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

Very good pinot; recommended. Light cherry red color with slight bricking at the rim. Big pinot nose of strawberries, cherry cola, and grape stems. Enters the palate lightly, but the finish lingers. Classic mix of roses, berries, red cherries. Stemmy herbs in the mid-palate. Lacks the stuffing for long-term cellaring, but will hold another couple of years. Grade: A-

Ridge Lytton Springs (Dry Creek Valley) 2000

A blend of 80% zinfandel and 20% petite sirah. Medium-deep purple shading to ruby at the rim. No hint of bricking yet. Moderate nose. A little hot, expressing the high alcohol (almost 15%). Spicy and a little brambly. Blackberries and nettles, with a whiff of coffee pot. On the palate, the wine is big and brawny. Over the last year, however, the flavors have mellowed and blended. What started out as a jammy fruit salad with an odd funky note or two has smoothed into a warm berry jam. The finish is hot and moderately tannic. Highly concentrated. I've got a bit over half a case left and will hold off for another year or two, as it is still evolving. Grade: B+

Clois du Bois Marlstone (Alexander Valley) 1999

A blend of cabernet sauvignon, merlot, and malbec. Okay but not recommended. Medium depth; purple shading to ruby. Watery rim. Modest nose, with funky undertones. Atypical for cabernet on both nose and palate. The mid-palate is acidic, hollow, and thin; the finish is short and oddly industrial. Tomato paste, dried herbs, iron, and maraschino cherry. Tastes more like steak sauce than wine. Grade: C

The LA Strikes and the Economic Analysis of Unions

The LA grocery strike is getting to be a real pain. I rely on our neighborhood Ralph's for staples. Oddly enough, it also houses the only branch of my bank in our neighborhood. My problem is that, contrary to what I bet you suspect, I will not cross picket lines. Why not?

First, I come from a long line of union members. Second, Catholic Social Teaching emphasizes that workers have a natural right both to form unions and to strike. As I read the relevant encyclicals and pastoral letters, this teaching is not a matter of prudential judgment, but rather an authoritative teaching to which faithful Catholics must give religious assent. Finally, unions potentially are an important way of minimizing transaction costs.

Labor contracts are subject to moral hazard problems on both sides. Workers shirk—providing less effort than that to which they have agreed. Owners behave opportunistically—providing fewer rewards than promised. Preventing such shirking is one of the principal functions, in economic terms, of any labor relations system. Hence, at least among lawyer-economists in the transaction costs branch of law and economics, the once widely-held view that unions exist to capture monopoly rents for workers in the form of higher wages and superior benefits has given way to an understanding that unions play an important role in reducing transactions costs by constraining strategic behavior by management. Because workers value job security, firms can obtain lower labor costs if they can credibly promise to refrain from opportunistic conduct. One way of bonding that promise is to sign a collective bargaining agreement with a union. Collective bargaining transforms the decisionmaking process from unconstrained management prerogative to limited managerial discretion bounded by claims of right sounding under the agreement. The seniority system, with its ports of entry, internal promotion ladders, and protection from lay-offs, offers job security. Union monitoring helps ensure compliance by the firm with its contractual obligations. Grievance procedures allow for dispute resolution. Collective bargaining thus becomes a burden on the enterprise, in that it raises the transaction costs associated with decisionmaking processes and limits management discretion. Yet, because that burden serves to make the firm’s promises to its employees more credible, it is one rational managers would accept. (Putting the theory into practice, of course, has been a problem. Unions have been plagued by internal agency costs and been a source of social costs.) For a more detailed explanation see my articles Employee Involvement in Workplace Governance Post-Collective Bargaining and Corporate Decisionmaking and the Moral Rights of Employees.

Update re decisionmaking heuristics: One of my colleagues dropped by the office this afternoon to object that, whatever merit my arguments may have, I have not made a case for refusing to cross all picket lines. Good point. Neither efficiency or morality compels the result that every strike is worth respecting. My rule against crossing crossing picket lines, however, is economically justified as a transaction cost minimizing decisionmaking heuristic. Bounded rationality is a neo institutional economics concept capturing the idea that we all have inherently limited memories, computational skills, and other mental tools. These limitations become a significant constraint on decisionmaking under conditions of complexity and uncertainty. Under those conditions, we can reduce decisionmaking costs by adopting a heuristic -- a rule of thumb -- for making judgments. Yes, the rule of the thumb inevitably produces errors, but the benefit in time and effort saved may outweigh error costs. A rule of thumb of not crossing any picket line saves me the time and effort necessary to figure out whether a given strike is morally and economically justified.

Dow 10000, Psychology, and the ECMH

PoliBlog has an insightful post on the possible economic and political impact that would follow from the Dow getting back above 10,000:

While I am hardly saying that if the Dow hits 10k or more (and stays there) that that guarantees any particular outcome in the 2004 elections, can anyone argue that it wouldn’t help President Bush? Can anyone make the argument that a falling or stagnant stock market doesn’t help the Democrats? The election will turn on multiple factors, and the economy is always one them. So, good economic news, especially good economic news that is widely disseminated and fairly easily understood, certainly helps the party in power.

The problem is that it is not clear the Dow will stay above 10,000 in the near term. The WSJ (sub. req'd) is reporting on how 10,000 has emerged as a psychological barrier:

It sounds odd to some rationalists, but the Dow Jones Industrial Average has had a problem with the number 10000 .... Whenever the Dow has reached the 10000 level, it has run out of steam, sooner or later. The blue chips first surpassed 10000 in 1999, and eventually got as high as 11722.98 before succumbing to a bear market and falling back. Since that fizzle, the Dow industrials have moved past the milestone again and again. In all, they have surged above 10000 a total of 18 times, based on the average's closing value, only to lose momentum and fall below again on a later day. It makes no rational sense that a big round number like that should be a barrier, and yet...

As a quasi-rationalist, how can I square this evidence with my general belief in the efficient capital markets hypothesis (ECMH)? Easy.

ECMH's fundamental thesis is that, in an efficient market, current prices always and fully reflect all relevant information about the commodities being traded. In other words, in an efficient market, commodities are never over- or under-priced. The current price is an accurate reflection of the market's consensus as to the commodity's value. A hard rationalist version of the ECMH would claim that investor psychology is irrelevant. The hard rationalist version, however, is almost certainly wrong. Research in cognitive psychology suggests that investor idiosyncrasies do not always cancel one another out. Instead, investors sometimes act like a herd all running in the same direction, which can produce pricing errors. Large speculative bubbles that appear out of nowhere and crash without apparent reason are the most visible form of this phenomenon.

There is considerable evidence that markets adapt to investor irrationality over time, however. If investor irrationality produces pricing errors, it becomes possible to profit by taking advantage of them. At one time, for example, the capital markets showed a systematic bias against small cap firms. As a result, it was possible to earn abnormal returns by investing in a portfolio weighted towards small caps. Over time, many investors did so, including a substantial number of mutual funds that specialized in small cap investing. As a result, the small cap anomaly gradually faded to the point at which it was no longer possible to systematically beat the market by investing in them. Interestingly, however, the Dow 10,000 barrier has elicited a market adaptation that -- at least in the short run -- is likely to reinforce investor irrationality:

In practical terms, short-term investors have learned to make money by speculating that the market will gyrate when it hits key psychological points. ... People use index futures and other devices to bet that stocks will sag as they hit a symbolic barrier.

These bets create downward pressure that reinforces investor skepticism. Fortunately, there is evidence that experienced traders can learn their way out of the irrational behavior patterns that lie at the bottom of so many market anomalies. Herd behavior, moreover, is a fairly fragile thing. Introduction of credible new information can have a cascade effect, in which market opinion changes almost instantaneously. Enough good economic news therefore should eventually overcome the psychological barrier and let the Dow get back above 10,000, just as the Dow eventually managed to stay above 1,000.

Comments on Bebchuk and Cohen Firms’ Decisions Where to Incorporate

A perennial topic in academic corporate law is whether the evolution of state corporate law is better described as a race to the top or a race to the bottom. According to the "race to the bottom" hypothesis, states compete in granting corporate charters. After all, the more charters (certificates of incorporation) the state grants, the more franchise and other taxes it collects. Because it is corporate managers who decide on the state of incorporation, states compete by adopting statutes allowing corporate managers to exploit shareholders.

Many legal scholars reject the race to the bottom hypothesis. According to a standard 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 adopting excessively pro management statutes. The bulk of the empirical research appears to bear out this view of state competition, suggesting that efficient solutions to corporate law problems win out over time.

Lucian Bebchuk and Alma Cohen have made an important recent contribution to the debate in an empirical paper entitled Firms’ Decisions Where to Incorporate. Bebchuk and Cohen claim two key empirical findings:

[First, their] study has … produced findings that cast substantial doubt on the proposition that there is a vigorous competition among states over corporate charters. ... The overwhelming majority of non-Delaware companies are simply incorporated in the states where their headquarters are based.

[Second, their] findings indicate that the incorporation market rewards states that amass antitakeover statutes. ... At one end of the spectrum, states with no antitakeover statutes, such as California, do poorly and retain a relatively small fraction of the companies located in them. At the other end of the spectrum, states that amass most or all standard antitakeover statutes are the ones most successful both in retaining in-state companies and in attracting out-of-state companies.

In other words, the market for state competition in corporate charters is not perfect, and (2) agency costs affect management decisionmaking. Neither result will surprise any informed observer of the corporation law scene. The question is what, if anything, does confirming those points prove? Bebchuk clearly intends it to be one more nail in Delaware’s coffin. Does it succeed in slaying the race to the top beast?

Bebchuk and Cohen construct the following version of the race to the top hypothesis as a foil against which to argue:

[The] conventional view regards incorporation choices as a “pure” choice of a legal regime, based only on a comparison of states’ corporate law systems and a judgment on which of those systems would be best for the firm. … On this view, all states are viewed as “selling” their corporate law system to all publicly traded firms, and not especially to the firms located in them.

They then assert that their data disproves that conventional view.

Their chosen foil, however, is a caricature of the race to the top hypothesis. Did Ralph Winter or Roberta Romano, for example, ever claim that a Los Angeles-based lawyer sits down and thumbs through all 50 state statutes before deciding where to incorporate a client? If so, I missed it. Tellingly, there is no citation of any source setting out the purported “conventional view.” In my view, a fairer picture of the conventional view is that each state views itself as competing with Delaware, not with the other 48.

Why isn’t there greater state-to-state competition in the market for corporate charters? We all know that lawyers play a big role in the decision of where to incorporate. Lawyers are subject to the same bounded rationality constraints everybody else is, as well as the familiar incentives of agency cost economics. Under such conditions, lawyers naturally will adopt a heuristic; and, home state versus Delaware is far and away the most sensible heuristic.¹ Bebchuk and Cohen’s data are consistent with this hypothesis, but I doubt either the hypothesis or the data comes as a surprise to even the most ardent race to the top theorist. In other words, their data only helps disprove the race to the top hypothesis if we accept Bebchuk and Cohen’s characterization of that hypothesis, which I am not prepared to do.

Let us turn then to their second major finding, which you will recall is that the incorporation market rewards states that amass antitakeover statutes. Again, the result is not particularly surprising, although it is very helpful to have data showing the magnitude of the trend.

The causal relationship, however, is a bit harder to sort out. I said a moment ago that each state views itself as competing with Delaware, not with the other 48. One contribution of the Bebchuk and Cohen paper is to confirm that content matters, at least on the margins, in incorporation decisions. Curiously, however, their paper also provides further inferential support for the proposition that not all states are running in the race – i.e., not all states are trying to maximize the number of incorporations. Again, however, this is not a particularly surprising result. I suspect that the California legislature is annoyed that so many California-based firms incorporate in Delaware, but I don’t see any evidence that California wants to race Delaware for those incorporations. Why doesn’t California compete? California gets a very small share of state revenues from incorporation-related taxes. A key tenet of the race to the top hypothesis is that states compete to attract incorporations so as to collect the franchise taxes firms pay for the privilege of incorporating within that state. Delaware profits hugely from this competition, as Bebchuk and Cohen elsewhere observe: "Delaware's annual revenues from franchise taxes are on the order of $3,000 for each household of four in the state, and they constitute about 30% of the state's budget." This gives Delaware a strong incentive to offer corporation laws that attract entrepreneurs looking for a place to incorporate their business. In contrast, California generates such a small percentage of its revenues from incorporation-related fees, that California has very little incentive to draft corporation laws attractive to entrepreneurs and managers. Instead, California can indulge the luxury of allowing its corporation laws to reflect the overall anti-business/anti-capitalist leanings of the state's dominant left-liberal political elites. This is significant because it relates to Bebchuk and Cohen’s second finding. They view a particular type of content – antitakeover – statutes as being a driving engine of the incorporation decision. Arguably, however, causation runs in the other direction. In other words, California doesn't retain so few incorporations because it has no antitakeover statute; California has no antitakeover statute because it retains so few incorporations ... and doesn't care.²

A second reason to doubt the causal inferences drawn in the paper is suggested by their finding that large firms based in small states tend to incorporate in their home state. Bebchuk and Cohen posit, correctly I think, that this result reflects the ability of such firms to exercise clout through local favoritism. Many – probably most – state antitakeover laws are adopted at the behest of a large firm that is currently the subject of a takeover bid. At least two of the extreme statutes they discuss, Massachusetts and Pennsylvania, fall into that category. (The takeover of Armstrong World occasioned Pennsylvania’s disgorgement statute, while the bid for Norton was the motivation behind the Massachusetts classified board statute.) Hence, antitakeover statutes may be a symptom of local clout rather than an engine of incorporation decisions. The fact that the extreme statutes have not helped Pennsylvania or Massachusetts in attracting incorporations tends to confirm that interpretation.³

Granted, some large states have antitakeover statutes. All I am trying to suggest is that the causation analysis may be more complex than Bebchuk and Cohen acknowledge.

Having said that, I am persuaded by their finding to the extent it demonstrates that the content of state law matters, at least at the margins. Amassing state takeover laws really does seem to help states attract and retain incorporations. Does that disprove the race to the top hypothesis? As I read the pro-race to the top literature, proponents of the race to the top hypothesis concede that state regulation of corporate takeovers is an exception to the rule that efficient solutions tend to win out when states compete. And a very important exception, at that.

Bebchuk and Cohen therefore again construct a foil against which to argue:

The proliferation of antitakeover statutes is consistent with the view that state competition provides adverse incentives with respect to issues, such as the level of antitakeover protections, that have a substantial effect on the private benefits of managers. … However, the proliferation of state antitakeover statutes might present a problem for those holding the dominant view that state competition is generally beneficial. Supporters of this view have sought to reconcile it with their belief that state antitakeover statutes do not serve shareholders by arguing that state competition does not encourage, and is thus not responsible for, the adoption of antitakeover statutes.

Granted, there are passages in the pro-race to the top literature than can be read as making the point Bebchuk and Cohen claim for it. Yet, I do not think it is the only arrow in the race to the top quiver – or even the most significant one. As I read Roberta Romano’s The Genius of American Corporate Law, for example, her principal explanations for Delaware’s failure to adopt a strong antitakeover statute are three-fold: ⁴ (1) Delaware’s diverse corporate constituency, which includes both potential targets and potential bidders. (2) The lack of dominance by any one firm, which makes it easier for pro-takeover forces to have an influential lobby. (3) The importance of the Delaware bar, which benefits from takeover activity. (Pp. 59-60) This last point is confirmed by Larry Ribstein’s recent paper, Lawyers as Lawmakers paper, which argues that states where transactional lawyers are powerful (e.g., Delaware) are likely to have efficient laws in areas where ex ante choice of law is viable, as with corporate governance. So the problem in California, for example, is that the trial lawyers are more powerful than the transactional lawyers.

Hence, contrary what the paper argues, it is possible to simultaneously believe that antitakeover laws are bad public policy and that state competition is a race to the top. Markets are not perfect. Efficient solutions usually win out, but not always, and antitakeover statutes are a readily explicable exception to the general rule.

So what are we to conclude about this second finding? There is an agency cost problem in the decision of where to incorporate, with some managers opting for the protections provided by state anti-takeover laws. Coupled with the home state versus Delaware heuristic I posted earlier, this explains Bebchuk and Cohen’s result that adoption of antitakeover statutes helps a state retain or even attract incorporations. Again, however, I think is neither surprising nor fatal for the race to the top project.

Let us assume, however, that I am wrong about that – i.e., assume Bebchuk and Cohen have finally slain the race to the top. Does that validate their normative agenda? As they explained in a recent Daily Deal article, their normative agenda has two pieces:

First, to invigorate competition a federal incorporation option should be provided. Such an option has been offered in Canada with considerable success.

Second, it would be desirable for the federal government to provide a mandatory switching rule under which shareholders would be able to initiate and approve, even over the objection of management, a reincorporation to another jurisdiction. Such a measure would tie success in the incorporation market more closely to the provision of rules that serve shareholders.

I have little sympathy for either goal.

Lucian would have made my life easier, of course, if he proposed mandatory federal incorporation. Instead, he proposes only an option. As a good contractarian, how can I argue against giving people more choices? Suffice it to say that Bebchuk and Cohen’s paper does demonstrate that the content of corporate matters, at least at the margins.⁵ If so, I doubt whether a federal incorporation option would keep Delaware up nights. Anybody who watched Congress make a hash out of Sarbanes-Oxley or the SEC muck up shareholder access and still thinks the federal government can do a better job than Delaware is beyond my powers to help.

Turning to Bebchuk and Cohen’s second idea – a shareholder power to initiate reincorporation – why is it necessary? When a corporation goes public, shareholders in a sense approve the choice of state of incorporation by buying shares. Shareholders who don’t like Pennsylvania’s antitakeover laws can decline to buy those shares unless the startup entrepreneurs opt-out of the statute. (Granted, there are imperfections in the IPO market, as result of which the impact of the incorporation choice may not be fully priced, but are we to think there is no effect?) When a public corporation changes its state of incorporation, it does so through a merger that typically requires shareholder approval. When Adolph Coors recently asked shareholders to approve a merger to change its corporate domicile to Delaware, by the way, 80% of the shareholders approved. Given that shareholders already have a voice in selecting the state of incorporation, I don’t see what this proposal adds. On top of which, as those of you who have been following my work on director primacy know, I am no fan of proposals that shift power from boards to shareholders. But that is a topic for another day.

Notes

¹In California we also think about Nevada, which is consistent with their finding that Nevada is coming in (a very distant) second in the race.

²The preceding paragraph will be familiar to regular readers. I extracted it from an earlier post. It’s encouraging that blogging and scholarship are proving to have at least some synergies.

³Bebchuk and Cohen conclude, by the way, that Pennsylvania’s statute has not hurt that state in the incorporation market. Why should it? It is very easy to opt out of the statute and the vast majority of firms have in fact opted out. Given an easy opt-out, why should the statute discourage Pennsylvania incorporations. The much more significant finding is that the statute has not helped Pennsylvania attract incorporations.

⁴A word perhaps should be said at this point about Bebchuk and Cohen’s critique of the standard argument that Delaware has weak anti-takeover protections. They acknowledge, as they must, that Delaware has no antitakeover statute. Instead, they argue that Delaware has a “large body” of case law validating the just say no defense. As our exchange in the Stanford colloquium last year illustrated, Lucian and I read the Delaware cases quite differently. As I read the Delaware cases, especially recent decisions like Omnicare and Quickturn, I come away doubting that “just say no” is good law in Delaware today, if it ever was.

⁵Content isn’t the only thing that matters, of course. Delaware’s other advantages include having a separate court, the Court of Chancery, devoted largely to corporate law cases. The Chancellors have great expertise in corporate law matters, making their court a highly sophisticated forum for resolving disputes. They also tend to render decisions quite quickly, facilitating transactions that are often time sensitive.

Gordon Smith on "The Attraction of Delaware"

At his new Venturpreneur site, Gordon Smith chimes in on the Delaware v. California discussion Mike O'Sullivan of Corp Law Blog and I have been having. (HERE for Smith; Here for O'Sullivan; Here for me):

Steve Bainbridge offers another content-driven explanation for Delaware. His purpose is not so much to explain Delaware as to explain why not California (as if the recent recall election isn't reason enough!), but his argument rests on assumptions about the importance of content. He writes provacatively: "California can indulge the luxury of allowing its corporation laws to reflect the overall anti-business/anti-capitalist leanings of the state's dominant left-liberal political elites. In other words, California doesn't retain so few incorporations because it has no antitakeover statute; California has no antitakeover statute because it retains so few incorporations ... and doesn't care." One problem with this argument is that takeover laws do not seem to be an important determinant in the incorporation decision. (See Rob Daines' recent work on this.) Another, more serious, problem is that it does not explain the relative lack of success of all 48 other states in the hunt for corporate charters. Most of those states have anti-takeover statutes -- indeed, most have statutes much more protective of managers than Delaware's -- and still they fail to attract firms from outside their state.

I don't agree with Gordon's assessment of the empirical evidence. The most recent empirical study is Bebchuk and Cohen's paper Firms' Decisions Where to Incorporate. Bebchuk and Cohen find that "the fraction of local firms that each state retains is correlated with the number of antitakeover statutes that the state has." (21). A finding even more pertinent to Smith's argument is Bebchuk and Cohen's result "that offering a stronger antitakeover protection is also helpful in attracting out-of-state incorporations." States that do so do not do as well as Delaware, but they do better at attracting out-of-state firms than states with no antitakeover law. I will have some critical things to say about Bebchuk and Cohen's paper when I post my comments from the Vanderbilt conference (probably on Saturday), but these findings strike me as persuasive evidence that content matters a lot. Content is not all that matters -- other factors were suggested by the Coors reincorporation proxy blawgged a while back and there is a trumping factor I'll identify in my post this weekend -- but it does matter.