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Provenance Rutherford Cabernet Sauvignon (Napa Valley) 2000

Provenance 2000 Rutherford cabernet sauvignon (WS 90). It was infanticide — nowhere near ready to drink — but with promise for the future. Firm with smooth tannins, deep color, but almost no nose. The flavor profile included currants and cassis, leathery beef, and oriental spices; not much Rutherford dust. Needs time. Interestingly, Provenance is run by Duckhorn’s longtime winemaker Tom Rinaldi. At Provenance he is pursuing the same blending philosophy he championed at Duckhron. This wine, for example, is 15% merlot. Grade: A-

Outsider reverse veil piercing

In outsider reverse veil piercing, a personal creditor of the shareholder seeks to disregard the corporation's separate legal existence. Unlike regular veil piercing, in which a creditor of the corporation is trying to reach the personal assets of a shareholder, in this situation a creditor of the shareholder wants to reach the assets of the corporation in order to satisfy the creditor's claims against the shareholder. A number of courts have recognized such a cause of action. I think it’s a pernicious and evil doctrine that should be cast into the outer darkness where there is weeping and gnashing of teeth.

This post is specifically prompted by C.F. Trust, Inc. v. First Flight L.P., 580 S.E.2d 806 (Va.2003), in which the Virginia supreme court recently recognized outsider reverse piercing as valid under Virginia law. (For those who want even more information on regular veil piercing, reverse veil piercing, and/or outsider reverse veil piercing, you can buy my Corporation Law and Economics text and flip to Chapter 4.)

The CF Trust court opined “that there is no logical basis upon which to distinguish between a traditional veil piercing action and an outsider reverse piercing action. In both instances, a claimant requests that a court disregard the normal protections accorded a corporate structure to prevent abuses of that structure.” Au contraire. The problem presented by outsider reverse veil piercing is reminiscent of the issues raised by the old "jingle rule" of partnership law. Section 40 of the UPA (1914) provides that personal creditors of a partner have priority with respect to the partner's personal assets and creditors of the partnership have priority with respect to partnership assets. The "jingle rule," however, has been superseded for all practical purposes by section 723 of the federal Bankruptcy Code. That section provides that the firm's creditors will be paid out of firm assets and then have equal rights to participate with personal creditors in dividing up personal assets. The rationale for this change seems to have been that prospective creditors of the partnership rely on the creditworthiness of the individual partners in making lending and contracting decisions. In response to the federal law, UPA (1997) section 807 de facto repealed the jingle rule.

UPA (1997) thus does not allow a personal creditor of a partner direct access to partnership assets. Section 502 limits the partner's "transferable interest" in the firm to "the partner's share of the profits and losses of the partnership and the partner's right to receive distributions." Section 504 then allows a "judgment creditor" of a partner to "charge the transferable interest of the judgment debtor to satisfy the judgment." In effect, the creditor thus gets a lien on the partner's interest. Although a creditor who has foreclosed on that lien may seek judicial dissolution of the partnership, a court will only grant dissolution if "it is equitable to wind up the partnership business." UPA (1997) section 801(6).

Corporate law does not contain comparable provisions, but essentially the same result obtains through application of the standard judgment collection rules. Courts that accept outsider reverse veil piercing, however, disrupt this scheme by allowing personal creditors of a shareholder direct access to corporate assets.

To the extent that outsider reverse veil piercing effectively gives priority to personal creditors in the corporate setting, it seems just as problematic as the old jingle rule, albeit for slightly different reasons. As with the jingle rule question, the issue is: whose creditors shall have priority with respect to which assets? Outsider reverse veil piercing allows the creditor to avoid the more demanding proof required by traditional theories of conversion or fraudulent transfer. Outsider reverse veil piercing also effectively bypasses the standard approach to collecting a judgment against a corporate shareholder, in which the creditor attaches the debtor's shares in the corporation rather than the assets of the corporation itself. Unsecured creditors who relied on firm assets in lending to the corporation are thus disadvantaged. Similarly, if there are other shareholders, their interests are adversely affected if the corporation's assets can be directly attached by the personal creditor of one shareholder. In contrast, in ordinary (i.e., forward) veil piercing cases, a creditor may reach only the assets of the controlling shareholder who is determined to be the corporation's alter ego.

Mark Roe's "Strong Managers, Weak Owners"

In their 1932 classic, THE MODERN CORPORATION AND PRIVATE PROPERTY, Berle and Means brought to popular attention the separation of ownership and control in U.S. corporations: shareholders exercised virtually no control over either day to day operations or long-term policy; instead, control was vested in the hands of professional managers. Separation of ownership and control occurred, according to Berle and Means, because important technological changes during the 1800s, especially the development of modern mass production techniques, gave great advantages to firms large enough to achieve economics of scale, which in turn gave rise to giant industrial corporations. These firms could be financed only by aggregating many small investments. Modern corporate governance scholars refer to the consequences of separating ownership and control as agency costs, but Berle and Means had identified the basic problem over forty years before the current terminology was invented: "The separation of ownership from control produces a condition where the interests of owner and of ultimate manager may, and often do, diverge ...."

In STRONG MANAGERS, WEAK OWNERS, Mark Roe strikes out in a new direction, by attacking the origins of the agency cost problem. The question Roe poses is the foundational one of whether Berle and Means were correct in assuming that the separation of ownership and control is an inherent aspect of large public corporations. Roe contends that dispersed ownership was not the inevitable consequence of impersonal economic forces, but rather the result of a series of political decisions motivated by a fear of concentrated economic power. Investments could have been channeled to industrial enterprises through large financial intermediaries, such as banks, insurance companies, and mutual and pension funds. Put another way, while it was necessary to aggregate and tap the savings of large numbers of individual investors in order to fund major industrial corporations, such aggregation could have taken place in financial institutions specifically designed to provide savings opportunities. In turn, it would have been those institutions that invested in industrial corporations. American corporate governance did not evolve along these lines because the law created a series of obstacles to financial intermediaries. If those obstacles had not existed, ownership might not have fragmented and thus might not have separated from control. The implication of this thesis, of course, is that while economic forces shaped modern corporate governance, they did so within the parameters set by law. As such, the governance structure of U.S. public corporations may not be optimal in an absolute sense, but only relative to the set of possibilities defined by our legal system.

If I ever get around to working up the "Corporate Canon" blog "a reader" requested, Roe's book defintely would be on it. It is a major and important contribution to our understanding both of (a) how American corporate law/governance evolved, describing in detail the forces that affected that evolution, and (b) comparative corporate law analysis across diverse economic systems, especially the US, Germany, and Japan. This is not too say that I don't disagree with parts of Roe's analysis. I set out my critique in the extended post below. For even more gore details, you can download a law review article-length book review I wrote some years ago here.

Roe focuses on legal rules preventing institutional investors from acting as financial intermediaries between the investing public and the management of public corporations. The first third of STRONG MANAGERS is devoted to a historical review of the rules that preclude institutions from playing a significant role in corporate governance. In the second third, he reviews recent developments, which perpetuated the legal obstacles to governance activism by institutions. In the final part, he addresses the essential policy implication of his analysis: should the legal system encourage institutions to take a more active governance role?

One can quibble with portions of Roe's historical argument. There is, for example, good evidence that ownership and control separated long before most of the rules Roe blames for the separation went on the books. At the very latest, ownership and control of large corporations had separated by the middle of the nineteenth century. In contrast, the rules with which Roe is concerned mostly came into existence only after 1900. Granted, banks fragmented in the first third of the 18th century, but a number of critical restrictions did not come into play until the New Deal. Insurers were largely unregulated until after 1906. Mutual funds, albeit long of little importance, likewise were essentially unregulated until the New Deal. Given this free market environment, why did these or other financial intermediaries not step into the economic niche opened when ownership and control separated during in the early and mid-1800s?

In other words, Roe has not proven that the Berle-Means corporation would not have evolved in the absence of the constraints on financial intermediaries he describes. But, at a minimum, Roe does demonstrate that politics did nothing to impede the development of the Berle-Means corporation, perhaps facilitated its evolution, and certainly helped sustain it by preventing financial intermediaries from taking active governance roles. In and of itself, that showing is a formidable accomplishment and a valuable contribution to the literature.

Although the first two sections of STRONG MANAGERS are notable in their own right, the book takes on importance mainly because of the significance of the policy questions to which the final section is addressed. Space does not permit one to do full justice to Roe's argument, which is nuanced and well-crafted. Suffice it to say that relatively little has changed since STRONG MANAGERS was published. Despite increased activism in recent years, institutions still are mostly passive. Even the most active institutional investors spend only trifling amounts on corporate governance activism. Institutions devote little effort to monitoring management, rarely conduct proxy solicitations, do not to try to elect directors, and rarely coordinate their activities. And, perhaps, this is a good thing. As Roe concedes, there is good evidence that bank-dominated finance has harmed that Japanese and German economies by impeding venture capital. Moreover, institutional investors may well abuse control by self-dealing. Even if institutional investors are entirely self-less, greater control on their part would still be undesirable if the separation of ownership and control mandated by U.S. law has substantial efficiency benefits. Here is where Roe and I part company-I suspect the Berle-Means corporation has significant economic advantages over its alternatives; he is skeptical. Perhaps only time will tell, as competition in increasingly global markets puts various systems of economic organization to the test. In the meanwhile, Roe's book belongs in the library of anyone interested in corporate law or governance.

Does state corporate law really race to the top?

The Michigan legislature recently amended the state’s control share acquisition statute to make it easier for the Taubman family to fend off the hostile bid for Taubman Centers from Simon Property Group and Westfield America Trust (I describe these statutes and the Michigan amendment in the Extended Post below). Several readers have written or used the comment feature to ask how I square these statutes with the race to the top hypothesis I have espoused in earlier posts. A fair question, indeed, but the two can be squared.

According to the standard race to the top account, investors will not purchase, or at least not pay as much for, securities of firms incorporated in states that cater too excessively to management. Lenders will not make loans to such firms without compensation for the risks posed by management's lack of accountability. As a result, those firms' cost of capital will rise, while their earnings will fall. Among other things, such firms thereby become more vulnerable to a hostile takeover and subsequent management purges. Corporate managers therefore have strong incentives to incorporate the business in a state offering rules preferred by investors. Competition for corporate charters thus should deter states from racing to the bottom. (The competing “race to the bottom” hypothesis argues that states compete in granting corporate charters. After all, the more charters the state grants, the more franchise and other taxes it collects. According to the race to the bottom theory, because it is corporate managers who decide on the state of incorporation, states compete by adopting statutes allowing corporate managers to exploit shareholders.)

The evidence on the race to the top versus race to the bottom dispute is not free from controversy, but I think the weight of the evidence clearly favors the race to the top. Roberta Romano’s event study of corporations changing their domicile by reincorporating in Delaware, for example, found that such firms experienced statistically significant positive cumulative abnormal returns. Roberta Romano, Law as a Product: Some Pieces of the Incorporation Puzzle, 1 J. L. ECON. & ORG. 225 (1985). In other words, reincorporating in Delaware increased shareholder wealth. This finding strongly supports the race to the top hypothesis. If shareholders thought that Delaware was winning a race to the bottom, shareholders should dump the stock of firms that reincorporate in Delaware, driving down the stock price of such firms. As Romano found, and all of the other major event studies confirm, there is a positive stock price effect upon reincorporation in Delaware. See generally ROBERTA ROMANO, THE ADVANTAGE OF COMPETITIVE FEDERALISM FOR SECURITIES REGULATION 64-73 (2002) (discussing the relevant studies and criticisms thereof).

The event study findings are buttressed by a well-known study by Robert Daines in which he compared the Tobin’s Q of Delaware and non-Delaware corporations. (Tobin’s Q is the ratio of a firm’s market value to its book value and is a widely accepted measure of firm value.) Daines found that Delaware corporations in the period 1981-1996 had a higher Tobin’s Q than those of non-Delaware corporations, suggesting that Delaware law increases shareholder wealth. Robert Daines, Does Delaware Law Improve Firm Value?, 62 J. FIN. ECON. 525 (2001). Although subsequent research suggests that this effect may not hold for all periods, Daines’ study remains an important confirmation of the event study data.

Additional support for the event study findings is provided by takeover regulation. Compared to most states, which have adopted multiple anti-takeover statutes of ever-increasing ferocity, Delaware’s single takeover statute is relatively friendly to hostile bidders. An empirical study of state corporation codes by John Coates confirms that the Delaware statute is the least restrictive and imposes the least delay on a hostile bidder. John C. Coates IV, An Index of the Contestability of Corporate Control: Studying Variation in Takeover Vulnerability (June 30, 1999). Given the clear evidence that hostile takeovers increase shareholder wealth, this finding is especially striking. See generally Stephen M. Bainbridge, Corporation Law and Economics 612-14 (2002). The supposed poster child of bad corporate governance, Delaware, turns out to be quite takeover-friendly and, by implication, equally shareholder-friendly. (Indeed, check out this headline: "Beware Delaware." The article goes on to argue that: "Since last summer, the Delaware Supreme Court has issued at least five decisions of great concern to the corporate bar. Each was remarkable not only because it found against directors and in favor of shareholders, but also because it reversed a lower court ruling that went the other way.")

This takes us to the Michigan anti-takeover statute. Given that state takeover regulation demonstrably reduces shareholder wealth but that most states have nevertheless adopted anti-takeover statutes, what are we to make of that data point? In my view, we must concede that state regulation of corporate takeovers appears to be an exception to the rule that efficient solutions tend to win out. But so what? Nobody claims that state competition is perfect. The question is only whether some competition is better than none. Delaware’s relatively hospitable environment for takeovers suggests an affirmative answer to that question.

In other words, the Michigan statute proves a central point of public choice theory. The incentives of legislators and regulators are driven by rent-seeking and interest group politics. In turn, the incentives of directors and managers who lobby state legislators vary by context. In most contexts, the financial incentives of directors and managers are aligned with those of shareholders for the reasons discussed above. In the hostile takeover context, however, the incentives of directors and managers deviate from those of the shareholders. Hostile takeovers are frequently followed by management purges, especially at the top management and board levels. Nobody likes to be fired, so it is hardly surprising that directors and managers try to use the legislative process to protect their jobs. Neither, however, does it disprove the race to the top hypothesis; it only shows that there is an exception to every rule.

Control share acquisition statutes rely on the states' traditional power to define corporate voting rights as a justification for regulating the bidder's right to vote shares acquired in a control transaction. A "control share acquisition" is typically defined as the acquisition of a sufficient number of target company shares to give the acquirer control over more than a specified percentage of the voting power of the target. The triggering level of share ownership is usually defined as an acquisition which would bring the bidder within one of three ranges of voting power: 20 to 33 1/3%, 33 1/3 to 50% and more than 50%. Most control share acquisition laws provide that shares acquired in a control share acquisition shall not have voting rights unless the shareholders approve a resolution granting voting rights to the acquirer's shares. See chapter 8 of my Mergers and Acqusitions text for more details.

Members of the Taubman family formed a group to pool their shares’ voting powers to oppose the Simon Property and Westfield hostile bid. Once aggregated, their combined shares exceeded the 33 1/3% threshold. Under the Michigan statute as then worded, the formation of the group constituted a control share acquisition as defined by statute (even though they did not acquire more shares in the usual sense of buying some), or so a federal court held back in May. Accordingly, the formation of the group required approval by Taubman Center’s other shareholders. The new bill amends the control share acquisition statute to permit shareholders to form such a group without triggering the voting requirement.

The stated purpose of control share statutes is providing shareholders with an opportunity to vote on a proposed acquisition of large share blocks which may result in or lead to a change in control of the target. These statutes are premised on the assumption that individual shareholders are often at a disadvantage when faced with a proposed change in control. If the target's shareholders believe that a successful tender offer will be followed by a purchase by the offeror of non tendered shares at a price lower than that offered in the initial bid, for example, individual shareholders may tender their shares to protect themselves from such an eventuality, even if they do not believe the offer to be in their best interests.

By requiring certain disclosures from the prospective purchaser and by allowing the target's shareholders to vote on the acquisition as a group, control share acquisition statutes supposedly provide the shareholders a collective opportunity to reject an inadequate or otherwise undesirable offer. For example, since control share acquisition statutes generally require the offeror to disclose plans for transactions involving the target that would be initiated after the control shares are acquired, shareholders presumably would be unlikely to approve a creeping tender offer or street sweep which would be followed by a squeezeout back end merger at a price less than or in a consideration different than that paid by the acquirer in purchasing the initial share block.

Al Hunt on Grasso and the NYSE

Al Hunt’s op-ed in today’s Wall Street Journal (subscription req’d) uses the Grasso pay imbroglio to recycle virtually every grievance in the current left-liberal talking points guide, but lets stick to our knitting – i.e., corporate governance. Hunt complains that Grasso’s salary of $140 million is “indefensible” relative to what the “average worker” gets paid. (In a particularly invidious move, Hunt drags in the case of a wounded GI who had to reimburse the government for food during his hospital stay. While deplorable, its not clear what that case has to do with Grasso specifically or even executive compensation generally.) All of which raises the question: in thinking about executive compensation is the comparison to what average workers make a valid one or just a debater’s cheap shot?

If comparing what Grasso makes to the pay of an average worker is okay, then don’t we also have to compare what Shaquille O’Neal makes to that worker’s pay? If Hunt wants to argue that there is a dollar amount of annual earnings that nobody should be allowed to exceed, that’s one thing. But I doubt even Paul Krugman would go that far. Indeed, Hunt says that some folks – naming Tiger Woods, Kevin Costner, and Bill Gates – deserve their compensation, just not Grasso: "Most Americans are upwardly mobile and celebrate the riches of the truly successful and deserving, whether it's Michael Jordan, Kevin Costner, or Bill Gates. But in a time when sacrifices are being made by firefighters, schoolteachers and Marine staff sergeants, many of these same Americans resent the Dick Grassos." I don’t know why he thinks people resent Grasso's pay, but not Costner's. Has Hunt seen any of Costner’s recent movies? I mean, really. If any of the four he names should be joining firefighters et al. making sacrifices, it is Costner. Did you see "Waterworld"? or "The Postman"? Whereas nobody seriously doubts that Grasso was, at the very least, competent and most concede he was doing a good job.

But lets get serious about this for a minute. How much you get paid depends in large part on the thickness of the market for your services. In a thick market, wages tend to be low because there are many potential employees – all more or less fungible – competing for jobs. In a thin market, however, wages tend to be high because many employers are competing to hire a small number of eligible workers. The market for burger flippers is very thick. The market for law professors is relatively thick (so, for that matter, is the market for pundits -- if blogging has done nothing else, it has proven that people like Glenn Reynolds or Eugene Volokh can do punditry at a very high level even though they lacked access to a national medium until recently -- so maybe Hunt's mad because he's in for a paycut?). The market for CEOs of Fortune 500 companies (which is what the NYSE essentially is) is thin. I’d guess the number of people who have what it takes to run a Fortune 500 company isn’t much larger than the number of people who can run a NBA fast break. Its just supply and demand, folks.

Having said that, there are some important differences between Grasso’s and Shaq’s contracts, which do cut against the former. First, although I don't have the citations at the tip of my fingers, I have seen a couple of recent studies to suggest that boards erroneously believe the CEO market is thinner than it actually is, which tends to artificially inflate CEO salaries. Boards tend to want proven track records (picking an unproven CEO who tanks is bad for the board’s reputation), which limits the pool through the “Experience Required” phenomenon. Boards also tend to pick CEO candidates who resemble the prevailing demographics of the directors, which further artificially limits the pool.

Second, and more pertinent, Shaq is accountable in ways that Grasso was not. Shaq is subject to constant evaluation by Phil Jackson and Jerry Buss – neither of whom are shrinking violets. One has little doubt they make darn sure they are getting what they pay for. In contrast, although Grasso was nominally subject to evaluation by the NYSE board, that board was comprised in large part of ceremonial “public” directors who we now know did not take the job as seriously as they should have and representatives of the seat-holders who we have long known have various conflicts of interest. The board itself, moreover, was accountable to no one. So it all comes back to governance. In fairness to Hunt, he does devote a section in the middle of the screed to the governance issues. Contra the main thrust of Hunt’s column, however, the problem is not the dollar amount. The problem is that NYSE’s current governance structure had no mechanism for ensuring that the Exchange got back value commensurate with whatever amount it paid. Everything else is just so much populist agitprop.

Mercuro and Medema's Economics and the Law

What is law and economics? It is the school of jurisprudence in which the tools of microeconomic analysis are used to study law. Those of us who practice economic analysis have a deceptively simple task. We translate some legal doctrine into economic terms. We then apply a few basic principles -- cost-benefit analysis, collective action theory, decision-making under uncertainty, risk aversion, and the like -- to the problem. Finally, we translate the result back into legal terms.

Law and economics unquestionably is the most successful form of intellectual arbitrage in the history of jurisprudence. Why? Traditional forms of legal scholarship were mostly backward looking. One reasoned from old precedents to decide a present case, seemingly without much concern (at least explicitly) for the effect today's decision would have a future behavior. Yet, law is necessarily forward looking. To be sure, a major function of our legal system is to resolve present disputes, but law's main job is to regulate future behavior. The law and economics movement succeeded because it recognized that judges cannot administer justice solely retrospectively. They must also consider what rules their decisions will create to guide the behavior of other actors in the future. Even more important, however, law and economics gives judges systematic mechanisms for predicting how rules will affect behavior.

Mercuro and Medema's Law and Economics offers a comprehensive overview of law and economics. Unlike many texts, it is not limited to the Chicago School (as exemplified by such stalwarts as Manne, Easterbrook, and Posner). They also describe the New Haven school (classically exemplified by Calabresi), the public choice theory of Arrow, Buchanan, and others, as well as both the traditional and new institutional economics. By reminding us that law and economics is not a homogeneous field, and providing a fair commentary on each of the major traditions within the larger discipline, they offer an excellent introduction to this important area of jurisprudence.

One nice touch, which makes the text useful for a wide audience, is that it does not assume familiarity with either economics or law. The introduction offers a brief historical overview of basic jurisprudence, as well as an appendix explaining basic economic principles. Consequently, the book will serve well the interests both of lawyers who need to brush up on economics and economists interested in law.

Criticisms: There is little in the way of critical evaluative judgment. Indeed, Mercuro and Medema disavow any effort at criticism. As a result, the reader is left to his own devices. Second, I am not persuaded by Mercuro and Medema's decision to include a rather lengthy chapter on critical legal studies. Criticism of law and economics has been a major project of CLS scholars, but CLS scholarship has had no influence of any significance on any of the dominant strains of law and economics thinking. In this case, moreover, the failure to exercise critical evaluative judgment means that the generalist reader may have difficulty assessing the (bogus) claims made by CLS. In general, while maintaining facial neutrality on their own part, Mercuro and Medema give far more attention to CLS and Marxist critiques of law and economics than they do to conservative critiques thereof or to law and economics criticisms of CLS.

Behavioral Economic Analysis of Law

Law and economics remains the most successful example of intellectual arbitrage in the history of corporate jurisprudence. It is virtually impossible to find serious corporate law scholarship that is not informed by economic analysis. Even those corporate law scholars who reject economic analysis spend much of their time responding to those who practice it.

As with any model claiming predictive power, law and economics rests on a theory of human behavior. Specifically, neoclassical economics is premised on rational choice theory, which posits decisionmakers who are autonomous individuals who make rational choices that maximize their satisfactions. Critics of the law and economics school have long complained that rational choice is, at best, an incomplete account of human behavior. The traditional law and economics response to this complaint is that rationality is simply an abstraction developed as a useful model of predicting the behavior of large numbers of people and, as such, does not purport to describe real people embedded in a real social order. Until quite recently, moreover, empirical research tended to confirm that the rational choice model of human behavior is a good first approximation of how large numbers of people are likely to behave in exchange transactions.

Over the last 10-15 years, however, a new school of economic analysis has emerged that challenges the rational choice model precisely on its predictive power. Empirical and laboratory work by cognitive psychologists and experimental economists has identified a growing number of anomalies in which behavior appears to systematically depart from that predicted by rational choice. A good example is the so-called status quo bias: All else being equal, decisionmakers favor maintaining the status quo rather than switching to some alternative state. The status quo bias can lead to market failure where decisionmakers’ preference for the status quo perpetuates suboptimal practices.

My thoughts on this topic were prompted by hearing my colleague Russell Korobkin -- a member of the Volokh Conspiracy (albeit a rarely seen one) -- give a presentation to a faculty workshop on behavioral economic analysis of form contracts; his presentation was based on an excellent paper, by the way, which he has posted to SSRN. (Strongly recommended.) I got to thinking some more about behavioral economics after having lunch last Friday with my colleague Victor Fleischer of A Taxing Blog. Behavioral economics is something of the flavor of the month in legal education, especially on the part of those with an ideological disposition against the free market connotations of neoclassical economic analysis. After a brief flirtation with it myself, I have become much more skeptical, for the reasons developed at length in the Extended Post below.

Empirical demonstrations of this decisionmaking bias have focused on the so-called endowment effect. Subjects commonly place a higher monetary value on items they own than on those that they do not own, even if the two items have the same market value. Accordingly, subjects must be paid more to give up something than they would be willing to pay to acquire the same object. The classic demonstration of the endowment effect variant of the status quo bias was a laboratory experiment in which students were initially endowed either with a coffee mug or six dollars cash. Mug holders were asked to identify the minimum amount they would accept to sell the mug, while cash holders were asked to specify the maximum amount they would be willing to pay to purchase a mug. Subjects were told that a market-clearing price would be determined and trades executed between mug holders willing to accept that amount and cash holders willing to pay that price. It turned out that the price demanded by mug holders was about twice that cash holders were willing to pay, so that very few trades took place.

I do not deny that there is considerable empirical evidence for the endowment effect and the status quo bias. More generally, I also do not deny that behavioral economics is a potentially useful tool that any legal scholar should have in his toolkit. As the Economist explained:

[I]f the endowment effect is real, people's economic decisions are fundamentally different from what economists have assumed. The implications of this are profound. To take one example, the Coase theorem, which argues that initial allocations of wealth do not matter as long as markets allow people to trade their stakes—the rationale for government auctions of everything from radio spectrum to mobile-telephone licences—would no longer be valid. To take another, although economists have shown that you need only a few sharp traders for prices in financial (and other) markets to become efficient, the volume of trade with an endowment effect will be below what it might be without one.

But it is one that must be used cautiously; too many legal scholars are using it far too glibly. Consider, for example, the evidence that the endowment effect appears to vanish when people do not physically possess the commodity in question. Subjects trading tokens or vouchers demonstrate only a weak endowment effect. Because capital market transactions more closely resemble the token or vouchers context then experiments involving physical possession of a tangible commodity, for example, these results call into question the extent to which one can rely on the endowment effect as evidence of a capital market failure. [Update: Korobkin passed on one of his articles, which presents a more nuanced account of this evidence. The money quote is "Money itself does not create an endowment effect, but the effect does appear to exist for financial instruments that are valued only for the money they are worth (i.e., have no intrinsic value themselves) if the value of the instrument is uncertain. These results suggest that securities and other financial instruments can create an endowment effect even though they are held as stores of wealth rather than for their intrinsic or 'use' value." The Endowment Effect and Legal Analysis, 97 Northwestern University Law Review 1227, 1236-37 (2003). Is not clear to me, however, why the results Korobkin discusses are not better characterized as mere risk aversion as opposed to an endowment effect.]

More important, in light of the above update, as the Economist also reported, there is emerging evidence that market actors can learn their way out of biases like the endowment effect:

John List, an economist at the University of Maryland, recently tested the existence of the endowment effect in a new way. Instead of using callow students, he went to a real market with traders of varying degrees of experience: a sports-card exchange, one of many such, where Americans trade pictures of their favourite athletes. There, traders dealing in hundreds of cards mix with browsers who might buy only one.

List found:

[E]vidence for an endowment effect—but also that long experience as a card trader spilled over into his experimental mug-and-chocolate market. Only novices, like the students in earlier experiments, tended to be swayed by what they had been given. This implies that prospect theory can capture the behaviour of inexperienced people, of which the world has many in all sorts of markets. But experienced buyers or sellers in well-established markets get over their psychological “flaws”. They can even transfer their trading skills from one market to another. The neoclassicals, it seems, have scored a point.

I would add a different, but I think equally significant reservation: The claim that law can correct market failures caused by decisionmaking biases or cognitive errors treats regulators as exogenous to the system. Once the state is endogenized, however, regulators must be treated as actors with their own systematic decisionmaking biases. It thus becomes evident that behavioral economics loops back on itself as a justification for legal intervention. Public choice theory provides still another reason market failure is not a sufficient justification for government intervention. Again, the problem is one of treating an endogenous factor as exogenous. A welfare economics model that posits legal intervention as a solution to market failure ignores the fact that regulators are themselves actors with their own self-interested motivations.

In sum, there is a strong temptation to use behavioral economics too glibly. Advocates of government intervention are akways tempted to jump from positing the status quo bias, citing the coffee mug experiments, to an assertion that the government needs to shake up the status quo, without demonstrating that the bias is truly valid in the specific setting at hand. In addition, a certain degree of skepticism about the power of law to effect social change seems warranted. Indeed, behavioral economics itself offers additional reasons to doubt the capacity of law as agent for social change. Finally, one cannot justify government intervention without asking whether the case for it survives endogenizing the state.

You can read an even more extended version of my argument, with application to the longstanding debate over mandatory disclosure in securities regulation, in my article Mandatory Disclosure: A Behavioral Analysis, 68 University of Cincinnati Law Review 1023 (2000).

Can a Board Meet Online?

The Wall Street Journal (subscription required) has a good article in Monday's technology section on how corporations are using dedicated board of directors websites to let directors communicate with management and each other. But here's the part that caught my eye:

The main functions of a directors' Web site are simple enough: easy online access to briefing papers and internal company data, so directors can do their homework at home or on the road a few days before board meetings and show up fully informed; the ability to fine-tune a document online, so directors can hold a brief but urgent committee meeting online from different locations; and an exclusive e-mail system.

Can they really meet online? It depends on whether they use Internet telephony or a real-time text-based mechanism (like a chat room). Delaware General Corporation Law sec. 141(i) provides that directors may conduct a meeting:

by means of conference telephone or other communications equipment by means of which all persons participating in the meeting can hear each other....

Web-based supplements to a telephone conference call thus are fine, but real-time text based messaging is OUT. To conduct a meeting exclusively online, in a Delaware corporation at least, you must use Internet telephony. I wonder if any Delaware corporations have held invalid text-based board meetings online? I emailed this post to the reporter who wrote the story and asked him. I'll report back if he answers. In the meanwhile, I once wrote an article motivated by DGCL section 141(i)'s requirement that directors be able to hear one another. Why a Board? Group Decision Making in Corporate Governance, 55 VANDERBILT LAW REVIEW 1 (2002). To be clear, the article's not about online meetings -- its a theoretical inquiry (neoinstitutional and behavioral economics with a dose of social norms theory) into why corporations are run by a board rather than an individual autocrat (of course, in practice, many CEOs are individual autocrats). But section 141(i) was what got me thinking about the theory issues.

The requirement that members be able to “hear” one another seems quaint in an era of electronic mail, instant messaging, and internet chat capabilities. Yet, when Delaware recently amended its corporation statute to permit much greater use of electronic forms of communication, it retained the requirement that board meetings be conducted in such a way that all members may hear one another. As it turns out, this appears to have been the right choice. Research on decision making has found that groups linked by computer make fewer remarks and take longer to reach decisions than do groups meeting face to face. Kiesler and Sproul, for example, not only found that meetings conducted through computers result in greater delays, but also that the decisions made in such meetings were more likely to exhibit the risky shift phenomenon. Sara Kiesler and Lee Sproul, Group Decision Making and Communication Technology, 52 Org. Beh. & Human Decision Processes 96 (1992). They also found that time-constrained groups exchanged much less information when meeting electronically than when meeting face-to-face.

Electronic communication takes place mostly through text-based mediums. For many people reading and typing are slower and require greater effort than verbal communication. Text-based communication also deprives participants of social cues, such as body language and tone of voice, that may be important signals. Social norms constraining behavior apparently function less well in text-based communication, as illustrated by the flame wars that plague Usenet newsgroups.

As with other aspects of the rules governing board meetings, accordingly, there seems to be a legitimate basis for otherwise formalistic rules. Even such housekeeping rules as notice requirements prove to be consistent with the research on group decision making. Unless the articles of incorporation require otherwise, no notice of regularly scheduled board meetings is required. Special meetings require at least two days notice. As a matter of statutory law, the requisite notice need not announce the purpose of the meeting. Because the directors’ duty of care requires them to make an informed decision, however, it is advisable whenever possible to provide directors of advance notice of the reason for calling a meeting and any relevant documentation. As with other requirements relating to board meetings, the notice rules are intended to ensure that the board functions as a collegial body, all of whose members participate and get the benefit of the participation by all other members. MBCA § 8.23 cmt.

That notice requirements effectively carry out that function is suggested by research on group performance. Michaelsen et al. conducted a study in which individuals were pre-tested and then re-tested as members of a group. Under those conditions, groups outperformed individuals. Michaelsen et al. analogize this testing order to organizational decision-making processes in which “group members prepare a position paper and circulate it to other group members prior to problem-solving discussions.” Larry K. Michaelsen et al., A Realistic Test of Individual Versus Group Consensus Decision Making, 74 J. App. Psych. 834, 834 (1989). A board meeting conducted after meaningful notice likewise replicates this testing order.

UPDATE: The WSJ reporter (Geroeg Anders) have given me permission to blog his response: "As far as I can tell, boards (either deliberately or inadvertently) are staying within the bounds of the Delaware code as currently written. Even when computer-to-computer interactions are a meaningful part of a remote board/committee meeting, there usually are parallel phone lines that are open, so that people can ask questions the old-fashioned way."

SEC injunction against Hollinger

The SEC's successful pursuit of an injunction against changes in composition or mission of the Hollinger special committee has gotten less attention than it deserves. At base, the Hollinger scandal is about allegedly unauthorized payments by Hollinger to Conrad Black and some of his cronies. This is classic corporate governance stuff - governed by Delaware General Corporation Law § 144's provisions on conflict of interest transactions. Granted, there are related federal fraud issues arising out of the nondisclosure of the challenged transactions. The federal claims, however, are essentially seconday to - even parasitic on - the state law claims. For the SEC to invoke federal authority therefore allows the tail to wag the dog. When that federal authority is used to impede core corporate governance powers - selecting the membership of a board and its committees - we have a dramatic federal preemption of state law. I think the creeping federalization of corporation law is a very bad idea. I think federalizing corporate law without even having a debate on the subject is an even worse idea.

Sarbanes-Oxley Winners and Losers

Dwight Klingenberg, a business journalist, writes:

A little over a year ago, Congress passed the most sweeping legislation affecting businesses since the creation of the Securities and Exchange Commission in the '30s. Although the Sarbanes-Oxley Act - we'll call it Sarbox from here on - itself is a scant 66 pages, the subsequent implementation rules and regulations will fill numerous hard drives over the next few years. At this stage, who are the winners and losers?

66 pages is scant? Anyway, go read the whole thing. To whet your appetite, here's a summary of winners and losers:

Winners
Treadway Commission
The SEC
Law firms
Software vendors
Outsourcers

Losers
Research analysts
The AICPA
Private companies and agencies

Too close to call
In-house counsel
Public companies [This was the one I was prepared to question, leaning towards putting public companies into the loser category for the reasons stated in thefirst sentence that follows, but I am semi-persuaded by the second sentence. I'll need more data before making up my mind on that one.]

Public firms are now strapped with significant new costs: whistleblower hotlines, expanded internal audit departments, extensive control documentation, higher director compensation, shocking increases in directors' and officers' insurance and bigger fees from their auditors. However, most CFOs we speak to will admit privately that the documentation effort resulted in finding control issues and shortcomings they are fixing.

CPA firms
Directors

New Article on Sarbanes-Oxley Section 307

The Social Science Research Network is a site for legal, economic, management, and accounting scholars to post working papers before they are formally published in a professional journal. All of my articles since 1998 are collected there, along with most of the ones published before that date. SSRN just released to its data base my newest article, co-written with UCLA grad Christina Johnson, entitled "Managerialism, Legal Ethics, and Sarbanes-Oxley Section 307. This article was prepared for a conference on the Sarbanes-Oxley Act (a.k.a. the 'Public Company Accounting Reform and Investor Protection Act' of 2002), this Article focuses on the professional responsibility rules promulgated by the Securities and Exchange Commission under Section 307 of the Act. According to the theoretical model of corporate governance espoused by all business corporation statutes, a corporation is to be run by its board of directors for the benefit of its shareholders. In practice, however, corporations frequently are run by their top managers for the benefit of those managers.

A number of recent trends have empowered boards of directors vis-a-vis management. As this Article's review of the statutory text and its legislative history demonstrates, Congress intended the Sarbanes-Oxley Act to further that trend. We further demonstrate that Section 307 should be understood as part of the Act's overall anti-managerialist intent. Congress sought to enlist legal counsel in strengthening the board. Specifically, Congress directed the SEC to create an up the ladder reporting requirement pursuant to which a firm's legal counsel would report evidence of misconduct to the board of directors, thereby redressing one of the information asymmetries between boards and managers.

This Article argues that, as a normative matter, Sarbanes-Oxley Section 307 was well-intentioned. As a practical matter, however, Section 307 seems unlikely to effect significant changes in corporate governance. In our view, the nature of legal practice, the largely unchanged relationship between lawyers and managers, and the problematic approach taken by the SEC to implementing Section 307 suggest that the new legal regime is unlikely to result in significantly better information flows within the corporate hierarchy.

You can download the full paper HERE.

Estancia Meritage (Alexander Valley) 1999

A cabernet/merlot blend. A modest nose that is, unfortunately, reminiscent of cherry-flavored cough syrup. Tannic and acidic on the palate, with notes of red cherries and mocha java. I wonder if they acidified it, although I don’t think they used citric acid the way some cheapskates do (the lemon flavor usually gives it away in reds). Not bad for a mid-week wine, albeit a bit pricey for that purpose (MSRP $30, although I paid a lot less), but not one I would buy again. On the other hand, the other bottle in the cellar will get drunk rather than just going into the stock pot. And, I should note, the good wife liked it better than I did. My main problem with this wine is that it’s not really ready to drink, but I’m also not sure it will age that well. Grade: C-

Why the Problem at the NYSE is the same as the Problem at Freddie and Fannie

The Wall Street Journal editorializes today (subscription required) on Treasury Sec'y Snow's testimony yesterday on Freddie Mac and Fannie Mae:

Arguing that publicly traded companies should have only private directors, he suggested the time had come for Fan and Fred to eliminate the directors on their boards who are now appointed by the President. Good corporate governance, he crisply noted, requires that the people who are running companies serve the stockholders.

Apropos of that point, a reader writes:

My opinion is that Freddie Mac's board [mild expletive deleted] its shareholders by ordering an investigative law firm to try to pin blame on senior management (and therefore not on the Board) for an accounting scandal. The result may have covered the board's posterior, but it damaged the company both internally and externally. Is there any solution for this in terms of corporate governance? My guess is that shareholder lawsuits are a lousy tool for creating Board accountability, but is there a better tool that would not have the side effect of giving board such a strong incentive to cover itself that it hires a hit squad investigator to go after management and trash the entire company?

How does this tie into the on-going Grasso pay imbroglio? The trouble with all three entities is that they are neither fish nor fowl. Their government connections insulate them from discipline by markets and investors. The NYSE is part of a trading market oligopoly with very high barriers to entry, some of which are attributable to SEC rules. (The SEC, for example, long let the NYSE get away with listing standards making it almost impossible for a firm to de-list.) In the case of Freddie and Fannie, though, its even worse: the markets believe (with some justification) that the federal government has (implicitly) guaranteed their debts, which allows them to avoid by market discipline by borrowing at below-market rates. Moreover, because their board includes political appointees, both are further insulated from investor discipline. The solution for all three is privatization. Let them run as for-profit corporations in competitive markets, with full disclosure (none of them are very transparent as to either governance or finances).

UPDATE: Broc on Grasso:

And don't get me started about the NYSE's governance structure. True, its not a public company but it does have all the earmarkings of a poster child for bad governance. A CEO who handpicks the board - and the compensation committee. A compensation committee who approves CEO compensation arrangements that it doesn't understand. A compensation committee comprised of CEOs from companies that have inherent conflicts of interest with the CEO by virtue of him being their regulator.

Check.

UPDATE 2: Gregg Easterbrook blogs:

Turns out the compensation board that approved Grasso's grotesque bonus contained executives from big companies that had a keen interest in insuring that the NYSE did not act against stock-market manipulation. Citigroup, Morgan Stanley and Merrill Lynch--the key offenders who admitted in the recent $1.4 billion Securities and Exchange Commission settlement that they deliberately misled investors--all had seats on the committee setting Grasso's pay. So did AOL Time Warner which, during the period Grasso was being assigned the grotesque bonuses, was engaged in the most determined campaign to wipe out shareholder value in American business history. These tainted companies were in effect offering Grasso huge amounts of money if he played along and made sure the NYSE did nothing to expose them--and Grasso, a faithful water-carrier, made sure the NYSE did absolutely nothing. There's a word for all this, and the word is "corruption."

Check again.

Sarbanes-Oxley Ethics Codes

Kansas city corporate attorney Arthur Chaykin sends along the following observations:

I had been hopeful that the Sarbanes-Oxley Act would have one saving virtue: I thought, perhaps, that CEO's would do what they could to improve business decision making in their companies if only to avoid immediate disclosure through anonymous "hotline" directly to the Board. I reasoned that such calls could, at the very least, become an annoyance for CEO's and, at worst, could give the Board the impression that the CEO did not know how to run the company. Therefore, I thought it was at least possible that CEO's would "pump up" corporate ethics codes and programs in an earnest attempt to reduce the number of "bad acts" within the company.

However, on further reflection, I am concerned that the Sarbanes-Oxley Act may have the exact opposite impact. As you know, the Act requires an ethics code, at least for financial officers, or an explanation as to why no ethics code is presented (and no company will want to explain that). Furthermore, the Act requires a company to explain any "deviation" from its ethics code. As I read it, that means that anytime a company decides to make a reasonable exception to a conflict of interest policy, it has to do a public filing. In order to avoid that, I am sure companies will try to (a) obfuscate their codes so that it will be hard to know whether a violation has occurred or not (thus defeating the entire purpose) or (b) attempt to reserve discretion in some body within the corporation so that they do not have to report the exception as a deviation (but it is not clear that will work). So, I expect a lot of companies to select (a). I have had one general counsel indicate that she had just written the new code and made sure that it only did the bare minimum because she did not want to incur additional disclosure obligations.

Can you believe it?

Yes, I can believe it. Arthur is exactly right that no company in its right mind will want to explain the absence of an ethics code (in the trade we call this therapeutic disclosure, about which I will be posting soon). He's also exactly right that no company will want to be put in the position of disclosing deviations from the code. Hence, we're going to get bare bones ethics codes, which is exactly what seems to be happening.

A Review of "The Company"

The Company: A Short History of a Revolutionary Idea. John Micklethwait & Adrian Wooldridge. New York, The Modern Library, 2003. Although I recommend this text to generalist readers seeking a (remarkably) concise introduction to history of the business corporation, personally I came away somewhat disappointed. There is little doubt Micklethwait and Wooldridge are correct in their claim that the corporation is now the key economic institution in Western nations. Yet, it did not have to turn out that way. As Micklethwait and Wooldridge usefully remind us, two centuries ago, leading business and economic thinkers (including the great Adam Smith) derided the joint stock company. What explains the relatively rapid development in the mid-19th century of a recognizably modern corporation and, in turn, that entity's emergence as the dominant form of economic organization?

Micklethwait and Wooldridge offer a fairly conventional answer to that question, based largely on new technologies -- especially the railroad -- requiring vast amounts of capital, the advantages such large firms derived from economies of scale, the emergence of limited liability that made it practicable to raise large sums from numerous passive investors, and the rise of professional management. Readers familiar with the work of business historian Alfred Chandler will find relatively little new in this part of the story, although Micklethwait and Woolridge's treatment has the advantage for generalist readers of being considerably more accessible than is most of Chandler's work. Instead of offering any novel historical analysis, Micklethwait and Wooldridge's principal potential contribution (albeit one they failed adequately to realize) is the normative thesis to be derived from the historical account.

In their introduction, Micklethwait and Wooldridge lay out a claim that will be familiar to readers of Michael Novak's work (surprisingly, however, they seem unaware of his seminal work). Like Novak, Micklethwait and Wooldridge argue not only that the corporation is one of the West's great competitive advantages, but also that the number of private-sector corporations a country boasts is a relatively good guide to the degree of political freedom it provides its citizens. Unfortunately, this insight goes nowhere.

The normative claim is entirely plausible. The rise of modern corporations did more than just expand the economic pie. The legal system that facilitated their rise necessarily allowed individuals freedom to pursue the accumulation of wealth. Economic liberty, in turn, proved a necessary concomitant of personal liberty -- the two have almost always marched hand in hand. In turn, the modern public corporation has turned out to be a powerful engine for focusing the efforts of individuals to maintain the requisite sphere of economic liberty. Those whose livelihood depends on corporate enterprise cannot be neutral about political systems. Only democratic capitalist societies permit voluntary formation of private corporations and allot them a sphere of economic liberty within which to function, which gives those who value such enterprises a powerful incentive to resist both statism and socialism. As Michael Novak has observed, private property and freedom of contract were indispensable if private business corporations were to come into existence. In turn, the corporation gave liberty economic substance over and against the state. Regrettably, after laying it out, Micklethwait and Wooldridge fail to pursue this thesis. Instead, their book lapses into mere narrative history.

Having said that, however, it is exceptional narrative history. As journalists for the Economist, which I regard as the best-written magazine around, they write clearly yet powerfully. There are numerous insights, cleverly turned phrases, and interesting anecdotes. All of which makes for a compelling read, if not a compelling normative argument.