ProfessorBainbridge.com

Schumpeter and the American Illness

Among a number of very fine articles on the way regulation is crippling the American economny, the Schumpeter column's argument that "America is becoming a less attractive place to do business" strikes particularly close to home. Schumpeter elaborates:

The March issue of the Harvard Business Review is devoted to “American competitiveness” (by which it means the country’s ability to improve productivity and living standards). A gaggle of gurus delivers a harsh verdict. Michael Porter and Jan Rivkin of the Harvard Business School (HBS) sum up the mood: “The US government is failing to tackle weaknesses in the business environment that are making the country a less attractive place to invest and [is] nullifying some of America’s most important competitive strengths.” The Review also reports that declinism is prevalent among HBS alumni: in a survey, 71% said that American competitiveness would decline in the coming years.

This struck home because I participated in a similar gaggle of gurus organized by Frank Buckley in which a number of very prominent legal experts discussed the ways the law in their particular field of expertise is throttling the US economy. Frank is collecting the resulting essays into a book entitled The American Illness to be published by Yale University Press. You can preview the table of contents here. You can download preliminary working drafts of some chapters here.

My contribution to the volume is tentatively entitled Corporate Governance and U.S. Capital Market Competitiveness and can be downloaded here. The abstract follows:

During the first half of the last decade, evidence accumulated that the U.S. capital markets were becoming less competitive relative to their major competitors. The evidence reviewed herein confirms that it was not corporate governance as such that was the problem, but rather corporate governance regulation. In particular, attention focused on such issues as the massive growth in corporate and securities litigation risk and the increasing complexity and cost of the U.S. regulatory scheme.

Tentative efforts towards deregulation largely fell by the wayside in the wake of the financial crisis of 2007-2008. Instead, massive new regulations came into being, especially in the Dodd Frank Act. The competitive position of U.S. capital markets, however, continues to decline.

This essay argues that litigation and regulatory reform remain essential if U.S. capital markets are to retain their leadership position. Unfortunately, the article concludes that federal corporate governance regulation follows a ratchet effect, in which the regulatory scheme becomes more complex with each financial crisis. If so, significant reform may be difficult to achieve.

Selected portions of that chapter were also worked into the relevant parts of my book Corporate Governance after the Financial Crisis.

Go buy the latest issue of The Economist

The most recent Economist has extensive treatment of the way regulation is strangling the American economy. A briefing paper gives extended treatment of how Dodd-Frank continues to grow through regulatory actions fleshing out vague Congressional mandates, for example.

My major quibble is that the various articles lay the blame at the feet of Congress and regulators. The role courts play in gumming up the works gets only brief mention in an article on nuclear power. Any realistic assessment of how the US is over regulated would have to take into account the role of activist judges and so-called "public interest" litigants using environmental and other statutes to throttle growth.

The role of the trial lawyers as so-called private attorneys general also needs to be considered when assessing the impact of law and regulation on the economy. As the Trial Lawyers Inc. project demonstrated, tort suits (and lawsuits in related fields like securities regulation) devour at least 2% of GDP per year. It found that "Over the last 30 years, tort costs grew at a compound annual rate of 9.1%; by comparison, the U.S. population grew 1.1% annually, the consumer price index grew 5.0% annually, and the gross domestic product grew 7.6% annually during the same period."

Anyway, you need to read this compelling critique.

Using the financial crisis to justify regulating Main Street

Lucian Bebchuk is still trying to use the financial crisis of 2007-2008 to justify his sweeping regulations of executive compensation:

In fact, pay arrangements did provide substantial incentives for excessive risk-taking. Under the standard design of pay arrangements, executives were fully exposed to the upside of risks taken but enjoyed substantial insulation from part of the downside of such risks. As a result, executives had incentives to increase risk-taking beyond optimal levels.

The trouble with this rhetorical move should be obvious. Unfortunately, Bebchuk's not the only one peddling it. So I was forced to spell out the problem in my book Corporate Governance after the Financial Crisis:

Scholars are divided as to whether this incentive structure causally contributed to either the housing or credit crunch. Grant Kirkpatrick contends that incentive pay encouraged high levels of risk taking.  Richard Posner argues that the structure of executive compensation practices encouraged management to cling to the housing bubble and “hope for the best.”  In contrast, Peter Mulbert contends that the empirical evidence does not support treating compensation as a major causal factor.  What seems clear, however, is that the problem was localized to the financial sector. Whether or not financial institution executive compensation practices contributed to the crisis, there is no evidence that executive compensation at Main Street corporations did so.

Accordingly, using the financial crisis as a legitimate rationale for regulating Main Street executive compensation practices is a bogus argument.

Should we reward long-term stockholders better than short-termers?

Schumpeter looks at some options for "sustainable" capitalism, including ways of rewarding investors for being long-term holders.

Macey talks to the Economist about Dodd-Frank

Jonathan Macey of Yale Law School explains why the Dodd-Frank bill may not have prevented the financial crisis, but will create jobs for regulators and lawyers, plus I like his tie.

What good are hedge funds? — Marginal Revolution

How can they beat the market consistently, especially if we take EMH seriously at all?  And if they don’t beat the market, how is 2-20 to be justified?  Here is a snippet from an interesting Amazon review:

via marginalrevolution.com

It's an interesting take

Comply or explain versus trial lawyers

Comply or explain requirements have been a feature of the UK regulatory regime for quite a while. It's much less widely used in the US, although a few provisions of SOX and Dodd-Frank adopt versions of it.

Comply or explain gives companies flexibility in responding to corporate governance mandates, while ensuring transparency for investors.

One issue with expanding comply or explain in the US is developing clear guidance on what constitutes an adequate explanation. Jim Hamilton reports on developments in the UK regarding that issue.

A more serious issue, however, is the far more rapacious plaintiffs bar/litigation environment in the USA. Companies may choose to comply rather than risk being sued over claims that their explanation is fraudulent or otherwise inadequate, which eviscerates the key advantage of the comply or explain approach to regulation; namely, flexibility.

If we're going to get serious about comly or explain in the US, we're going to need safe harbors to protect the explanation from being subjected to constant frivolous lawsuits of the sort we're seeing with respect to say on pay disclosures.

Liberal Democrats push SEC on conflict mineral disclosure

Jim Hamilton reports:

Urging the SEC to quickly implement the conflict minerals disclosure provisions of the Dodd-Frank Act, Senators Patrick Leahy (D-VT) and Christopher Coons (D-DE) emphasized that the final regulations must require company conflict minerals reports to be filed with the Commission not furnished. In a letter to the SEC, the Senators also advised that the filed reports should contain enough substantive information so that investors can understand what actions a company has taken to make a reasonable country of origin inquiry. Reports that do not clearly list a company's activities, they said, and SEC regulations allowing a category of ``indeterminate’’ would undermine the congressional intent of Section 1502 of Dodd-Frank. The letter was also signed by House Members Jim McDermott (D-WA) (a co-author of Section 1502), Harold Berman (D-CA), Gregory Meeks D-NY), Donald Payne (D-NJ) and Karen Bass (D-CA).

Section 1502 of the Act requires companies that report to the SEC to disclose the measures they use to certify that their products do not contain conflict minerals. Companies also have to track their supply chains back to a mineral's origin. 

I've been writing about the conflict mineral disclosure requirement for a while. 

 In February 2011, I quoted a discussion of the issue by Broc Romanek and opined that:

My guess is that the costs of providing this disclosure are going to vastly exceed the benefits to investors. As such, it is yet another example of how narrow interest groups were able to hijack the legislative process during Dodd-Frank's drafting so as to advance an agenda wholly distinct from the financial crisis. It's thus also an example of how Congress keeps raising the cost of being public. It's thus yet another example of why American capital markets are losing their competitive standing in the global economy.

In May 2011, I quoted an earlier BNA report predicting that conflict mineral disclosures were going to be hugely expensive to prepare and noted that:

Congress seems to love what I call Kumbayah laws. Everybody on the Hill gets around in a circle, holds hands, condemns some (often admittedly heinous) abuse, sings a couple of choruses of Kumbayah, and then dumps the problem in somebody else's lap. Congress gets to feel good, NGOs pat them on the back, and it costs Congress nothing.

But somebody pays. Consider, for example, the mandate in Dodd-Frank that companies "certify that their products contain no conflict minerals from the Democratic Republic of the Congo (D.R.C.) and adjoining countries." BNA reports that this mandate is going to prove hugely expensive for companies--especially tech companies--and amount to a de facto embargo on such minerals ....

I continued:

Last year President Obama pledged to double US exports by 2015. As the Economist recently commented in a report on the declining value of the US dollar, however:

For Americans concerned about their country’s export prospects, the depressed value of the greenback ought to be good news. In February, the most recent month for which trade data are available, the dollar was 4.5% cheaper in real terms than a year earlier. But although America’s trade deficit did fall in February, it was only because exports fell less steeply than imports. That month’s deficit was still $6 billion higher than a year earlier, when Barack Obama announced a plan to double exports in five years. Achieving that will take more than a cheap currency.

One thing that would help top achieve that goal would be to stop heaping these sort of costs on US business. How about a 4 year freeze on Kumbayah laws?

The STOCK Act will not make whistle blowing illegal

A friend sent along a link to an NRO article by two guys from the Competitive Enterprise Institute -- named John Berlau and David Bier -- in which they claim that the STOCK Act banning insider trading by members of Congress will also ban whistle blowing.

There are so many mistakes in this article that it's hard to know where to start or what order in which to take them up. (As you can see, they caught me on a bad day. But even on a good day we're so close to finally passing the STOCK Act that misinformation about the Act is going to light a very short fuse. And if the civility nannies have a problem with that, they can [colorful but highly uncivil suggestion deleted].)

First, it's critical for you to understand that there are two basic theories of insider trading liability. As the Supreme Court explained in US v. O'Hagan, 521 U.S. 642, 652 -53 (1997):

The two theories are complementary, each addressing efforts to capitalize on nonpublic information through the purchase or sale of securities. The classical theory targets a corporate insider's breach of duty to shareholders with whom the insider transacts; the misappropriation theory outlaws trading on the basis of nonpublic information by a corporate “outsider” in breach of a duty owed not to a trading party, but to the source of the information. The misappropriation theory is thus designed to “protec[t] the integrity of the securities markets against abuses by ‘outsiders' to a corporation who have access to confidential information that will affect th[e] corporation's security price when revealed, but who owe no fiduciary or other duty to that corporation's shareholders.”

The concern in whistle blowing cases, of course, is not the whistle blower will himself trade on the basis of material nonpublic information, but rather that someone to whom he discloses the information will do so. Berlau and Bier thus set up the following hypothetical:

You are a conscientious congressional staffer who still takes seriously the need to be a steward of taxpayers’ money. ... Suddenly, you hear about an outrageous earmark about to be slipped into the bill that would enrich a Fortune 500 company. You decide to alert a network of fiscal watchdogs you’ve met with over the years to wage an instant campaign against this piece of corporate welfare. ...

You sit back and think, “It is indeed possible that someone I send this to could buy stock in the company, or could short the company based on the coming outrage.” You stare at the computer screen wondering how virtually no one noticed how this law could have potentially criminalized an act of whistleblowing as abetting “insider trading.”

They thus claim that the STOCK Act bans whistle blowing. It's possible they could be more wrong, but it's hard to see how.

1. As currently drafted, the STOCK Act broadly bans insider trading by members of Congress, Congressional staffers, and other federal employees. As currently drafted, however, the STOCK Act is unnecessarily broad. As I demonstrated (conclusively, if I may so myself who shouldn't) in my article Insider Trading Inside the Beltway, insider trading and tipping by Congressional staffers and executive branch employees is already illegal under current law. It was only Members of Congress who fell through the cracks of current law. If whistle blowing constitutes an illegal tip, accordingly, it's illegal under current law. The STOCK Act thus doesn't change the liability exposure of Congressional staffer whistle blowers in a single iota.

Berlau and Bier's hysteria is thus wholly misplaced. But even if the STOCK Act did change the law applicable to staffers, it still wouldn't make whistle blowing illegal. You see, all the STOCK Act does is to extend current law to members of Congress etc. And there's no way whistle blowing is illegal under current law.

2. In insider trading jargon, disclosure to someone who uses the information to trade is known as "tipping." Under the classical theory of insider trading, it is clear beyond the shadow of a doubt that a tipper can only be held liable if he gets a personal benefit for making the tip. as the Supreme Court explained in Dirks v. SEC, 463 US 646, 661-63 (1983):

In determining whether a tippee is under an obligation to disclose or abstain, it thus is necessary to determine whether the insider's “tip” constituted a breach of the insider's fiduciary duty. All disclosures of confidential corporate information are not inconsistent with the duty insiders owe to shareholders. ... Whether disclosure is a breach of duty therefore depends in large part on the purpose of the disclosure. This standard was identified by the SEC itself in Cady, Roberts: a purpose of the securities laws was to eliminate “use of inside information for personal advantage.” Thus, the test is whether the insider personally will benefit, directly or indirectly, from his disclosure. Absent some personal gain, there has been no breach of duty to stockholders. And absent a breach by the insider, there is no derivative breach.

The Dirks case itself in fact involved whistle blowing, albeit in the corporate context. The Court held that the whistle blower got no personal benefit (Id. at 666-67):

It is clear that neither Secrist nor the other Equity Funding employees [i.e., the tippers] violated their Cady, Roberts duty to the corporation's shareholders by providing information to Dirks. The tippers received no monetary or personal benefit for revealing Equity Funding's secrets, nor was their purpose to make a gift of valuable information to Dirks. As the facts of this case clearly indicate, the tippers were motivated by a desire to expose the fraud. In the absence of a breach of duty to shareholders by the insiders, there was no derivative breach by Dirks [i.e., the tippee].

Berlau and Bier's claim -- based on a single 2003 law review article -- that "courts are split on whether a 'personal benefit' is even required for guilt" is thus obviously erroneous insofar as the classical theory is concerned.

3. To be sure, most (all?) Congressional staffer tipping would implicate the misappropriation theory (since they're unlikely to be insiders of the issuer about whom they tipped information). And it is true that some older district court opinions cast doubt on whether the Dirks personal benefit requirement applies to misappropriation theory.

BUT (and it's a big but) those cases were almost all district court opinions. The relevant passages of most are dicta rather than holding. They are all older cases. And they are clearly in the minority.

In a 2011 PLI outline, Michael S. Schachter and Ian M. Christy of Willkie Farr & Gallagher (1903 PLI/Corp 447, 453) explain that:

Most courts considering the issue have held that the personal benefit test does apply in misappropriation cases for policy reasons. The Eleventh Circuit noted in SEC v. Yun that attaching different requirements “constructs an arbitrary fence” between the two theories, while the harm to the securities market would be the same in both cases. Additionally, because insiders who tip are often misappropriating information as well, employing different tests for liability would, according to Yun, “essentially render Dirks a dead letter” by creating a loophole for the government to avoid the personal benefit test in many cases involving corporate insiders.

Law professor Donna Nagy likewise explains that (94 Iowa L. Rev. 1315, 1348 n.196): "courts generally apply Dirks' requirement of a personal benefit in misappropriation cases, notwithstanding that Dirks was a case under the classical theory." As support she cites the leading treatise Ralph C. Ferrara, Donna M. Nagy & Herbert Thomas, Ferrara on Insider Trading and the Wall 2-71 to -74 (2008).

4. It's probably not enough that the tipper think it is "possible that someone I send this to could buy stock in the company." In Elkind v. Liggett & Myers, Inc. 635 F.2d 156, 167 (2d Cir. 1980), the Court held that:

One who deliberately tips information which he knows to be material and non-public to an outsider who may reasonably be expected to use it to his advantage has the requisite scienter. ... One who intentionally places such ammunition in the hands of individuals able to use it to their advantage on the market has the requisite state of mind for liability under [sec.] 10(b) and Rule 10b-5.

Granted, the Second Circuit subsequently rejected the argument that "that tippers must specifically know that their breach of a fiduciary obligation in misappropriating information will lead to trading on the information." U.S. v. Libera, 989 F.2d 596, 600 (2d Cir. 1993). As Professor Donna Nagy has observed (59 Ohio St. L.J. 1223, 1263 n.199), however:

This aspect of Libera's holding certainly must be reevaluated in light of O'Hagan. If the tippers did not have any knowledge that the information conveyed would be used by the tippees for securities trading purposes, it is difficult to see how the tippers' breach of duty (in which the tippees are co-participants) can satisfy even the broadest interpretation of Section 10(b)' s “in connection with” nexus. And without a breach of duty on the part of the tipper “in connection with” a securities transaction, there is simply no basis for imposing Section 10(b) and Rule 10b-5 liability on either the tippers or the tippees.

On top of which, I don't see how Libera could ever have been squared with the scienter requirement under Rule 10b-5.

5. In an especially egregious piece of fearmongering, Berlau and Bier claim that the SEC might extend Regulation FD to Congress, such that it will "require meetings and calls in which Congress members and staffers participate to be open to the public or not occur at all. The result would be less outflow of information from Congress and a less informed public." There is NOTHING in the STOCK Act that would require, encourage, or authorize the SEC to do so. Nada. Zilch. Zip. On top of which, Regulation FD was adopted precisely because the Dirks framework did not make selective disclosure by corporate insiders to analysts illegal. The SEC authority to adopt Reg FD thus does not depend on insider trading law. Accordingly, in the incredibly unlikely event that the SEC decides to extend Regulation FD to Congress, it could do so even if the STOCK Act never passes.

6. I admit that I've long suspected that the SEC thinks there is an invisible footnote to the First Amendment that exempts it from the prohibition on interfering with the right of free speech. After all, what is disclosure regulation if not a regulation of speech? What is the rule on shareholder proposals, if not forced speech? But surely not even the SEC would argue that it can police political speech in the same manner it polices corporate speech. And even if the SEC did so, have Berlau and Bier never heard of the courts? I'm prepared to wager the best bottle of wine in my cellar (probably the 1982 Chateau Gruaud Larose or the 1982 Chateau Montrose) that if the SEC tried to apply the insider trading laws to whistle blowing or Reg FD to Congress that the courts would invalidate in a heartbeat.

To SUM up: I don't know why Berlau and Bier decided to peddle this load of codswallop, but a load of codswallop it is. The STOCK Act doesn't change the law applicable to Congressional staffers. Under current law, whistle blowing is not illegal tipping. Ergo, whistle blowing by staffers will still be perfectly legal once Congress passes the STOCK Act.

Further reading:

Bainbridge, Stephen M., The Stop Trading on Congressional Knowledge Act (August 13, 2009). UCLA School of Law, Law-Economics Research Paper No. 09-16. Available at SSRN: http://ssrn.com/abstract=1449744

Bainbridge, Stephen M., Insider Trading Inside the Beltway (June 30, 2010). UCLA School of Law, Law-Econ Research Paper No. 10-08. Available at SSRN: http://ssrn.com/abstract=1633123

Quoted re STOCK Act by CNBC's John Carney

It appears that we are very close to outlawing insider trading by members of Congress. ...

It may prove difficult to prosecute members of Congress for insider trading. Congress, after all, controls the budget of the Securities and Exchange Commission. Are regulators likely to pursue lawmakers who can defund their agency?

This prompted UCLA law Professor Stephen Bainbridge to ask “will the SEC bite the hand that feeds it?”

via www.cnbc.com

 

What are the most over studied problems in corporate law?

Dave Hoffman recently posted on the question of whether corporate veil piercing is really the most frequently litigated issue in corporate law, to which I responded (civilly, mind you) by posing a question of my own. In response, Hoffman wrote:

I suppose I care, mildly, because it might be that attention better spent on other issues in corporate law, like someone's ... nontraditional ... theories of director primacy, has instead been diverted to veil piercing on the theory that piercing is more practically important than it is.  And because if if you search the web, you'll find dozens of companies puffing this exact claim to sell you their incorporation products and advice.  Or it might be that the question is worth asking simply for love of the game.

The love of the game answer is, of course, unresponsive because the same answer would justify paying attention to veil piercing.

Hoffman's other point, however, is both responsive and quite interesting. In effect, he's asking what corporate law topics get more attention from legal scholars then their real world importance merits and which topics get too little attention given their real world importance. And that's a question worth thinking about, because it implies that we corporate law scholars are collectively falling down on the job. Put another way, we're exhibiting classic herding behavior by collectively beating a few horses to death.

So what would go on my list of topics to which we devote too much attention? Please note, that I'm not necessarily saying these are unimportant topics. I'm just saying they get more attention than necessary. So here are some candidates, in no particular order. 

• Whether the corporation is a nexus of contracts
• Corporate philanthropy
• Corporate social responsibility
• Predicting what Rawls or Dworkin would say about anything remotely related to corporate law
• The Perlman v. Feldman suite of issues
• The utility of rational actor models in the law and economics of corporate governance
• Anything having to do with the Constitution and corporations
• Insider trading? (Very important, of course, but written to death)
• Executive compensation (ditto)
• Agency costs (ditto)
• Corporate takeovers (ditto, at least back in the day)
• The race to the bottom
• Fiduciary duty of directors in the vicinity of insolvency
• A federal law of corporations
• Corporate personhood

Mea culpa.

I'm opening comments on this post, for on topic non-anonymous suggestions only.

"Is Any CEO Worth $189,000 Per Hour?"

Prompted by news of the $378 million new Apple CEO Tim Cook will make in his first year on the job, BusinessWeek posted an article headlined by the titular question. It's a fair article, which you ought to go read.

Qoheleth tells us that "What has been, that will be; what has been done, that will be done. Nothing is new under the sun! Even the thing of which we say, 'See, this is new!' has already existed in the ages that preceded us."

Just so.

Back in the 1930s, a lawsuit challenging executive bonuses as corporate waste gave rise to the aphorism “no man can be worth $1,000,000 per year.” One wonders what the anti-CEO pay campaigners of those days would make of a man supposedly worth $1 million per 5.3 hours?

I discuss these arguments in my new book Corporate Governance after the Financial Crisis, in which I argue that:

The rhetoric of class warfare makes a poor foundation for economic policy. As a justification for regulating executive compensation, however, it is particularly inapt. First, why single out public corporation executives? Many occupations today carry even larger rewards. The highest paid investment banker on Wall Street in 2006 was Lloyd Blankfein of Goldman Sachs, for example, who “earned $54.3 million in salary, cash, restricted stock and stock options,”[1] or about 4 times the median CEO salary from the year before. The pay of some private hedge fund managers dwarfed even that sum. Hedge fund manager James Simons earned $1.7 billion in 2006, for example, and two other hedge fund managers also cracked the billion-dollar level that year.[2] Not to mention, of course, the considerable sums earned by top athletes and entertainers.

Second, regulating executive compensation may scratch the public’s populist itch, but it does little to address inequalities of income and wealth. To be sure, as Brett McDonnell observes, fat cat “CEOs have become poster boys for” the dramatic increase in “inequality in income and wealth in this country.”[3] Even if one assumes that redressing such inequalities is appropriate social policy, however, capping or cutting CEO pay is not an effective means of doing so.

---

[1] Jenny Anderson & Julie Creswell, Top Hedge Fund Managers Earn Over $240 Million, N.Y. Times, Apr. 24, 2007.

[2] Id.

[3] Brett H. McDonnell, Two Goals for Executive Compensation Reform, 52 N.Y.L. Sch. L. Rev. 586, 587 (2008).