ProfessorBainbridge.com

On Delaware

Marcel Kahan and Ed Rock have published a fascinating paper, Our Corporate Federalism and the Shape of Corporate Law, which will be of interest to anyone who studies corporate law and/or questions of federalism. I don't agree with every jot-and-tittle of their analysis, but I think it is a wonderful stab at sorting out some very interesting problems:

ABSTRACT: In the public debate sparked by the corporate scandals of the last years, Delaware has been strikingly absent. In contrast to the high profile activity of Congress, the Securities and Exchange Commission, the stock exchanges, federal prosecutors, and even state law enforcement officials, Delaware has been largely mute: no legislation; no rule-making; no criminal investigations; few headlines. In this Article, we use Delaware's relative passivity during this latest episode of corporate law-making as a starting point in the analysis of the shape of American corporate federalism and Delaware's place within it.

We argue that Delaware long ago opted for what we will call a "classical" or "19th-century" common law model of corporate law-making. In Delaware, corporate law is largely judge-made; judicial opinions are filled with quasi-deterministic reasoning; statutory law is comparatively narrow and rarely subject of partisan disputes; the judiciary as well is relatively non-partisan and has claim to technical expertise; and the law is enforced through litigation brought by private parties. We view these traits through the lens of the institutional and political landscape in which Delaware must operate. This landscape is characterized by a federalist system in which Delaware's regulatory powers co-exist with, and can be constrained by, the powers of the federal government. In this system, Delaware is faced with the threat that populist pressures will lead to a federal preemption of Delaware corporate law and thus eradicate the huge profits Delaware derives from being the domicile of choice for public- traded U.S. corporations. By creating and enhancing an apolitical gloss over Delaware's corporate law, the various traits we identify help shield Delaware against this threat. At the same time, the scope of Delaware's corporate law is designed to minimize conflicts by assuring that Delaware has the requisite personal jurisdiction over defendants to enforce its law effectively and that the prevailing conflict rules point to substantive Delaware law as applicable to a corporate law dispute.

But this classical model of law making carries with it intrinsic limitations. Specifically, legal change is slow, standard-based and incremental. Faced with the recent corporate scandals, calls for action, and Sturm und Drang, Delaware reacted accordingly: Basically, it does nothing until cases are brought. Any more pro-active response by Delaware actors would have threatened to undermine the political legitimacy achieved by Delaware's commitment to the classical common law model. But because the classical common law style, together with jurisdictional and conflict rules, constrain Delaware, federal law is needed to complement Delaware's. In that respect, the relation between federal law and Delaware law is symbiotic, rather than antagonistic: Delaware is happy to have federal law pick up the slack and thereby reduce the likelihood that ineffective regulation produces a populist backlash.

The corporation as lobster trap

The lobster trap is a useful metaphor for many legal regimes. A real lobster trap is easy to get into, but very difficult to exit. There is an emerging consensus amongst corporate governance theorists that the lobster trap aptly describes an important aspects of the corporation; namely, the ease with which investors can out equity into the firm but the difficulty with which they can get it out. My friend and UCLA colleague Lynn Stout has just posted to SSRN an accessible and fairly short essay exploring these ideas:

ABSTRACT: Legal experts traditionally distinguish corporations from unincorporated business forms by focusing on such corporate characteristics as limited shareholder liability, centralized management, perpetual life, and freely transferred shares. While this approach has value, this essay argues that the nature of the corporation can be better understood by focusing on a fifth, often-overlooked, characteristic of corporations: their capacity to lock in equity investors' initial capital contributions by making it far more difficult for those investors to subsequently withdraw assets from the firm. Like a tar pit, a corporation is much easier for equity investors to get into, than to get out of.

An emerging school of theorists has begun to explore the implications of this idea for corporate law and practice. The idea is still novel enough to lack a uniformly-accepted label - in addition to the phrase capital lock-in, scholars have described this aspect of incorporation as affirmative asset partitioning, the absence of a repurchase condition, and asset separation from shareholders. Whatever label one chooses, the idea shows great promise for illuminating a variety of thorny problems that have long troubled corporate scholars and practitioners.

In illustration, this essay considers how the idea of capital lock-in sheds light on three corporate mysteries: the sui generis nature of corporate directors' fiduciary duties; the rise of the large modern service partnership; and lawmakers' enthusiasm for meddling with corporate governance rules.

Could Shareholders Sue CBS Over the Forgery?

Glenn Reynolds sent along what I assume is an email from one of his readers re the CBS forgery story:

The officers and directors of CBS have fiduciary duties to the shareholders of CBS. Likewise the officers and directors of CBS's corporate owners have fiduciary duties to the shareholders of their companies. I.e., at some point their personal assets will be on the line for this. Additionally a stockholders' derivative action might now be feasible.

I'm as annoyed/amused as anybody by the forgery story (see, e.g., this post). So I hate to throw cold water on Glenn's reader's idea, but there is zero - nada, zilch - chance a shareholder derivative suit over the forgery story would succeed. (The following is adapted from the chapter on shareholder litigation in my treatise Corporation Law and Economics.)

First, any shareholder suit would have to be brought as a derivative one on behalf of the corporate entity rather than a direct shareholder class action. “Direct” shareholder suits arise out of causes of action belonging to the shareholders in their individual capacity. It is typically premised on an injury directly affecting the shareholders and must be brought by the shareholders in their own name. In contrast, a “derivative” suit is one brought by the shareholder on behalf of the corporation. The cause of action belongs to the corporation as an entity and arises out of an injury done to the corporation as an entity. The shareholder is merely acting as the firm’s representative. The basic tests are: (1) Who suffered the most immediate and direct injury? The shareholder or the corporation? Note that it is not enough for a shareholder to allege that the challenged conduct resulted in a drop in the corporation’s stock market price. (2) To whom did the defendant’s duty run? The shareholder or the corporation? As employees of CBS, Dan Rather and his fellow journalists owe a duty to the entity but owe no relevant duties directly to the shareholders thereof. In addition, to the extent the shareholders of CBS are injured, it will be a result of the prior injury Rather did to the corporate entity's reputation.

Second, because the suit must be brought derivatively, a shareholder-plaintiff will run into procedural barriers that likely will be insurmountable on these facts. Because the derivative suit is premised on a cause of action belonging to the corporation, one might assume that the corporation would simply bring the lawsuit itself. Derivative suits in fact are relatively rare; most corporate lawsuits are brought by the entity, rather than its shareholders. The derivative suit, of course, was devised so as to permit shareholders to seek relief on behalf of the firm in those cases where the corporation’s management for some reason elected not to pursue the claim. Logically, however, it would seem that the corporation should be given an opportunity to decide whether to bring suit before a shareholder is allowed to file a derivative suit. Accordingly, Federal Rule 23.1 provides that shareholders may not bring suit unless they first make demand on the board of directors or demand is excused.

Although the demand requirement looks like a mere procedural formality, it has evolved into the central substantive rule of derivative litigation. The foundational question in derivative litigation is the extent to which the corporation, acting through the board of directors or a committee thereof, is permitted to prevent or terminate a derivative action. Put another way, who gets to control the litigation—the shareholder or the corporation’s board of directors? Curiously, the answer to that question depends mainly on the procedural posture of the particular case with respect to the demand requirement.

New York and Delaware both require demand in all cases except those in which it is excused on grounds of futility. In the seminal Aronson v. Lewis decision, the Delaware supreme court set forth the following test for demand futility:

[T]he Court of Chancery in the proper exercise of its discretion must decide whether, under the particularized facts alleged, a reasonable doubt is created that: the directors are (1) disinterested and (2) independent and (3) the challenged transaction was otherwise the product of a valid exercise of business judgment.

The third prong will fall out in this case. The Delaware supreme court in Rales v. Blasband held that where the litigation, inter alia, arises out of some transaction or event not involving a business decision by the board (as this one would) only the first two Aronson prongs are in play: "a court must determine whether or not the particularized factual allegations of a derivative stockholder complaint create a reasonable doubt that, as of the time the complaint is filed, the board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand."

As to the first prong, directors are interested if they have a personal financial stake in the challenged transaction or otherwise would be materially affected by the board’s actions. The prospect of being sued is not enough; rather, there must be a financial interest in the underlying transaction. Obviously, this basis for excusing demand is irrelevant in this case. There's no way any of the directors have a direct, pre-existing financial stake in this story.

Under the second prong, the key doctrinal question is whether the directors can base their judgment on the merits rather than on extraneous considerations. Again, demand is not excused simply because the plaintiff has named a majority of the board as defendants. Indeed, it is not enough even to allege that a majority of the board approved of, acquiesced in, or participated in the challenged transaction. In other words, merely being named as defendants or participants does not render the board incapable, as a matter of law, of objectively evaluating a pre-suit demand and, accordingly, does not excuse such a demand. Instead, demand typically will be excused under this prong only if a majority of the board was dominated or controlled by someone with a personal financial stake in the transaction. Directors whose independence is compromised by undue influences exerted by interested parties are presumed, as a matter of law, of being incapable of exercising valid business judgment. Again, I can't see demand being excused under this prong. The board simply wasn't involved, as far as we now know.

Let us assume for sake of argument that Rather and his fellow journalists were grossly negligent in running the story. Because there is no evidence that CBS' board of directors were involved in any way in the decision to run the story, the shareholder will be unable to satisfy the Aronson standard for demand futility. Accordingly, the shareholder will have to make demand on the board that they sue Rather before the shareholder would be allowed to sue. (If the shareholder files the lawsuit without first making demand, the court would stay the litigation and require the shareholder to make demand.)

Where the shareholder makes demand, either pre-suit or after a judicial determination that demand was required, the board is expected to undertake a two-step process. The board must first inform itself of the relevant facts relating to the challenged transaction or other alleged wrongdoing, as well as the legal and business considerations attendant to resolving the matter. Any factual investigation must be reasonable and conducted in good faith, but within those parameters the board has great discretion. Having done so, the board must elect amongst the three principal alternatives available to it: (1) accepting the demand and prosecuting the action; (2) resolving the matter internally without resort to litigation; or (3) refusing the demand.

If the board accepts the demand and then attempts to resolve the matter through a settlement of the derivative claim with the shareholder-plaintiff, the parties must comply with the judicial approval requirement of Federal Rule 23.1 or its relevant state counterpart. Suppose, however, that the corporation resolves the matter through a settlement with the alleged wrongdoers. In that case, the judicial approval requirement under Federal Rule 23.1 and its state counterparts does not apply. If the corporation gives the defendants a sweetheart deal, of course, the shareholder-plaintiff could initiate a new derivative suit for “fraud or waste in releasing corporate claims for inadequate payment.” Presumably the same would be true if the corporation accepted demand but then lost the case due to a failure to vigorously prosecute it.

Anecdotal evidence strongly suggests that the board’s typical response, however, is to refuse the demand. If the board does so, the shareholder may seek judicial review of that refusal, but the plaintiff bears the burden of proving that the refusal was wrongful. Worse yet, at least from plaintiff’s perspective, the relevant standard of review is the business judgment rule. Worst of all, again from plaintiff’s perspective, plaintiff is not entitled to discovery.

Some suggest that the wrongful refusal inquiry should be directed at the business judgment rule’s applicability to the underlying challenged transaction where that transaction “was approved by the same directors who are reviewing the plaintiff’s demand.” In Grimes v. Donald, however, the Delaware supreme court made clear that the inquiry is directed to whether “the board in fact acted independently, disinterestedly, or with due care in response to the demand.” Note the potential for even a clear case of self-dealing, such as an interested director transaction, to be immune from challenge through a derivative suit so long as a majority of the board was not involved. A disinterested and independent majority of the board is deemed capable of deciding whether to refuse demand, at least where the decision does not involve fraud, illegality or self-dealing on the part of a majority of the board. A demand refusal by such a board will be protected by the business judgment rule.

So now we see the bottom line. If a shareholder sues CBS over Rather's conduct, the suit will be derivative. Demand will be required. The board of directors will refuse demand. The business judgment rule will insulate the board's decision. So the lawsuit will be dismissed. I guarantee it.

Some readers doubtless will be outraged by this result. But there are good and sufficient reasons for courts to defer to the board's judgment in these cases. If you want to know why, however, you'll have to buy the book.

Wine Ratings and Prices

One of the problems with most wine rating systems, such as Robert Parker's or the Wine Spectator's, is that they don't factor price into the equation. As such, one is often left sorting through a mass of unweildy data trying to find the $20 needle in the 95 point haystack. (Granted, the Spectator provides some help with its "Best Buy" feature.) Vinography has the scoop on a new wine newsletter who rating system explicitly factors price into its rankings:

Each issue of QPRwines groups wines by score, lists them by price and ranks them by value. A wine's QPR (Quality-Price Ratio) is how much more or less it costs compared to the average price of similarly scored wines. For example, the average price for a 93-rated 2000 Bordeaux is $119. But the 2000 Chateau Pontet-Canet from Pauillac costs only $50 -- a number that is 42% of the average price for a 93-point wine. Pontet-Canet thus has a QPR of 42%.

I'm probably going to take out a trial subscription. You can download the initial issue here.

Chateau Greysac (Medoc) 1999

Chateau Greysac is a deservedly popular cru bourgeois claret that never inspires but reliably churns out reasonably priced wine with clean and typical aromas and flavors. As is usually the case, the 1999 is a blend of Cabernet Sauvignon (50%), Merlot (40%), and Cabernet Franc (10%). It's a soft and easy drinking wine that suggests cedar shavings and cigars, with red and black berries in the background. Probably has a couple of years left. Grade: B--

Wanna Buy a Soup Franchise? Step to the Left

Al Yeganeh, whose soup restaurant gave rise to the classic Seinfeld character the Soup Nazi, is franchising. One would think that he would be trying to capitalize on the fame generated by the Seinfeld show; certainly one would think the franchisees would want to do so. But one would be wrong, at least according to the WSJ ($):

Mr. Yeganeh plans to bar the franchisees from using the term "Soup Nazi" in their promotional materials. In fact, he doesn't want his simmering soup empire to have any overt association with the show that helped make him famous. Tie-ins with "Seinfeld" will be "strongly discouraged" among franchisees, the company says.

For all the attention and business that the "Seinfeld" publicity has brought him, Mr. Yeganeh is not exactly grateful -- in fact he says he loathes the show's star. He refers to Jerry Seinfeld as "Jerry the Clown," and insists that it was he who helped make Mr. Seinfeld what he is today.

So he's barring the franchisees from using their single strongest selling point. I guess that's in keeping with a guy who sells soup at $30 a quart while ordering around his customers. Whether the franchisees will be able to get away with that nonsense without playing up the Soup Nazi tie-in seems doubtful. So no soup for me.

Eisner

Michael Eisner has announced that he will step down as Disney CEO when his current contract runs out in September 2006. About time. If you use the search box in the left sidebar to Google Eisner's name, you'll find a slew of posts documenting the problems Disney has had in the second half of Eisner's reign. But let's let bygones be bygones. Looking to the future there are some very interesting questions. (1) Will the institutional investors who revolted at the last annual shareholder meeting be willing to ride out two more years of Eisner? I'd guess yes. An orderly succession is in everybody's interest. A fight over a guy who is on his way out is one they probably wouldn't win. (2) Will the succession in fact be orderly? Suppose a clear internal candidate emerges fairly quickly (such as Robert Iger). If that happens, two problems emerge. First, there will be a lot of tension between lame duck Eisner and the heir apparent. It'll be like Henry IV versus Henry V, except there'll be no swords and better hygiene. Second, what if the shareholders think the heir apparent is as bad as Eisner? Relatedly, what if the heir apparent's area of operational control takes a nose dive at the last minute? (3) Will they go outside? Two years is a long time to run an executive search. Either they'll end up picking somebody fairly soon or they'll put it off to the last minute. Going outside almost certainly means the latter, since no viable candidate would want to hang around at his/her current job for two years waiting to take over. Of course, they could bring the outsider in as a subordinate to Eisner, but that presents the same problems discussed in #2. (4) Has the board finally learned its lesson? Will the board exert itself or allow Eisner to hand-pick his successor just the way he hand-picked directors for so long? If Disney is to have any corporate governance credibility, the board must take charge of this process.

Wine in the US

Consumption of wine rose 5.2 percent last year to 2.98 gallons per adult in the United States, according to the Adams Wine Handbook. Americans drank a record 258.3 million, 9-liter cases of wine in 2003 continuing a decade-long trend of increased wine consumption. All categories of wine, with the exception of wine coolers, showed growth. (Source)

Good for us. Personally, however, I'm putting away a lot more than 3 gallons a year, so some of you need to pick up the slack.

Ravenswood Vintner's Blend Cabernet Sauvignon (California) 2001

A perfectly inoffensive red table wine, which is fine for mid-week quaffing. It doesn't particularly taste or smell like a Cabernet Sauvignon; instead, it tastes like a generic (and rather non-descript) red blend. (I might have guessed cool climate Zinfandel). Clean blackberry and cherry flavors. Grade: C++

Conference Board on Global Warming

One of President Bush’s first acts upon taking office was taking the US out of the controversial Kyoto Protocol on global warming. In the face of significant outrage from environmental groups and our European allies, the President announced in June 2001 that the U.S. would “work within the United Nations framework and elsewhere to develop with our friends and allies and nations throughout the world an effective and science-based response to the issue of global warming.” In doing so, he also recognized “the responsibility to reduce our emissions.” Yet, even its friends must admit that the administration has moved slowly on the global warming issue. It took until August 2004, for example, for the administration to formally acknowledge the role human activity plays in causing global warming.

I am not an expert on the climate. I don’t claim to know whether human activity causes global warming or not. Instead, my expertise lies at the intersection of business and law. And I believe a watershed event has just occurred at that intersection; namely, the Conference Board’s report on global warming:

Concludes the report: “The Earth – for whatever the exact reasons – is on a trajectory toward an ever warmer climate. This cannot be avoided at this point, but the trajectory can be jiggled and potential risks associated with the warming can be mitigated. Ultimately the trajectory could be reversed.”

The report finds that “governments and markets are likely to act” on expanding scientific evidence and perceptions that climate change has become “an urgent priority that must be addressed through a variety of measures.” Participating scientists in the report strongly believe that “a reduction in human-caused emissions is an essential step in any overall strategy for dealing with climate change.” ...

Corporate boards will be increasingly expected to evaluate potential risks associated with climate change, says the report. It adds: “The frequently cited ‘Enron effect’ will likely result in increased pressure on boards to evaluate potential costs and risks associated with mitigation either of carbon emissions or the effects of actual climate changes.”

Unfortunately, the entire report is locked away behind a firewall and available only to Conference Board members. Yet, a couple of observations can be made on the basis of what we do know. First, the report was prepared by "11 noted climate scientists who met this June under the auspices of the American Association for the Advancement of Science." As such, it's likely to reflect conventional wisdom. Indeed, it appears that none of the participants are known global warming skeptics. Second, it is not at all clear what the "Enron effect" has to do with the issue. Enron involved failure to disclose financial accounting fraud. We're not yet at the point at which failing to disclose emissions data is considered securities fraud. The securities laws, moreover, do not require boards to evaluate potential costs of anything; that is a question of state law duty of care.

Having said all that, however, I believe we will one day look back on this report as a pivotal moment in the regulation of greenhouse gases. The Conference Board is a highly regarded and generally nonpartisan association of over 2000 large international companies. Their economic and corporate governance recommendations have frequently been highly influential on company policy. In addition, the Conference Board's participation in this project was facilitated by Environmental Defense, which most analysts regard as relatively centrist by the environmentalist community's standards. (But see a critical report by Capital Research.) The combination of a centrist business group and a center-left environmental group will make a potent lobbying team both on Capitol Hill and in the boardroom.

On global warming, the business community thus has taken a double whammy in the last month. First came the Bush administration report on global warming asserting that “the approximate 0.5°C rise over the second half of the century, most pronounced in the last 30 years, can only be explained when factors related to human activity, such as carbon dioxide and other greenhouse gas emissions, are taken into account.” Now comes the elite Conference Board endorsing a report reaching the same conclusion and calling on business to respond.

How then will business respond? As Benjamin Hunt recently demonstrated in The Timid Corporation, business today is terrified of taking risk. In our highly litigious society, business men and women naturally are afraid of getting sued or, worse yet, indicted. Hunt argues, however, that they are just as afraid of appearing to be unethical or even insensitive to politically correct elite opinion. As a result, business self-regulates in the name of risk management. In addition, business becomes reluctant to oppose government regulation on sensitive issues like the environment. (Some observers even think that business men and women are influenced by their children, who come home from schools that teach the evils of capitalism and the blessings of environmentalism.)

What should those of us who believe in free markets do now? We could continue to stick our heads in the sand, hoping the problem would go away or that some major paradigm shift in the scientific community would prove it was all nonsense. Or we could adopt the anarcho-libertarian view that any regulation is inherently evil, putting us on a slippery slope to fascism. Either way, we would lose. We would be fighting not just the environmentalists, but also the business community and, perhaps, even the Bush administration (or, at least, segments thereof).

If we are not to let the perfect become the enemy of the good, we therefore must become proactive. We must work with responsible business leaders to come up with pro-market (or, at least, market friendly) solutions. Emissions trading programs spring to mind as but one example. In addition, since basic research has many of the characteristics of a public good, the government can and should fund research into technological solutions, such as carbon sinks and scrubbing technologies.

Regulation designed to prevent global warming is inevitable. Both the Bush administration and the business community have now caved on the basic question of whether human activity contributes to the problem. But while regulation is inevitable, Big Brother Kyoto-style command and control is not. There is still time for market-based approaches, but only if those of us who support free markets will pull our heads out of the sands of denial.

Why Regulate Insider Trading?

My latest TCS Daily column

The Washington Post recently reported on the considerable attention the SEC and Justice Department are devoting to enforcement of the insider trading laws. Who can forget the recent high profile case against Martha Stewart, which is only the very tip of a large iceberg? Is this a useful expenditure of government resources?

Henry Manne's 1966 book Insider Trading and the Stock Market stunned the SEC and corporate law academy by daring to propose the deregulation of insider trading. Manne argued that insider trading benefits both society and the firm in whose stock the insider traded. First, he argued, insider trading causes the market price of the affected security to move toward the price that the security would command if the inside information were publicly available. If so, both society and the firm benefit through increased price accuracy. Second, he posited insider trading as an efficient way of compensating managers for having produced information. If so, the firm benefits directly (and society indirectly) because managers have a greater incentive to produce additional information of value to the firm.

Although I have tremendous respect for Manne's daring in proposing such provocative arguments, I'm afraid I don't buy either one. As to the first, Manne argued (correctly) that both firms and society benefit from accurate pricing of securities. The "correct" price of a security is that which would be set by the market if all information relating to the security had been publicly disclosed. But while U.S. securities laws purportedly encourage accurate pricing by requiring disclosure of corporate information, they in fact do not require the disclosure of all material information. Where disclosure would interfere with legitimate business transactions, disclosure by the corporation is usually not required unless the firm is dealing in its own securities at the time.

Manne argued insider trading is an effective compromise between the need for preserving incentives to produce information and the need for maintaining accurate securities prices. Suppose, for example, that a firm's stock currently sells at fifty dollars per share. The firm has discovered new information that, if publicly disclosed, would cause the stock to sell at sixty dollars. If insiders trade on this information, the price of the stock will gradually rise toward but will not reach the "correct" price. Absent insider trading or leaks, the stock's price will remain at fifty dollars until the information is publicly disclosed and then rapidly rise to the correct price of sixty dollars. Thus, insider trading acts as a replacement for public disclosure of the information, preserving market gains of correct pricing while permitting the corporation to retain the benefits of nondisclosure.

The problem with this argument is that insider trading affects stock market prices through what is known as "derivatively informed trading." First, those individuals possessing material nonpublic information begin trading. Their trading has only a small effect on price. Some uninformed traders become aware of the insider trading through leakage or tipping of information or through observation of insider trades. Other traders gain insight by following the price fluctuations of the securities. Finally, the market reacts to the insiders' trades and gradually moves toward the correct price. But while derivatively informed trading can affect price, it functions slowly and sporadically. Given the inefficiency of derivatively informed trading, the market efficiency justification for insider trading loses much of its force.

As for Manne's second argument, insider trading in fact appears to be a very inefficient scheme for compensating corporate managers. Even assuming a change in stock price that accurately measures the value of the innovation, the insider's "compensation" from insider trading is limited by the number of shares he can purchase. This, in turn, is limited by his wealth. As such, the insider's trading returns are based, not on the value of his contribution to the corporation, but on his wealth.

Another objection to the compensation argument is the difficulty of restricting trading to those who produced the information. Where information is concerned, production costs normally exceed distribution costs. As such, many firm agents may trade on the information without having contributed to its production.

A related objection is the difficulty of limiting trading to instances in which the insider actually produced valuable information. In particular, why should insiders be permitted to trade on bad news? Allowing managers to profit from inside trading reduces the penalties associated with a project's failure because trading managers can profit whether the project succeeds or fails. If the project fails, the manager can sell his shares before that information becomes public and thus avoid an otherwise certain loss. The manager can go beyond mere loss avoidance into actual profit making by short selling the firm's stock.

In sum, the arguments for deregulating insider trading are not very persuasive. But that doesn't answer the question, why do we regulate insider trading? Efficiency-based arguments for regulating insider trading (as opposed to those grounded on legislative intent, equity, or fairness) fall into three main categories: (1) insider trading harms investors and thus undermines investor confidence in the securities markets; (2) insider trading harms the issuer of the affected securities; and (3) insider trading amounts to theft of property belonging to the corporation and therefore should be prohibited even in the absence of harm to investors or the firm. Only the latter proves very persuasive.

There are essentially two ways of creating property rights in information: allow the owner to enter into transactions without disclosing the information or prohibit others from using the information. In effect, the federal insider trading prohibition vests a property right of the latter type in the party to whom the insider trader owes a fiduciary duty to refrain from self-dealing in confidential information. To be sure, at first blush, the insider trading prohibition admittedly does not look very much like most property rights. Enforcement of the insider trading prohibition admittedly differs rather dramatically from enforcement of, say, trespassing laws. The existence of property rights in a variety of intangibles, including information, however, is well-established. Trademarks, copyrights, and patents are but a few of the better known examples of this phenomenon. There are striking doctrinal parallels, moreover, between insider trading and these other types of property rights in information. Using another's trade secret, for example, is actionable only if taking the trade secret involved a breach of fiduciary duty, misrepresentation, or theft. Likewise, insider trading is only unlawful if the use of the information involves a breach of fiduciary duty by the insider.

The rationale for prohibiting insider trading is precisely the same as that for prohibiting patent infringement or theft of trade secrets: protecting the economic incentive to produce socially valuable information. As the theory goes, the readily appropriable nature of information makes it difficult for the developer of a new idea to recoup the sunk costs incurred to develop it. If an inventor develops a better mousetrap, for example, he cannot profit on that invention without selling mousetraps and thereby making the new design available to potential competitors. Assuming both the inventor and his competitors incur roughly equivalent marginal costs to produce and market the trap, the competitors will be able to set a market price at which the inventor likely will be unable to earn a return on his sunk costs. Ex post, the rational inventor should ignore his sunk costs and go on producing the improved mousetrap. Ex ante, however, the inventor will anticipate that he will be unable to generate positive returns on his up-front costs and therefore will be deterred from developing socially valuable information. Accordingly, society provides incentives for inventive activity by using the patent system to give inventors a property right in new ideas. By preventing competitors from appropriating the idea, the patent allows the inventor to charge monopolistic prices for the improved mousetrap, thereby recouping his sunk costs. Trademark, copyright, and trade secret law all are justified on similar grounds.

This argument does not provide as compelling a justification for the insider trading prohibition as it does for the patent system. A property right in information should be created when necessary to prevent conduct by which someone other than the developer of socially valuable information appropriates its value before the developer can recoup his sunk costs. Insider trading, however, often does not affect an idea's value to the corporation and probably never entirely eliminates its value. Legalizing insider trading thus would have a much smaller impact on the corporation's incentive to develop new information than would, say, legalizing patent infringement.

The property rights approach nevertheless has considerable justificatory power. Consider the prototypical insider trading transaction, in which an insider trades in his employer's stock on the basis of information learned solely because of his position with the firm. There is no avoiding the necessity of assigning the property right to either the corporation or the inside trader. A rule allowing insider trading assigns the property right to the insider, while a rule prohibiting insider trading assigns it to the corporation.

From the corporation's perspective, legalizing insider trading likely would have a relatively small effect on the firm's incentives to develop new information. In some cases, however, insider trading will harm the corporation's interests and thus adversely affect its incentives in this regard. This argues for assigning the property right to the corporation, rather than the insider.

Those who rely on a property rights-based justification for regulating insider trading also observe that creation of a property right with respect to a particular asset typically is not dependent upon there being a measurable loss of value resulting from the asset's use by someone else. Indeed, creation of a property right is appropriate even if any loss in value is entirely subjective, both because subjective valuations are difficult to measure for purposes of awarding damages and because the possible loss of subjective values presumably would affect the corporation's incentives to cause its agents to develop new information. As with other property rights, the law therefore should simply assume (although the assumption will sometimes be wrong) that assigning the property right to agent-produced information to the firm maximizes the social incentives for the production of valuable new information.

Because the relative rarity of cases in which harm occurs to the corporation weakens the argument for assigning it the property right, however, the critical issue may be whether one can justify assigning the property right to the insider. On close examination, the argument for assigning the property right to the insider is considerably weaker than the argument for assigning it to the corporation. As we have seen, Manne argued that legalized insider trading would be an appropriate compensation scheme. In other words, society might allow insiders to inside trade in order to give them greater incentives to develop new information. As we have also seen, however, this argument founders because insider trading in fact is an inefficient compensation scheme.

The economic theory of property rights in information thus cannot justify assigning the property right to insiders rather than to the corporation. Because there is no avoiding the necessity of assigning the property right to the information in question to one of the relevant parties, the argument for assigning it to the corporation therefore should prevail.

None of this is to say that the precise set of rules the SEC has adopted is ideal. To the contrary, as I detailed in my book on insider trading, there are serious problems with a number of features of the current enforcement regime. As to the basic question of whether we ought to regulate insider trading, however, economic efficiency commands an affirmative answer.

Beaulieu Vineyard Pinot Noir Reserve (Carneros) 2001

This Pinot Noir is an attractive ruby of medium depth. Strong aromas of cherries and raspberries dominate, but there is a pleasant undertone of earth and game. On the palate there is a noticeable oak element in the vanilla flavors, but the dominant impression is earth and cherries. Smooth tannins and good acidity suggest that medium-term cellaring would not go unrewarded. Buy half a case, drink a couple now, and then forget about the rest for 5 years or so. Grade: B++

The Ownership Society

Lew Rockwell thinks (I use the term very loosely) President Bush's ownership society is disguised tyrrany:

Under a certain kind of government structure--let's just call it fascism for short--ownership can be in private hands only in the most formal sense, but its control and use is subject to central command.

Along the way, he misrepresents the thrust of my recent TCS column on the ownership society. This is why I find it impossible to take the anarcho-libertarian fringe remotely seriously. Not only do the allow the perfect to become the enemy of the good, they misrepresent and distort the good.

Meanwhile, the Washington Post quotes my column in a piece on Bush's RNC speech:

The most prominent recommendation of Bush's Social Security Commission in late 2001 would ultimately put the nation's largest entitlement program on a path to solvency, according to a recent analysis by the nonpartisan Congressional Budget Office. It would also make stock ownership almost universal, "which surely would be the ultimate expression of the American dream," argues Stephen Bainbridge, a law professor at the University of California at Los Angeles.

Corporations Really do Rule the World

Proof from the NYC anti-GOP protests via Daniel Henninger:

At midweek, another march up to Madison Square Garden began at Ground Zero downtown. Amid the marchers, you could see shoes by Nike and Timberland, bike helmets by Bell, backpacks by Kelty, Caribee and Mizuno. They knew how to assemble this stuff.

So it seemed a paradox that at the other end of the demonstration, outside Madison Square Garden, the protesters were wearing pig masks, yelling "oink, oink" and making fun of Dick Cheney, calling Halliburton "Halli-bacon" and denouncing the Republicans as slaves to corporate America, even while they themselves were draped in corporate design logos.

No paradox. Part selective outrage, part stupidity, and part the dominance of economic life by corporations.

What Bush Needs to Do: The Ownership Society

My latest TCS Daily column

President Bush has been talking a lot lately about creating and fostering an "Ownership Society." George Melloan recently wrote an excellent WSJ ($) column on the political advantages of this policy program for the Republicans. In the course of doing so, Melloan made a very important point about the essential foundation without which such a society would founder:

"The promise by politicians to protect the sanctity of private property is not exactly a new idea in American politics. It just got lost somewhere back there when environmental radicals started dictating how private land could be used, municipal authorities started using their eminent domain powers recklessly and lawyers became birds of prey, hunting for deep pockets to pick. That has been a dangerous trend, because the protection of private property has been fundamental to American economic and political development.

"Alexis de Tocqueville in 'Democracy in America' (published in 1835 and 1840) discovered the social value of property rights: 'Why is it that in America, the land par excellence of democracy, no one makes that outcry against property in general that echoes through Europe?' His answer: 'It is because there are no proletarians in America. Everyone, having some possession to defend, recognizes the right to property in principle.'

"Indeed, the Founding Fathers planned it that way. James Madison, perhaps the most influential politician in the design of the American Constitution, wrote: 'That alone is a just government which impartially secures to every man whatever he owns.'"

In The Conservative Mind, Russell Kirk put it somewhat more succinctly: "freedom and property are closely linked: separate property from private possession, and the Leviathan becomes master of all."

The freedom to accumulate property and use it as you wish does more than merely protect economic interests. Economic liberty, of which the rights of private property are the foundation, is a necessary concomitant of personal liberty -- the two have almost always marched hand in hand. The pursuit of property has been a major factor in destroying arbitrary class distinctions, moreover, by enhancing personal and social mobility. At the same time, the manifest failure of socialist systems to deliver reasonable standards of living has undermined their viability as an alternative to democratic capitalist societies in which accumulation of property is a paramount societal goal. Accordingly, it seems fair to argue that the economic liberty to pursue and use property is an effective means for achieving a variety of moral ends.

Unfortunately, we live in a society in which neither party is fully committed to protecting private property rights. Both parties routinely infringe on property rights through taxation and regulation. At least since the Reagan Revolution, of course, the GOP has been the lesser of two evils on this score. If Bush is serious about creating an ownership society, however, he must convert the GOP into an affirmative friend of private property-promoting and protecting ownership by all.

What then should Bush's agenda be? Creating an ownership society will require a radical rethinking of the nanny state at almost all levels, but here are some key starting points:

1. Major tax reform that shifts the focus from taxing income, investment returns, and savings to taxing consumption. Many of our tax laws currently seem designed to discourage investment and wealth creation. The double taxation of corporate profits paid out as dividends and taxation of interest on savings are just two obvious examples. Other aspects of our tax laws distort investment decisions. The difference in tax treatment of dividends and capital gains, for example, warp decisionmaking by both corporations and investors. In contrast, a consumption tax system -- relying on sales taxes, a VAT, and excise taxes -- would reward investment and, equally important, eliminate the distorting effects of the current system. Granted, you'd have to address the potential for a consumption tax to be unduly regressive. Even so, however, shifting to a consumption tax is essential if we are to reward and promote investment and ownership.

2. Permanent elimination of the estate tax. One of the chief incentives to wealth creation is the natural desire to ensure that one's children lead a better life than you do. The confiscatory estate tax negatively impacts wealth creation, especially by small business owners and family farmers, who are disproportionately affected by the death tax.

3. Social security reform that encourages private investment accounts. Over half of the American people already invest in the stock market. Privatization of pensions, even if partial, would make stock ownership almost universal. Every American would own a piece of the American economy, which surely would be the ultimate expression of the American dream. Instead of being at the mercy of future politicians, every American would begin building individual wealth.

4. Protecting private property from regulatory takings. OpinionJournal.com recently reported on the story of John Rapanos, a 68-year-old Michigan man who was convicted of breaking the Clean Water Act by having moved sand from one end of his own property to the other without a federal permit. As the nanny state thus extends its power to regulate how we use our own property, Kirk's Leviathan looms ever larger.

As Melloan pointed out, Bush's goal of an "ownership society" extends a long-standing American dream. It harkens back such historical examples as the Homestead Act, by which the very first Republican President empowered Americans by granting settlers 160 acres if they farmed it for at least 5 years. It is a principal argument for reelecting President Bush. Now he needs to articulate how he'll achieve the ownership society if we give him a second term.