to stop the crisis. Instead, disclosure must be radically enhanced to enable investors to better analyze intricate financial instruments, such as asset-backed securities and derivatives; the models used to price these instruments, set risk management policies, and guide trading strategies; and the complex market interactions of these instruments and trading strategies.

Various technologies can revolutionize disclosure including: "tagging" assets that underlay asset-backed securities and derivatives to allow investors to trace which assets affect which financial instruments; access to underlying data that is aggregated in financial statements; "open source" risk models; real-time financial disclosure; and interactive disclosure that allows users to change certain assumptions or accounting methods to see how financial disclosure would change. Employing these technologies poses certain risks and costs, which this article analyzes. The article argues that an "open source" approach to technologically-enhanced disclosure can mitigate agency costs and advocates experimental testing of disclosure effectiveness.

This proposal substitutes a sort of bottom-up for a top-down disclosure model. Investors get the tools to penetrate bottom line results down to a more granular level, and to fiddle with the assumptions that underlie particular disclosures. Among other things, this makes it harder for regulators to mess up disclosure by imposing their own assumptions. Gerding shows how this could avert mispricing that can arise under more rigid disclosure models.

The proposal implicitly relies on efficient market mechanisms to create and filter the new information Gerding would make available. In other words, it does not envision that ordinary investors would be using tags to trace assets. Rather, market intermediaries would do the work and apply the results to their investment decisions. These decisions, in turn, should drive more accurate market pricing of risk.

Some possible issues that arise under the proposal:

1. To what extent would the costs the proposal imposes on issuers outweigh the benefits? Compare proposals that simply involve reformatting of information that must already be disclosed with those that require issuers to come up with new information.

2. To what extent does the proposal inefficiently erode property rights in information? Requiring disclosure of formerly proprietary risk models could discourage the development of innovative models.

3. Should we be concerned about creating a new type of information asymmetry which favors those who develop or have expertise concerning the new disclosure technologies? I would say no. After all, the proposal emphasizes the importance of efficient securities markets. At some point we have to decide that market efficiency trumps ensuring equality of information.

4. Real-time disclosure could present the "overload" problem that Paredes has warned about. In other words, we may end up with more data but less usable information because of limits on the market's processing power. Subject to the next point, I'm not very worried about this.

5. Perhaps most fundamentally, it is important to emphasize the proposal's reliance on market efficiency. To the extent that securities laws undercut efficiency by, for example, over-regulating hedge funds and short selling, we will hamstring investors from using the new tools Gerding would make available. Then information overload becomes more of an issue.

In general I thought the paper was a productive suggestion as to how to improve disclosure, and I look forward to Erik's developing the proposal and addressing some of the underlying issues.

Can bloggers be defamed?

Clay Travis, via WSJ Law Blog, wonders about this:

[I]n an internet age, drawing the line on who is a public figure and who is not, is fascinating to me. . . . For instance with Facebook, Twitter, online profiles on work sites, and the like it's awfully hard to distinguish where the line is between public and private for anyone with an online presence. Is a Facebook status message that is limited to only your friends, for instance, fair game for the entire world to consume? We've had several instances of those messages being huge national stories in the sporting arena. Surely those messages were intended only for the "friends" on that network. What about sports message boards, some of the wildest places around? Are all college athletes public figures? Is a lacrosse player at Loyola of Chicago the same as Tim Tebow?

I'd argue that there's almost a default presumption that we're all public figures now in the way that reporting and internet linkage takes place. But that position has not really been explored yet by the courts. * * *

Here's what I have to say in From Bricks to Pajamas: The Law and Economics of Amateur Journalism, 48 Wm & Mary L. Rev. 185, 229-30 (2006) (footnotes omitted):

Amateur journalism may force rethinking of this distinction [between public and private figures]. For example, Gertz [v. Welch] indicates that a blogger who is prominent among amateur journalists, even if not generally in society, would be deemed as a result of his blogging activities to have "thrust [himself] to the forefront" of a controversy. One who defamed the blogger would then be judged under the lax actual malice standard. Also, the blogger may be deemed to have "effective opportunities for rebuttal" through his blog. Even amateurs arguably have access to a public forum to "counteract false statements" and have opened themselves up for attack by publicly posting comments. * * *

Bloggers' public access, however, may be more apparent than real because it depends not just on being able to plug into the Internet, but also on the informal screening of Google and other search engines that enable readers to find the blog. The courts might take blog rankings into account for purposes of determining public figure status and damages, or emphasize the blog's importance within a subcommunity that is relevant for reputation purposes.

In other words, bloggers beware: defamation may be the price of popularity.

Hot off the press: The Rise of the Uncorporation

Just got my advance copy today.  Looks great.  Had occasion to read it over the weekend for presentation at Margaret Blair's Theory of the Firm seminar at Vanderbilt and it reads pretty well.  Maybe it actually is good. You can test drive the first chapter.  But why not read the whole thing?

Perspectives on Feinberg-pay

The WSJ reports that Kenneth Feinberg, Treasury's pay czar,

will cut in half the average compensation for 175 employees at firms receiving large sums of government aid [AIG, Bank of America, Citigroup, GM, GMAC, Chrysler Group LLC and Chrysler Financial], with the vast majority of salaries coming in under $500,000, according to people familiar with the government's plans. As expected, the biggest cut will be to salaries, which will drop by 90% on average.

* * * An executive at one of the seven companies under Mr. Feinberg's authority said the terms came as a shock, especially because they changed so suddenly. The compensation restrictions "were clearly much worse than what had been anticipated."* * *

The point of biggest debate will be the cutting of cash salaries, which are expected to hold below $500,000. Instead, employees will receive what has become known as "salary stock" -- long-term stock grants in lieu of cash that can't be touched for at least four years. * * * Included in Mr. Feinberg's order are incentives for these companies to return the government's cash. Employees might get earlier access to their long-term stock grants if their companies pay back their bailout funds. * * *

Professor Bainbridge fumes:

The basic problem is here is that many (most?) of the compensation deals the Obama administration is shredding were set in employment contracts. Granted, some of those employment contracts were signed after the law setting up pay "czar" Kenneth Feinberg's position and empowering him to review pay packages at TARP firms. But a lot of them are pre-existing contracts and it's those contracts that are the main concern. * * * The bottom line thus is that Obama is having his minion coerce TARP executives and employees into ripping up contracts Obama doesn't like so as to assuage the populist public. In doing so, Obama and his appropriately entitled "czar" are exhibiting a basic lack of respect for the rule of law.

More from David Zaring.

Let's put this into perspective.

1. As for rewriting contracts, these firms became government bureaucracies (and their employees knew it) as soon as they took TARP money trailing thick strings, including the Treasury's power over pay. It's bad, but should this latest move really be so shocking?

2. As Alex Tabarrok says, "[t]here is no way this will work as advertised.  * * * [M]ost of these executives will quit and get higher paying jobs elsewhere.  Executives not directly affected by the pay cuts will also quit when they see their prospects for future salary gains have been cut.  Chaos will be created at these firms as top people leave in droves." Commenters responded that the executives were incompetent anyway, so who cares? But if that's so, why are taxpayers flushing billions down incompetently managed firms, and then constructing pay rules so they can't attract better ones?

3. Even apart from the market for talent, Feinberg-pay won't have the desired incentive effects. As I've described at length in my Rise of the Uncorporation (which, by the way, has just been published and will be shipping soon), compensation is embedded in larger governance schemes that need to be coherent to function properly. You can't just pick off one term (compensation) and expect the rest the scheme to work.

4. Speaking of larger governance schemes, it seems to be little noticed that Feinberg, according to the WSJ, "will also demand a series of corporate governance changes at the firms, including splitting the chairman and CEO positions, requiring boards of directors to create "risk" committees and eliminate staggered board elections, which critics charge inhibit change." If you are skeptical about Feinberg's ability to micromanage executive pay, what about having him design the whole firm?

5. I suspect that executive talent and banking business ultimately will go to the better-designed firms that take the place of the government wards Feinberg is setting up. Perhaps these will be similar to hedge funds (see, again Rise of the Uncorporation), unless these, too, are regulated out of existence, in which case markets will come up with something else – probably some other variation on the flexible uncorporation.

6. These may not, however, be publicly held firms. That's because, as the WSJ points out, "Sen. Charles Schumer (D., N.Y.) plans to press for legislation extending Mr. Feinberg's governance changes to all publicly traded companies."

7. There's a process concern here that is being overlooked. The WSJ notes that Feinberg was brought in to take the heat off Geithner:

Since bringing Mr. Feinberg to the Treasury Department, the Obama administration has largely stayed out of his business, preferring instead to let him make the controversial calls unlikely to please many people. Mr. Feinberg has met with Mr. Geithner just twice and hasn't spoken with White House officials at all.

Perhaps the worst aspect of this whole thing is the Obama administration's attempt to avoid political accountability by creating a "czar." Process is supposed to matter in a democratic system. This is, in fact, what's at stake in the PCAOB case. I wonder if the Supreme Court will have in mind the current administration's approach to governance when considering the constitutionality of a past effort to create an agency with executive power but not executive accountability.