ProfessorBainbridge.com

Frodo Lived

Scientists have discovered a new and tiny species of human that lived in Indonesia at the same time our own ancestors were colonising the world. The new species - dubbed "the Hobbit" due to its small size - lived on Flores island until at least 12,000 years ago.

The fact that little people feature in the legends of modern Flores islanders suggests we might have to take tales of Leprechauns and Yeti more seriously. ... Flores' inhabitants have incredibly detailed legends about the existence of little people on the island they call Ebu Gogo. The islanders describe Ebu Gogo as being about one metre tall, hairy and prone to "murmuring" to each other in some form of language. They were also able to repeat what islanders said to them in a parrot-like fashion.

"There have always been myths about small people - Ireland has its Leprechauns and Australia has the Yowies. I suppose there's some feeling that this is an oral history going back to the survival of these small people into recent times," said co-discoverer Peter Brown, an associate professor of archaeology at New England. ... Henry Gee, senior editor at Nature magazine, ... speculates that species like H.floresiensis might still exist, somewhere in the unexplored tropical forest of Indonesia. (Source)

Cool. You will recall, of course, that the Prologue to the Lord of the Rings implies that Hobbits still live among us, albeit in hiding. So perhaps Mr. Gee is right. On the other hand, perhaps Hobbit evolution in fact continued to its logical conclusion. In either case, please don't tell Chomsky; you know how he gets when it comes to Hobbits.

Senate Stock Trading

Taken together, the semi-strong and strong forms of the Efficient Capital Markets Hypothesis teach that no class of investors can beat the market over time without routine access to material nonpublic information. Many studies have shown that the only investors who, as a class, routinely produce postive abnormal returns are corporate insiders. It turns out, however, that there is a second such group. As reported in today's WSJ($):

A study suggests that U.S. senators possess stock-picking skills that even the most seasoned money manager would envy. During the boom years of the 1990s, senators' stock picks beat the market by 12 percentage points a year on average, according to the study. Corporate insiders, meanwhile, beat the market by about six percentage points a year, while U.S. households underperformed the market by 1.4 percentage points a year on average, according to separate studies. The final details of the study will be published in the December issue of the Journal of Financial and Quantitative Analysis. ...

Looking at the timing of cumulative returns, the senators also appeared to know exactly when to buy or sell their holdings. Senators would buy stocks just before the shares suddenly would outperform the market by more than 25%. Conversely, senators would sell stocks that had been beating the market by about 25% for the past year just when the shares would fall back in line with the market's performance.

What explains this miraculous performance? Given that the senators are producing returns that best even such stars as Peter Lynch and Warren Buffet, shouldn't they go manage mutual funds instead of running the country? Or are senators trading on the basis of inside information? It looks like the latter:

The researchers say senators' uncanny ability to know when to buy or sell their shares seems to stem from having access to information that other investors wouldn't have. "I don't think you need much of an imagination to realize that they're in the know," says Alan Ziobrowski, a business professor at Georgia State University in Atlanta and one of the four authors of the study.

Senators, for example, are likely to know which tax legislation is apt to pass and which companies might benefit. Or a senator who sits on a certain committee might find out that a particular company soon will be awarded a government contract or that a certain drug might get regulatory approval, says Prof. Ziobrowski.

So it seems that we are ruled by crooks and cheats. The sad part, of course, is that I'm not all surprised.

More on Sinclair Broadcasting

Over at Right Coast, my friend Tom Smith opines:

So here, apparently, is what happened with "Stolen Honor." Bill Lerach, strike suit entrepreneur, threatened Sinclair with a shareholder suit if it ran the movie. Then the controller of the state of New York, in charge of a public employee pension funds, threatened Sinclair with legal action as well. Sinclair caved, but who can blame them. Running the movie probably would have been good business, but standing up to political thuggery is not. ...

As to the New York state pension fund, well, some of us in the corporate law world said a long time ago that shareholder activism was a bad idea. Pension funds are run by bureaucrats, who are no more immune to the temptations of power than anybody else. The idea that a New York pension fund has an economic stake in whether Sinclair shows a movie, which probably would have garnered many viewers, is beyond absurd. The political hack who made that call should be tossed out of her job, but who's going to launch the hostile tender offer on the pension fund and the state of New York? Oh, I forgot, nobody monitors the Solons at the pension funds.

As long time readers know, I'm one of those folks "in the corporate law world [who] said a long time ago that shareholder activism was a bad idea." See, e.g., my article Director v. Shareholder Primacy in the Convergence Debate, which argues:

Abstract: Although the question of whether international corporate governance is converging on the U.S. model remains contested, there is general agreement as to the nature of that U.S. model. Specifically, virtually all participants in the convergence debate assume that U.S. corporate law is based on a norm of shareholder primacy. This assumption is wrong. U.S. corporate law is far more accurately described as a system of director primacy than one of shareholder primacy. In this essay, the author argues that the comparative corporate governance literature's erroneous understanding of the U.S. model distorts both the positive and normative aspects of the convergence debate. On the positive side, if we use the extent of shareholder primacy as our metric, we end up with a distorted estimate of the extent to which systems have converged. On the normative side, corporate governance is a potentially important instrument by which to increase the economy's efficiency. In recent years, elite U.S. corporate law scholars have played a significant role in "reforming" the corporate laws of transition economies. If the goal is to export the U.S. model, on the assumption of its superiority, we do those economies no good - and may do much harm - by exporting the wrong model. Hence, we are constrained to examine the normative question: Does it matter? Is director primacy superior to shareholder primacy? This essay acknowledges that investor participation in corporate governance has economic benefits, but argues that director primacy is preferable on balance.

Hitching Post Bien Nacido Vineyard Pinot Noir (Santa Maria Valley) 2000

When last noted in October 2003, this was still a young and vigorous wine. A year later, it is smoother and rounder, showing some signs of age in its color. Strawberries, cherry cola, and roses still dominate though. Plus that uniquely Pinot Noir note in the bouquet that to me always evokes grape stems. I'd estimate that it has a couple of years left, but it is very hard to resist now. Grade: A-

Ridge Geyserville (Sonoma County) 1999

A Zinfandel-based blend (68%) with 16% @ Carignane and Petite Sirah proves once again that Zinfandel may not be as long-lived as Cabernet Sauvignon, but nevertheless rewards medium-term cellaring. At age 5, this Geyserville was ready to drink but hardly finished. I'm confident it can go another 3-5 years without problems. It is so delicious now, however, that holding off on the last two bottles in the cellar will be very hard. Wild berries, chocolate, black pepper, and a touch of bramble. Yummy. Grade: A

Is the Supreme Court Coherent?

In today's NYT, Harvard law prof (and Reagan-era SG) Charles Fried argues that the Supreme Court under Rehnquist has consistently pursued a policy of promoting classical liberalism:

Since the mid-1970's the Supreme Court has been fashioning a series of doctrines that have been characterized as conservative, though I would call them liberal with a small l, the liberalism of classic individualism. These decisions - about race, free speech and campaign finance, property rights, constitutional criminal procedure, religion and federalism - have not, as their opponents have caricatured them, been extreme or lacking in nuance. ...

BS. Yale law prof and blawgger Jack Balkin correctly points out the rather simple error in Fried's analysis:

What decisions like Casey v. Planned Parenthood, United States v. Lopez, and Hibbs v. Department of Social Services have in common is not they are are all classical liberal decisions. What they have in common is that Justice O'Connor joined in them or wrote them. So perhaps Charles is really saying that he wishes that O'Connor was more of a classical liberal, and that she has disappointed him in Grutter (the affirmative action case) and McConnell (the campaign finance case). Fair enough. But one shouldn't expect a swing Justice like O'Connor to match a particular coherent political ideology. That's simply not what such Justices do. And don't expect a Court whose decisions depend on what swing Justices do to produce a coherent political ideology. That's not what multimember bodies do, either.

Exactly right. My professional life is devoted to studying a multimember decisionmaking body called the board of directors. Multimember decisionmaking bodies have a very hard time hewing to a coherent policy with respect to widely disparate decision opportunities. For one thing, group members often vote strategically. Vote trading is common on boards (and presumably on multimember courts of judicial biographies are to be believed). As I pointed out in my article, Why a Board? Group Decisionmaking in Corporate Governance, although we might assume that group decision making has a moderating influence, social dilemma experiments demonstrate that groups actually make more extreme decisions than individuals. Finally, basic collective action problems, such as Arrow's Impossibility Theorem, suggest that group decisionmaking can often cycle between competing preferences. In sum, Supreme Court decisions reflect the personal policy preferences of a temporary and often-shifting alliance of 5 or more justices, but cannot be expected to consistently reflect a dominant ideology in the absence of a much more cohesive grouping than exists on the Court today.

Liveblogging Lindgren

Volokh Conspirator (and NU law professor) James Lindgren is here at UCLA today to present a paper on Chasing Cherished Superstitions About Conservatives to the Federalist Society. I'm a big fan of Lindgren's work, which is widely acknowledged to be fair and balanced in assessing empirical data. His talk today is a reply to the "study" by John Jost et al. that "found," as Byron York put it, that "conservatives are crazy."

Lindgren points out some flaws with the data Jost et al. used. First, they use a definition of conservative that includes people like Hitler and Stalin. Second, the data they rely on claims that women are more conservative than men, while Lindgren points out that every major survey find the opposite. Third, the surveys used in the Jost et al. meta-analysis assume that conservatives are less well-educated than liberals, while the widely used General Social Survey finds the opposite.

An email by Lindgren that was quoted some months ago by a blogger summarizes some of the many other data points Lindgren offers as rebutting the Jost analysis:

The Jost article claims that conservatives are angry and fearful and it builds on a literature that claims that conservatives are unhappy. I find this strange, given the decades of superb data showing the opposite. In the NORC General Social Survey (a standard social science database, second only to the U.S. Census in use by U.S. sociologists), the GSS asks the standard survey question about happiness in general. In the 1998-2002 GSS, extreme conservatives are much more likely to report being "very happy" than extreme liberals--47.1% to 31.6%. Earlier years show a similar pattern.

This conservative happiness carries over into most other aspects of life as well. Conservatives usually report being happier in their jobs than liberals. In the 2002 GSS, for example 65.2% of extreme conservatives report being "very satisfied" with their jobs in general, while only 50% of extreme liberals report being very satisfied. When the question is broadened to satisfaction with job or housework, a similar pattern obtains. In the 1998-2002 GSS, 61.0% of extreme conservatives reported being very satisfied, compared to 53.6% of extreme liberals.

As to finances, in the 1998-2002 GSS 34% of extreme conservatives report being satisfied with their finances compared to 26.4% of extreme liberals. More extreme liberals (34.5%) than extreme conservatives (25.8%) report being "not at all satisfied" with their finances.

Conservatives usually tend to report less marital unhappiness than liberals. In the 1998-2002 GSS, 5.1% of those who report being "slightly liberal" say that they are "not too happy" in their marriages, compared to 0.9% of those who are "slightly conservative." Ordinary liberals (3.7%) and extreme liberals (8.9%) also differ from ordinary conservatives (2.4%) and extreme conservatives (4.1%) in the levels of reported marital unhappiness. Indeed, in the 1998 GSS, 18.2% of extreme liberals reported that their marriages were "not too happy," while only 1.6% of extreme conservatives reported marital unhappiness.

Earlier General Social Surveys found that conservatives were more satisfied with their health, their friendships, their family life, and the city or place they live--all in all, a remarkably consistent picture.

Another claim in the Jost paper is that conservativism is driven by anger and fear. Again, their claims conflict with some of the highest quality data available. In the 1996 GSS, questions were asked about anger and fearfulness. Extreme conservatives were much less likely to report being mad at someone every day in the last week--7.3% to 24.2% for extreme liberals. Extreme conservatives were also less likely to report being fearful in the last week--32.5% to 56.3% for extreme liberals. In other words, a staggering one-quarter of extreme liberals report being mad at someone EVERY DAY and most extreme liberals report being fearful at least once a week.

I am surprised that the Jost group was not aware of the very strong and remarkably consistent data that conservatives report being happier than liberals about their lives in general, their jobs, their finances, their health, their friendships, their family life, and where they live. Nor does the Jost group deal with the less extensive data suggesting that conservatives are less fearful and less angry than liberals. I will have to look into more of the studies that Jost cites to see why these fairly obvious patterns are missed. I wonder whether Jost relied too much on studies that either used unrepresentative samples (such as undergraduates) or used biased questions or indices -- asking about issues on which conservatives tend to be unhappy but not about issues on which liberals tend to be unhappy. In either event, the Jost group seems to have missed decades of very high quality survey data that undercut their thesis.

More by Lindgren on this topic here. See also non-Lindgren commentary here.

All of this does raise an interesting question: what makes someone a liberal or conservative? Nature or nuture? Environment, education, or economic success/failure? My guess is that conservatives and liberals tend to be born, not made. Doubtless factors like environmental and class play into it, but my guess is that we tend to be hardwired for one side or the other. (When I asked Lindgren this question, he suggested looking at twin studies, which apparently are the classic way of doing nature versus nurture studies. A post over at the 2Blowhards discusses a twin study that seems to confirm the nature hypothesis.)

Sidenote: Lindgren notes that he can't study libertarian attitudes is because the number of people who self-report to the GSS as libertarians is so small that they don't even collect the data. Heh.

The Behavioral Challenge to the ECMH

Great article today in the WSJ($) on the debate between efficient capital markets theorists (exemplified by Eugene Fama) and behavioralists (exemplified by Richard Thaler). Here's a sample:

For forty years, economist Eugene Fama argued that financial markets were highly efficient in reflecting the underlying value of stocks. His long-time intellectual nemesis, Richard Thaler, a member of the "behaviorist" school of economic thought, contended that markets can veer off course when individuals make stupid decisions.

In May, 116 eminent economists and business executives gathered at the University of Chicago Graduate School of Business for a conference in Mr. Fama's honor. There, Mr. Fama surprised some in the audience. A paper he presented, co-authored with a colleague, made the case that poorly informed investors could theoretically lead the market astray. Stock prices, the paper said, could become "somewhat irrational."

Coming from the 65-year-old Mr. Fama, the intellectual father of the theory known as the "efficient-market hypothesis," it struck some as an unexpected concession. For years, efficient market theories were dominant, but here was a suggestion that the behaviorists' ideas had become mainstream.

"I guess we're all behaviorists now," Mr. Thaler, 59, recalls saying after he heard Mr. Fama's presentation.

Well, perhaps not quite. The ECMH is central to both many SEC policy debates and investment techniques. Its validity is thus a critical question. I plan to address the continued validity of the hypothesis in a TCS column (assuming Nick takes it). In the meanwhile, check out these old blog posts:

• Random stock traders and the ECMH; with a review of Malkiel's Random Walk
• Dow 10000, Psychology, and the ECMH

Using Game Theory in Legal Analysis

Larry Solum has a great post entitled Game Theory & the Prisoner's Dilemma. As Larry explains:

One of the most useful tools in analyzing legal rules and the policy problems to which they apply is game theory. The basic idea of game theory is simple. Many human interactions can be modeled as games. To use game theory, we build a simple model of a real world situations as a game. Thus, we might model civil litigation as a game played by plaintiffs against defendants. Or we might model the confirmation of federal judges by the Senate as a game played by Democrats and Republicans. This week's installment of the Legal Theory Lexicon discusses one important example of game theory, the prisoner's dilemma.

I used the prisoner's dilemma to model the behavior of sovereign debtors vis-a-vis creditors in my article Comity and Sovereign Debt Litigation: A Bankruptcy Analogy:

Abstract: On repeated occasions in the post-war period, the cumulative effects of policy mistakes, recessions, inflation, and other economic problems have made it difficult for sovereign debtors to service their external debt. Unlike a domestic U.S. private debtor, who may resort to formal bankruptcy procedures in the event of insolvency, a defaulting sovereign debtor has no formal mechanism for triggering a restructuring of its debt.

In some cases, sovereign debtors have resorted to a moratorium on debt payments. This article argues that U.S. courts ought to give effect to such moratoria under the international law principle of comity. Using standard game theory methodology (the so-called "creditors dilemma" variant of the famous "prisoners dilemma"), the article argues that creditors of such debtors would agree in advance to give effect to such a moratorium provided it neither repudiated the sovereign's debts not gave preference to certain creditors. A legal test for granting comity to sovereign debt moratoria is therefore proposed.

The Vaccine Problem

Today's WSJ($) opined:

Americans are angry about the sudden shortage of flu vaccine, and well they should be. But we hope they don't fall for the current story line that this is all the fault of a single company and its British factory. The real problem lies with a political class that has driven all but a handful of companies out of the vaccine business. ... [A]ny company brave, or foolish, enough to make vaccines has had to run an obstacle course of price controls, regulation and tort lawyers. Until Congress and federal officials come to grips with these fundamental problems, life-threatening vaccine shortages will continue to occur.

Economist Alex Tabarrok apparently agrees:

President Bush was correct when he said that liability risk is one factor in the recurrent shortage of vaccines. ... Liability is not the only issue, however. Costly FDA regulations and requirements, for example to remove thimerosal from vaccines despite no evidence of safety problems, have pushed firms out of the industry. ...

A further problem is that the federal government is the major purchaser of vaccines, although not the flu vaccine, and it uses its monopsony powers and the law to require companies to sell at low prices. Firms have left the industry because they are squeezed on one end by regulation and on the other by low prices and, for vaccines like the flu vaccine not covered by VICP, potential liability. Note that even if the prices are high enough to earn the company a modest profit the point is that they are not high enough to make it worthwhile to make a surplus of vaccine that can be sold in the event of a contamination problem, as has happened this year. If the firms can't price high during a shortage then there is no incentive to plan for a shortage.

Howard Stern Blasts Radio

Radio shock jock Howard Stern currently has a contract with Infinity Broadcasting, a division of Viacom, which expires in 2006. Stern recently announced he had signed a deal with to join Sirius satellite radio after his Infinity contract expires.

What’s the corporate law problem? According to the LA Times:

“Stern has already begun promoting Sirius on his website, and many people speculate that he will do the same on Infinity's airwaves.”

If so, Stern appears to have violated his fiduciary duties to Viacom (he may also be in breach of contract).

Analytically, the initial issue is whether Stern is an agent of Infinity. According to the Restatement (Second) of Agency:

An agency relationship exists if you have a manifestation of consent by one person (the principal) that another person (the agent) act (a) on the principal’s behalf; and (b) subject to the principal’s control; and (2) the agent’s consent to so act.

The employment contract between Stern and Infinity for him would suffice to demonstrate the requisite consents.

As an agent, Stern is entitled to begin preparing to compete with Infinity. Comment e of section 393 of the Restatement (Second) of Agency provides that an agent can make arrangements to compete with his principal even before the termination of the agency, but that he cannot properly use confidential information peculiar to his employer’s business and acquired therein.

“Thus, before the end of his employment, he can properly purchase a rival business and upon termination of employment immediately compete. He is not, however, entitled to solicit customers for such rival business before the end of his employment nor can he properly do other similar acts in direct competition with the employer’s business.”

Because promoting Sirius on the air and at his website almost certainly would be deemed an effort to solicit customers, Stern is in a clear breach of fiduciary duty.

In addition, Stern’s show includes a number of side-kicks, whom he has solicited to follow him to the new show on Sirius. Again, comment e to Restatement (Second) of Agency is relevant:

“The limits of proper conduct with reference to securing the services of fellow employees are not well marked. An employee is subject to liability if, before or after leaving the employment, he causes fellow employees to break their contracts with the employer. On the other hand, it is normally permissible for employees of a firm, or for some of its partners, to agree among themselves while still employed, that they will engage in competition with the firm at the end of the period specified in their employment contracts. However, a court may find that it is a breach of duty for a number of the key officers or employees to agree to leave their employment simultaneously and without giving the employer an opportunity to hire and train replacements.”

To the extent Stern induces the sidekicks to break their own employment contracts, there clearly would be a problem. In addition, courts are much less forgiving of employee solicitation when the solicitor has a supervisory role vis-à-vis those who are solicited. On the whole, however, this strikes me as a much less clear cut case than the problem of soliciting customers of terrestrial radio to shift to satellite.

Sinclair to Air Anti-Kerry Program

Sinclair Broadcasting Group Inc., which owns 60-odd TV stations in many major US media markets, has ordered its stations to preempt ordinary programming in order to air "Stolen Honor: Wounds That Never Heal," a film about Senator John Kerry's Vietnam record that many regard as being anti-Kerry.

Some have suggested that Sinclair shareholders sue Sinclair's board of directors to prevent the airing of the program and/or to recover damages. Would such a suit succeed? The short answer: almost certainly not. The long answer follows.

The only plausible corporate law claim a shareholder could have against Sinclair's officers and directors in this context would be a breach of the fiduciary duty of care and/or loyalty. The care claim would posit that Sinclair management injured Sinclair's business (whether negligently, recklessly, or intentionally) by injecting Sinclair into a partisan debate, which might have negative effects on viewership if a proposed boycott proves effective. The loyalty claim would allege that Sinclair management used corporate assets for personal purposes. The loyalty claim likely would be unsuccessful. The fact that managers get some sort of psychic or other non-pecuniary gain from an action usually is not enough to state a loyalty claim unless they also got some sort of personal pecuniary benefit. Hence, I will focus on the care claim.

The care claim would have to be brought directly rather than derivatively. A “direct” shareholder suit arises out of a cause of action belonging to the shareholder in his or her individual capacity. It is typically premised on an injury directly affecting the shareholder and must be brought by the shareholder in his or her 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 thus merely acting as the firm's representative. Nevertheless, for most procedural purposes the shareholder is treated as the named plaintiff and the corporation is treated as a defendant.

It is often difficult to tell which type of action a particular case falls under. The basic tests are: (1) Who suffered the most immediate and direct injury? If the corporation, the suit is derivative. (2) To whom did the defendant's duty run? If the corporation, the suit is derivative.

Suppose the treasurer of one of the firms in which you have invested absconds with all the firm's money. Your stock is now worth less, since the firm has no money. Can you sue the treasurer directly or must you sue derivatively? Although you have suffered a loss, you cannot directly sue the treasurer. It is not enough for a shareholder to allege that the challenged conduct resulted in a drop in the corporation's stock market price. Instead, because your loss is “derivative” of the corporation's loss, only the corporation can sue. Likewise, any loss suffered by Sinclair's shareholders likely would be derivative of prior losses (say from a boycott) by the corporation.

The fact that a shareholder would have to sue derivatively is bad news for a would-be plaintiff. In the chapter on shareholder derivative litigation in my book Corporation Law and Economics, I identify five major procedural problems faced by the derivative suit plaintiff: Verification; Contemporaneous ownership; Fair and adequate representation; Recovery goes to the corporation; and Security for expenses statutes. Above all these, however, towers the demand requirement.

In most states, a shareholder must make demand on the board of directors prior to filing suit. The demand is typically a letter laying out the reasons the shareholder thinks the corporation has been injured and why it has a remedy against identified wrongdoers. As noted, demand is required in all cases, except those in which it is excused those cases in which it is excused as futile.

Well, so what? The problem is that in demand-required cases, the board of directors has a lot of control over the litigation. After the shareholder makes the required demand, the board of directors is obliged to take it under advisement. If the board concludes, following its review of the demand, that suit should go forward, the board assumes control of the litigation. If the board concludes that suit should not go forward, the board will "refuse" the demand. At that point, plaintiff can sue alleging that the refusal was wrongful. Unfortunately for the plaintiff, however, the relevant standard of review is the business judgment rule. Unless the board, in making its decision to refuse demand, made an uninformed decision, committed fraud, or engaged in self-dealing, the court will uphold the decision and plaintiff will not be allowed to sue. Note that possible board misconduct with respect to the underlying transaction is irrelevant; the question here is whether the board engaged in misconduct when deciding what to do about the demand.

Because it is so hard to overcome a board refusal of a demand, the real action in these cases is at the stage in which it is determined whether demand is required. The plaintiff typically will file suit without making demand and contend that demand is excused as futile. The precise standard for determining demand futility varies from state to state, but generally requires that the plaintiff must allege specific facts showing that (1) a majority of the directors have a direct personal financial interest in the transaction (the mere fact that they might be defendants in a lawsuit arising out of the transaction is not enough); or (2) and a majority of the directors are dominated and controlled by the alleged wrongdoers; or (3) the challenged transaction was not a valid business judgment. If the decision was made by management, rather than the board of directors, as appears to be the case, this standard will be very hard to meet. The first prong falls out. The third is irrelevant, because there was no exercise of business judgment. Instead, as the Delaware supreme court explained in Rales v. Blasband, 634 A.2d 927 (Del. 1993), the issue will boil down to whether, "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" to sue managers. Do the Sinclair brothers so dominate and control the other members of the board that those members are incapable of exercising independent business judgment?

Where board members were nominated and/or elected by a controlling shareholder, for example, concerns over their independence seem legitimate. Likewise, insider board members may be dependent upon other board members for their continued employment. Neither fact standing alone suffices, however, as the Delaware supreme court made clear in Aronson v. Lewis, 473 A.2d 805 (Del. 1984). In that case, the chief alleged wrongdoer owned 47% of the corporation’s stock and allegedly had personally selected each board member. The supreme court held that all of this did not render the board per se incapable of exercising independent judgment. Instead, plaintiff must “demonstrate that through personal or other relationships the directors are beholden to the controlling person.” Consequently, courts will not presume inside directors are subject to improper influence merely by virtue of their employment relationship with the firm.

In sum, a shareholder suit against Sinclair's board of directors likely will be deemed derivative rather than direct. Demand likely will be required rather than excused. If so, and the board refuses demand, that decision almost certainly will be upheld under the business judgment rule. Kerry fans therefore should not put much stock in corporate law to help them (pun intended). The court will want the board of directors to decide whether to sue the managers who made this decision; not the shareholders or the courts. This preference was nicely explained by the court in Kamin v. American Express Co., 383 N.Y.S.2d 807 (Sup. Ct. 1976), aff’d, 387 N.Y.S.2d 993 (App. Div. 1976), where the court observed that:

“The directors’ room rather than the courtroom is the appropriate forum for thrashing out purely business questions which will have an impact on profits, market prices, competitive situations, or tax advantages.” Hence, absent “fraud, dishonesty, or nonfeasance,” the court will not substitute its judgment for that of the directors.

The decision to air the program is a business decision. It may be a bad business decision, but it is still a business decision. As such, the courts are unlikely to interfere at the behest of a shareholder.

The Ovitz Lawsuit and Corporate Governance

Today's WSJ($) quotes self-appointed shareholder activist Nell Minow on the impact of the lawsuit against Walt Disney's directors over their handling of former Disney President Michael Ovitz's compensation package:

Because cases like this rarely go to trial, the Ovitz dispute "has every director quaking in his boots," says veteran shareholder activist Nell Minow, editor and chairman of the Corporate Library, a research group in Portland, Maine, that covers corporate governance.

Nonsense. This is a relatively unique case involving a rare confluence of several factors. First, you have a company with a long history of crony capitalism:

The case will animate, in great detail, the bad old days of Disney's corporate governance, when Mr. Eisner ruled a board that was widely seen as stacked with cronies too passive and unwilling to challenge him.

Second, you have an unusually large compensation package who structure created fewer incentives for Ovitz to work hard than it did for him to find a way of being terminated without cause. Finally, you had a board full of Eisner cronies and/or ceremonial directors who allowed the decisionmaking process to be usurped by Eisner and, indeed, allowed it to poractically disintegrate. If the directors are held liable for the breakdown in the decisionmaking process, that will hardly break much new legal ground. As I explain in the chapter on directors' duty of care in my Corporation Law and Economics treatise:

It is frequently said that the exercise of “reasonable diligence and care” is a precondition for the business judgment rule’s application. This phraseology is most unfortunate. It implies the necessity to inquire into the care exercised by the board .... The problem reduces to one of mere semantics, however, if we understand the requirement of “reasonable diligence and care” as being limited to the process by which the decision was made. Numerous Delaware decisions confirm that judicial references to a requirement of due care really go to the adequacy of the decisionmaking process—what the court has begun calling “process due care.” It would be better to follow the lead of those decisions and simply stop talking about whether the board exercised “reasonable diligence and care.” Instead, the requisite precondition [to application of the business judgment rule] would be better stated as a rational and good faith decisionmaking process. ...

[The leading case of Smith v.] Van Gorkom rests not on failure to comply with some judicially imposed decisionmaking model but on the absence of a sufficient record of any deliberative process. Put differently, if the decisionmaking process is adequate, the court will continue to defer to the decision that emerges from that process. The basic thrust of the opinion then is that the board must provide some credible, contemporary evidence that it knew what it was doing. If such evidence exists, the court will not impose liability—even if the decision proves to have been the wrong one.

By so focusing its opinion, the Van Gorkom court arguably created a set of incentives consistent with the teaching of the literature on group decisionmaking. The decision disfavors agenda control by senior management. The decision penalizes boards that simply go through the motions. The decision encourages inquiry, deliberation, care, and process. The decision strongly encourages boards to seek outside counsel and financial advice, which is consistent with evidence groupthink can be prevented by outside expert advice and evaluations. Even the court’s criticism of the board’s willingness to take action after a single meeting is consistent with suggestions that a “second-chance meeting” also helps prevent groupthink.

My discussion of this issue closes, however, with a warning that will become especially pertinent if Delaware Chancellor Chandler holds the Disney directors liable:

Van Gorkom probably has resulted in many board decisions being over-processed. In many cases, even relatively minor board decisions are subjected to exhaustive review, with detailed presentations by experts. Why? The answer lies in the incentive structures of the relevant players. Who pays the bill if the director is found liable for breaching the duty of care? The director. Who pays the bill for hiring lawyers and investment bankers to advise the board? The corporation and, ultimately, the shareholders. Suppose you were faced with potentially catastrophic losses, for which somebody offered to sell you an insurance policy. Better still, you don’t have to pay the premiums, someone else will do so. Buying the policy therefore doesn’t cost you anything. Would not you buy it?

It’s also important to consider the incentives of the lawyers who advise corporations. Deciding how much time and effort to spend on making decisions is itself a business decision. Because that decision is driven by liability concerns, however, legal advice is usually critical to the making of the decision. Why might lawyers have an incentive to encourage boards to over-invest in the decisionmaking process? The cynical answer is that a more complicated decisionmaking process, which is driven by liability concerns, is likely to result in higher fees. A less cynical explanation is that the law is full of sports, mutants, and mistakes. Clients often lack the information or willingness to recognize that their situation was one of the exceptions that proves the rule. Instead, clients tend to blame the lawyer for an adverse outcome even if the lawyer did nothing wrong. Because the lawyers will be blamed even if losing the case was an act of god equivalent to a 100-year flood, lawyers are often conservative in giving advice. (The term conservative here is not used in its political sense, but rather in the sense of being cautious.) In economic terms, lawyers are risk averse. In a risky situation, the best thing for the lawyer to do is to point the client towards strategies whose outcome is certain.

In sum, the incentives of both sellers and buyers of legal advice are congruent. Lawyers have strong incentives to encourage clients to expend a lot of time, energy, and money on the decisionmaking process, while corporate boards of directors have strong incentives to take that advice. All of which goes to show that otherwise puzzling things become readily explicable if one understands the economic incentives at play.

Robert Mondavi Cabernet Sauvignon (Napa Valley) 1996

After double decanting, the wine offered a powerful nose and delicious flavors. The dominant impression is of classic Cabernet markers: cassis, black currants, and cedar. Underneath is a layer of asian spices, anise, and cashews. It should continue to improve for some years. Grade: B++

Joseph Phelps Syrah (Napa Valley) 1999

A deep, almost black wine that shows almost no signs of age. After double decanting, it offered a powerful bouquet and intense flavors. There's a good layer of fruit (mostly wild berries) but the dominant impression is smoke, herbs, and black pepper. Very drinkable now, although there were enough tannins left to suggest that a few more years of aging would not be amiss. Grade: B++