ProfessorBainbridge.com

Pasta con Filetto alla Crema e Funghi

Ingredients:

• 1/2 pound whole wheat spaghetti
• 2 tablespoons olive oil
• 1 shallot, diced fine
• 6 oz. Crimini mushrooms sliced thinly
• 1 teaspoon dried Italian herbs
• 2 garlic cloves, crushed
• 1 oz. dried porcini mushrooms, reconstituted and diced
• 1 cup heavy cream
• 1 teaspoon truffle paste
• Salt and pepper
• 4 4-oz. filet mignon steaks
• Parmesan cheese, flaked

Cook spaghetti according to package directions.

In a grill pan over high heat, cook the filets 4 minutes per side. Set aside and tent with foil.

In a large skillet, heat the olive oil, and add the shallots. Sweat for a couple of minutes until softened. Add the Crimini mushrooms, the herbs, salt, and pepper, and cook for approximately 5 minutes, or until tender. Add the porcini mushrooms and saute briefly. Add the garlic and saute briefly. Add the truffle paste, stir thoroughly, and add the cream. Simmer until slightly thickened. Taste and adjust seasoning as necessary. Add the filets and any collected juices to the skillet.

To serve, plate the pasta, top with sauce and steaks, and sprinkle with Parmesan flakes.

Geithner's Regulatory Ambition

AP reports:

Treasury Secretary Timothy Geithner asked Congress on Tuesday for broad new powers to regulate nonbank financial companies like troubled insurer American International Group whose collapse could jeopardize the economy.

"AIG highlights broad failures of our financial system," Geithner told the House Financial Services Committee. "We must ensure that our country never faces this situation again."...

Geithner joined Bernanke in calling for greater governmental authority over complicated and troubled financial companies — power they likened to the authority wielded over banks by the Federal Deposit Insurance Corporation. That includes the power to seize control of institutions, take over their bad loans and other illiquid assets and sell good ones to competitors.

This proposal would effect an astonishing expansion of the federal role in regulation on non-depository financial sector firms. It raises any number of serious questions:

 

First, why should we expect government officials to be better at regulating systemic risk than private sector actors? Or that government officials will have the right incentives, even if they have other comparative advantages relative to the private sector? Basic interest group theories of regulation tell us that expecting government regulation to be optimal is a fool's game.

 

Second, because systemic and firm-specific risks tend to blur into one another, a federal systemic risk regulator inevitably will tend to dampen risk taking across the board by regulated firms. Because risk and return are positively correlated, regulated firms inevitably will have lower returns than unregulated firms. This will cause a brain drain to the latter, as the latter will have higher profits to share with managers. It will also skew capital flows to the latter, because investors will be able to obtain higher returns. Regulated firms thus will be at a systematic disadvantage relative to unregulated firms.

 

Third, the link between systemic risk and the financial crisis remains uncertain. As a result, Peter Wallison has argued that:

The fact that the current financial crisis is caused by doubts about the solvency of almost all of the world's major financial institutions sets it apart from any other financial crisis in history. It also casts doubt on the notion that the crisis is the result of systemic risk. There is no evidence of the contagion that is the hallmark of a systemic risk event. Instead, the world's financial institutions got into trouble the old-fashioned way: by taking unnecessary risks when acquiring assets--in this case MBS and CDOs backed in whole or in part by subprime and Alt-A loans--and not through a cascade of losses transmitted from one failing firm to another.

This suggests that to the extent that greater regulation is in prospect, it should focus on limiting the risk-taking of regulated institutions such as insured commercial banks and savings and loan associations. The failure of a large number of insured depository institutions shows that better regulation and better regulatory tools are warranted. The failure of at least two investment banks raises the question of whether investment banks should be regulated. The answer to this question would be yes, if there is evidence that the failure of a large investment bank such as Lehman caused others to fail or even to become substantially weaker. If so, that could--if large enough in effect--be an example of systemic risk. Thus far, however, there is no evidence that Lehman's failure has had any substantial adverse effect--there has been no contagion--even though a market panic resulted. If there had not been widespread concern about the financial stability of most of the world's major financial institutions, it seems highly likely that the panic itself could easily have been addressed by the Fed's action in making large amounts of liquidity available--as it has done in similar circumstances in the past--on a temporary basis.

Thus, unless there is compelling evidence of contagion, the current financial crisis does not furnish any support for regulating institutions such as investment banks, securities firms, hedge funds, private equity firms, finance companies, leasing companies, retailers, or the myriad other financial players that currently grant credit or otherwise participate in the financial markets in one way or another. Nothing that has happened thus far in the financial crisis suggests that the failure of these organizations has had or would have any significant effect on the financial institutions--primarily insured depository institutions--for which the federal government is responsible and whose failure could result in costs for the taxpayers.

In sum, the case for moving forward with a federal systemic risk regulator simply hasn't been made.

Ryan v Lyondell Roundup

Ashby Jones:

According to Pace University Law Professor Andrew Lund, the decision was notable for a couple of reasons. First, the court held that the duties put forth in the famed 1986 Revlon decision, did not apply to the Lyondell board during the two month period of relative inactivity. “The problem with the trial court’s analysis,” reads the opinion, “is that Revlon duties do not arise simply when a company is ‘in play.’ The duty to seek the best available price applies only when a company embarks on a transaction . . . that will result in a change of control.” In other words, Revlon kicks in when a board starts a negotiation to sell the company.

Okay, so what about the week-long period after hearing about the offer? Did the directors fail in their duty of good faith to the shareholders? Lund points to a pivotal section late in the opinion in which the court explains: “Only if [the directors] knowingly and completely failed to undertake their responsibilities would they breach their duty of loyalty. The trial court approached the record from the wrong perspective. Instead of questioning whether disinterested, independent directors did everything that they (arguably) should have done to obtain the best sale price, the inquiry should have been whether those directors utterly failed to attempt to obtain the best sale price.”

Lund explains that given this language, it’s going to be hard for shareholders going forward to make “good faith” claims against corporate boards in such circumstances. “It all but eviscerates the ability to bring such a claim.”

Lund also says that the court didn’t need to go this far; it could have just made its Revlon ruling as it pertained to the two month period, and sent the case back to the Chancery court to apply the Revlon analysis to the one-week period. “But the court swung for the fences,” says Lund, by articulating this new “good faith” standard, particularly the “completely” and “utterly” adverbs. “It’s not going to make the plaintiffs’ bar very happy.”

Gordon Smith:

Importantly, this [case] depends on a strikingly narrow understanding of "bad faith" in Delaware fiduciary law. In my first post on this case last August, I observed, "Disney and Stone now have defined 'bad faith' in a manner that does not require illegality or fraud (the traditional meanings of 'bad faith'), or disloyalty -- at least in the traditional sense of self-dealing. 'Bad faith' now has a more expansive meaning, that might include actions by directors who are admittedly independent and disinterested." While all of this remains true, it appears that the Delaware courts still have an extremely narrow view of bad faith.

Gordon goes on to note that plaintiffs now are going to need AIG-like facts to even get to trial on a bad faith claim.

Francis Pileggi's blog posts a through review by Kevin Brady:

The Supreme Court disagreed noting that the problem with the Court of Chancery’s analysis was that Revlon duties arise not because a company is “in play” (such as in this case where there was a Schedule 13D filing) but rather when the company “embarks on a transaction – on its own initiative or in response to an unsolicited offer – that will result in a change of control.” In this case, that was when the Lyondell directors began negotiating the sale of Lyondell. The Supreme Court further noted that “there is no legally prescribed steps that directors must follow to satisfy their Revlon duties” and that the Lyondell directors failure to take any specific steps during the sale process could not have demonstrated a “conscious disregard of their duties.”

The Supreme Court concluded that the Court of Chancery “approached the record from the wrong perspective. Instead of questioning whether disinterested, independent directors did everything that they (arguably) should have done to obtain the best sale price, the inquiry should have been whether those directors utterly failed to attempt to obtain the best sale price.” Finding that the record clearly established that the Lyondell directors did not breach their duty of loyalty by failing to act in good faith, the Supreme Court reversed the decision of the Court of Chancery and remanded the matter for entry of judgment in favor of the Lyondell directors.

Ryan v Lyondell: Del Sup Ct Speaks

The Delaware Supreme Court's eagerly awaited decision in Ryan v Lyondell has just been released. Download it here.

 

In Ryan, the board of directors of Lyondell Chemical Co. was approached in April 2006 by Basell AF, which expressed an interest in acquiring Lyondell. The board thought the offered price was inadequate and said it wasn't interested in selling.

 

In May 2007, Access Industries, Basell's parent corporation, filed a Schedule 13D announcing that it had the right to acquire an 8.3% stake in Lyondell.

 

Lyondell's board recognized that the Schedule 13D put it into play, but decided to take a wait and see approach.

 

On July 9, 2007, Access owner Leonard Blavatnik met with Lyondell CEO Dan Smith to propose a $40 per share acquisition of Lyondell. Smith rejected that offer as too low and Blavatnik countered with an offer of $44-45. Smith agreed to take that offer to the board, but said he suspected the board would reject it as too low. Later that day, Blavatnik raised his offer to $48 per share, conditioned on a demand for a $400 million break up fee and a merger agreement to be signed not later than July 16th.

 

A one hour special meeting of the Lyondell board took place on July 10th. They authorized Smith to continue negotiations.

 

There was a certain amount of time pressure from Balavatnik's perspective. At the same time he was negotiating with Lyondell, he was also negotiating with an alternative target (Huntsman). Blavatnik had a deadline of July 11 to raise his offer for Huntsman if he wanted to go forward with that acquisition, so he asked Smith for Lyondell to provide a firm indication of interest by the end of the day on the 11th. Lyondell's board decided to provide the requested indication. Blavatnik announced he would not be raising his offer for Huntsman and Huntsman terminated its negotiations with Blavatnik.

 

Lyondell tried to get better terms from Blavatnik, who rejected most of the requests because he had already made his best offer.

 

On July 16th, following a presentation by Lyondell's financial advisors that indicated $48 was a home run price, and thast nobody else was likely to pay more, Lyondell's board approved the deal.

 

Despite the seemingly outstanding deal, a plaintiff filed suit. (There's an important article in the WSJ today explaining how plaintiff's lawyers are the real parties in interest in this sort of litigation. It's a scandal, but that's a subject for another post.)

 

More surpisingly, the Delaware Chancery Court declined to throw the case out on its ear. Instead, Vice Chancellor Noble that directors who conciously disregard their "Revlon duties" are potentially liable for breach of the duty of good faith (see Francis Pileggi's very helpful analysis).

 

In earlier, blog posts I raised a number of concerns about the Chancery Court opinion. I'm pleased to report that the Delaware Supreme Court has gone a long way towards answering those concerns.

 

For example, I suggested that Ryan renewed the old argument that there unique Revlon "duties" separate and distinct from those imposed by Unocal. The Delaware Supreme Court opinion makes clear that "Revlon did not create any new fiduciary duties." (9) The Court also rejected the notion that the enhanced scrutiny standad of the Unocal/Revlon line of cases can come into play even before the board has decided to sell the company. (12) Finally, the Court made clear that Revlon does not impose a roadmap directors must slavishly follow when selling the company. The Court reaffirmed its holding in Barkan v. Amsted Industries that "there is no single blueprint that a board must follow" when selling the company.

 

I also expressed concern that the Chancery Court opinion in Ryan suggested that Revlon applied to all sales of a company.

In my opinion, however, if Noble means to say that every sale of a corporation triggers "Revlon duties" in the sense that enhanced scrutiny applies to the board's conduct of every sale, I believe he is wrong both as a matter of policy and doctrine. I discussed the policy reasons why I think that's an error in the earlier post, The Borders of Revlon-land, so here let me focus on doctrine.
In 2003, the Delaware supreme court stated that: "This Court has held that a board's decision to enter into a merger transaction that does not involve a change in control is entitled to judicial deference pursuant to the procedural and substantive operation of the business judgment rule." Omnicare, Inc. v. NCS Healthcare, Inc., 818 A.2d 914, 928 (Del. 2003). Indeed!
Some 9 years earlier, the court had explained that:

 

The Court of Chancery held that Revlon was inapplicable under the facts of this case because the Merger did not involve a change in control. We agree....
The directors of a corporation "have the obligation of acting reasonably to seek the transaction offering the best value reasonably available to the stockholders," Paramount Communications, Inc. v. QVC Network, Inc., Del.Supr., 637 A.2d 34, 43 (1994), in at least ... three scenarios: (1) when a corporation initiates an active bidding process seeking to sell itself or to effect a business reorganization involving a clear break-up of the company; (2) where, in response to a bidder's offer, a target abandons its long term strategy and seeks an alternative transaction involving a break-up of the company, or (3) when approval of a transaction results in a sale or change of control.

Arnold v. Society for Sav. Bancorp, Inc., 650 A.2d 1270 (Del. 1994). I believe that, in the phrase "sale or change of control," control must be understood to modify both the words sale and change. Indeed, that conclusion would seem to follow directly from the Omnicare passage quoted above.

The Delaware Supreme Court apparently agreed, although it did not address the issue in depth. The Court held that Revlon enhanced scrutiny does not apply simply because a company's board recognizes that the company has been put in play. (14) Instead, the duty to get the best possible price applies only "when a company embarks on a transaction--on its own initiative or in response to an unsolicited offer--that will result in a change of control." (14-15) The transaction at issue did so because Basell was privately held.

Finally, I expressed concern that the Ryan Chancery Court opinion's view of the directors' good faith obligations would undermine the business judgment rule. In Turning Bad Faith into Full Employment for Lawyers, for example, I opined that: "Ryan v. Lyondell is "The Lawyer (and sometimes Investment Banker, Auditor, Compensation Consultant, Risk Management Guru, or Whatever Other Expert is Relevant) Full Employment Act of 2008." If this holds up, Ryan will continue the legacy of Smith v Van Gorkom as a source of excess investment in process."

In Good Faith and Risk Taking, I noted that:

Let's ... assume that a board conscious decided to make a decision even though the directors knew that there were factors as to which they were uninformed, and which might make the decision look bad in hindsight, but the opportunities available justified taking that risk and going forward on the basis of incomplete information. Under Stone v. Ritter--and, especially, Ryan v. Lyondell--this scenario raises a new and even more troubling question.

In Stone, the Delaware Supreme Court held that: "In Disney, we identified the following examples of conduct that would establish a failure to act in good faith: ... where the fiduciary intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties." Would directors who conscious decided to take action even though they knew there were facts they didn't know therefore have acted in bad faith? It would seem as though they consciously failed to act in the face of their duty to gather all material information reasonably available to them.

One would hope that the doctrine of good faith will not deter risk taking. After all, a key rationale of the business judgment rule is to encourage risk taking. Good faith shouldn't be allowed to gut that key function.

Finally, I worried in the Borders of Revlon-land that:

One of my key concerns about these cases, especially Lyondell, thus is that the emerging post-Stone v. Ritter jurisprudence on questions of good versus bad faith tend to undermine the barrier to judicial review created by the business judgment rule. This post is already too long to address the question of whether VC Noble's latest opinion in Lyondell, which denied certification of the case for interlocutory appeal, is correct in suggesting that his good faith analysis does not gut the business judgment rule. Suffice it say that I believe there is a very serious risk that the post-Stone good faith jurisprudence does in fact pose that very risk. The business judgment rule is designed to prevent courts from asking "did the directors act with reasonable care?" But good faith allows courts to ask "did the directors conciously disregard their duty to act with rasonable care." There is a difference between the two inquiries, to be sure, but we're starting to have to slice the baloney pretty thinly. It would have better if the Delaware supreme court had just drawn discreet veil around the whole question of good faith so that people could go on ignoring it, as they had done for decades. Pernicious may be too strong a word for Stone and its progeny, but I still think that the Delaware courts are going to have do to do some serious repair work to ensure that the business judgment rule remains intact. See generally my article The Convergence of Good Faith and Oversight, 55 UCLA Law Review 559 (2008).

The Delaware Supreme Court's decision in Ryan does a long way towards assuaging those concerns. The Court views the case as really raising only issues of care. (18) It emphasized that an "extreme set of facts" is required to sustain a bad faith claim. (18) "Only if [the directors] knowingly and completely failed to undertake their responsibilities would they brach their duty of loyalty" by acting in bad faith. A claim would lie here only if the directors "utterly failed to attempt to get the best sale price." (19)

Coupled with Chancellor Chandler's recent Citigroup decision (about which see my article Caremark and Enterprise Risk Management), Ryan thus goes a long way towards constricting the scope of bad faith claims to egregious and highly unusual sets of facts.

Even so, I stand by my earlier recommendation that the Delaware courts "should make it clear that the conscious disregard prong of good faith relates only to duties involving self-dealing. This would clarify that good faith cannot be used to end run the prohibition on judicial review of substantive due care."

I also stand by my earlier recommendation that the time has come for the Delaware legislature to revisit the issues raised by section 102(b)(7). As I documented in that post, the statute is being steadily eroded and its purposes steadily undermined by the Delaware courts.

Update: Jeff Lipshaw posts:

Courtesy of Steve Davidoff, we've learned that the Delaware Supreme Court has just issued its opinion, reversing the Chancery Court's troubling denial of summary judgment (under §102(b)(7) of the Delaware General Corporation Law) in Ryan v. Lyondell Corporation.

I had noted some real concerns with the Chancery Court opinion; it feels good to be vindicated once in a while.  In short, while it's at least conceivable that the directors didn't exercise sufficient care, the basis for the motion for summary judgment was that they were exculpated from damages under §102(b)(7) for duty of care violations; this case could only continue against them if they exhibited a failure of good faith.  While the possibility still exists that lack of care in the extreme could invoke the duty of loyalty (i.e., were you really acting for the corporation?), this set of facts just doesn't present that concern.

As readers know, I focus on big questions of judgment, and particularly those where law intersects with business.  Many areas of legal doctrine don't really rise to the level of impacting major business decisions.  This one does. There's a fine balance between accountability and the need to act expeditiously, and something as small as a overly conservative approach to summary judgment when a board is acting on what appears to be a pre-emptive offer, really does put the directors between a rock and a hard place.

Mark Cuban Brief

The Dallas News reports:

Mark Cuban is taking the offensive against accusations that he traded on insider information four years ago, recruiting legal superstars who question the government's case against him. ...

The professors argue that the SEC's case rests on a regulation that is "an invalid exercise of the agency's rule-making authority" and exceeds the scope of case law established by the U.S. Supreme Court. ...

The law professors who signed Monday's brief are SMU's Alan Bromberg, Harvard's Allen Ferrell, Yale's Jonathan Macey, Chicago's Todd Henderson and UCLA's Stephen Bainbridge. ...

In its lawsuit last year, the SEC said Cuban sold his stake in Mamma.com in June 2004 after learning the company planned to sell additional shares through a private offering. The SEC alleges he violated an oral agreement to keep the sensitive information confidential, thereby committing insider trading.

Cuban's lawyers have not conceded that he made such an agreement.

But if he did, they argue, he isn't liable for insider trading because he had no fiduciary duty to keep the information confidential. Cuban was a large shareholder in Mamma.com but not a company executive or board member.

"In the context of a business relationship, a confidentiality agreement alone is insufficient to create a fiduciary or similar relationship of trust and confidence between the parties," the five professors wrote in their brief, echoing earlier filings by Cuban's team.

You can download the brief here.

 

The WSJ blog entry on our brief is here.

Caremark and Enterprise Risk Management Posted to SSRN

My article, Caremark and Enterprise Risk Management, has been accepted by the Journal of Corporation Law for a June publication date. A working draft has been posted to SSRN and can be downloaded here.

 

Abstract: The financial crisis of 2008 revealed serious and widespread risk management failures throughout the business community. Shareholder losses attributable to absent or poorly implemented risk management programs are enormous.

Efforts to hold corporate boards of directors accountable for these failures likely will focus on so-called Caremark claims. The Caremark decision asserted that a board of directors has a duty to ensure that appropriate "information and reporting systems" are in place to provide the board and top management with "timely and accurate information." Although post-Caremark opinions and commentary have focused on law compliance programs, risk management programs do not differ in kind from the types of conduct that traditionally have been at issue in Caremark-type litigation.

Risk management failures do differ in degree from law violations or accounting irregularities. In particular, risk taking and risk management are inextricably intertwined. Efforts to hold directors accountable for risk management failures thus threaten to morph into holding directors liable for bad business outcomes. Caremark claims premised on risk management failures thus uniquely implicate the concerns that animate the business judgment rule's prohibition of judicial review of business decisions. As Caremark is the most difficult theory of liability in corporate law, risk management is the most difficult variant of Caremark claims.

 

The article covers in depth Chancellor William Chandler's recent Citigroup decision.

Keywords: board of directors, risk management, enterprise risk management, oversight, Caremark

JEL Classifications: K22

In Defense of Chandler’s Citigroup decision

Jay Brown is displeased with Delaware Chancellor William Chandler's opinion in the Citigroup subprime mortgage mess.

Citigroup is a multinational financial services corporation. In the period prior to the financial crisis, Citigroup's Securities and Banking Unit began marketing collateralized debt obligations (CDOs). This form of derivative security consists of "repackaged pools of lower rated securities that Citigroup created by acquiring asset-backed securities, including residential mortgage backed securities ("RMBSs"), and then selling rights to the cash flows from the securities in classes, or tranches, with different levels of risk and return." In some cases, the CDO's terms included a so-called "liquidity put," which allowed the purchasers to resell the securities to Citigroup at their original cost.

Eventually Citigroup had some $55 billion in exposure to the subprime mortgage market via these CDOs and other investments. As a result, Citigroup faced all three types of enterprise risk. Market risk arose, for example, because changes in interest rates and housing prices could significantly affect the value of CDOs based on mortgage-backed securities. Credit risk arose, for example, because adverse changes in the credit quality of subprime mortgage-backed securities could lead to Citigroup's counterparties exercising their liquidity puts. Operational risk is pervasive in the context of derivative securities, potentially arising from "inadequate systems, management failure, faulty controls, fraud, and human error":

[In fact,] many of the large losses from derivative trading are the direct consequence of operational failures. Derivative trading is more prone to operational risk than cash transactions are because derivatives, by their nature, are leveraged transactions. The valuation of complex derivatives also creates considerable operational risk. Very tight controls are an absolute necessity if a firm is to avoid large losses.

When the financial crisis hit and the subprime mortgage market collapsed, Citigroup in fact suffered very serious financial losses.

The defendants were current and former directors and officers of Citigroup. Plaintiffs' claims against them included an argument "that the director defendants are personally liable under Caremark for failing to 'make a good faith attempt to follow the procedures put in place or fail[ing] to assure that adequate and proper corporate information and reporting systems existed that would enable them to be fully informed regarding Citigroup's risk to the subprime mortgage market.'"

Chandler dismissed: "While it may be tempting to say that directors have the same duties to monitor and oversee business risk, imposing Caremark-type duties on directors to monitor business risk is fundamentally different. … Oversight duties under Delaware law are not designed to subject directors … to personal liability for failure to … properly evaluate business risk."

Jay writes:

Its enough, apparently, to have [a reporting system], no matter how good or bad (the only standard is that it can't result in "a sustained or systematic failure of the board to exercise oversight." That standard is ridiculously high, effectively a waste standard for the duty to monitor. Once a company has a reporting system in place, a board can only be liable for failing to react to react to the information that it receives under the entirely inadequate reporting system. …

The Chancery Court, however, treated the case as simply sour grapes based on an after the fact dissatisfaction with the company's business decisions. "When one looks past the lofty allegations of duties of oversight and red flags used to dress up these claims, what is left appears to be plaintiff shareholders attempting to hold the director defendants personally liable for making (or allowing to be made) business decisions that, in hindsight, turned out poorly for the Company."

Even more surprisingly, the Chancery Court took the position that it would be a mistake to impose on directors the possibility of liability for failing to adequately assess risks within the company. …

In other words, the Chancery Court characterized the subprime mess and the near nationalization of Citigroup as an ordinary risk taking transaction that did not require oversight by the board of directors. When it comes to examining the standards set by the Delaware courts for directors (or lack of standards), this case typifies the wrong headed approach of the courts. Even in the middle of the worst financial crisis since the Great Depression, the Delaware courts cannot bring themselves to entertain even the possibility that the board might have had a role in supervising the excessive risk taking by Citigroup.

Perhaps not surprisingly, I come down on the same side as Chancellor Chandler. As I explain in my forthcoming article on Caremark and Enterprise Risk Management, in Caremark, Chancellor Allen opined that the oversight claims countenanced by that case would be perhaps the most difficult corporate law claim for plaintiffs to satisfy. Guttman likewise emphasized that Caremark claims are difficult to prove. Stone reiterated the same emphasis on creating a high liability bar.

Risk management does not differ in kind from the more typical law compliance and accounting control cases in which Caremark claims have been brought in the past. Because risk management does differ in degree from such claims, however, particularly because it is inextricably intertwined with risk taking, the bar needs to be set particularly high with respect to such claims. If Caremark is the most difficult theory of liability in corporate law, risk management needs to be the most difficult variant of Caremark claims.

Risk management necessarily overlaps with risk taking because the former entails making choices about how to select the optimal level of risk to maximize firm value. There are only four basic ways of managing risk: avoiding it by avoiding risky activities, transferring it through insurance or hedging, mitigating it, and accepting it as unavoidable. All of these overlap with risk taking. Operational risk management, for example, frequently entails making decisions about whether to engage in risky lines of business and, more generally, determining whether specific risks can be justified on a cost-benefit analysis basis. As a result, it is becoming increasingly "difficult to draw a line between corporate governance and risk management."

The fuzzy line between risk-taking and risk management is nicely illustrated by how corporations use derivatives. On the one hand, they can be used to hedge risk. On the other hand, they can be used as speculative investments. In many cases, they can be used as both simultaneously.

As the Chancellor Chandler correctly recognized in Citigroup, Caremark claims premised on risk management failures thus uniquely implicate the core concerns animating the business judgment rule in a way typical Caremark claims do not.

Citigroup thus presents us with an opportunity for reiterating the case for insulating director decisions from judicial review.

The business judgment rule is corporate law's central doctrine. It pervades every aspect of the state law of corporate governance; from negligence by directors, to self-dealing transactions, to termination of shareholder litigation and so on. Of particular relevance, it is the governing standard when shareholders complain that about allegedly excessive executive pay.

Corporate directors are subject to a fiduciary duty of care, which requires them to the sort of care that ordinarily careful and prudent people would use in similar circumstances. Because the corporate duty of care thus resembles the tort law concept of reasonable care, one might assume the duty of care is violated when directors act negligently. Yet, the one thing about the business judgment rule on which everyone agrees is that it insulates directors from liability for negligence.

The rule doesn't completely insulate directors from liability, of course. As the Delaware Supreme Court explained in an earlier appeal in the Disney litigation, the rule simply means that:

"...directors' decisions will be respected by courts unless the directors are interested or lack independence relative to the decision, do not act in good faith, act in a manner that cannot be attributed to a rational business purpose or reach their decision by a grossly negligent process that includes the failure to consider all material facts reasonably available.[1]

Yet, even with those qualifications, the rule provides directors with considerably greater protection from liability than most economic actors enjoy.

The business judgment rule's traditional justification is that courts are not business experts.[2] It is probably true that most judges do not have much expertise in business law matters, although that's hardly the case for Delaware's judiciary, which more-or-less specializes in corporation law. Moreover, business law is not the only context in which judges are called upon to review complex issues arising under conditions of uncertainty. Reviewing a board of directors' decision to pay Michael Ovitz $140 million for 14 months work, for example, seems no more technically demanding than reviewing medical or product design decisions. Yet, no "medical judgment" or "design judgment" rule precludes judicial review of malpractice or product liability cases.

Why then do directors of corporations get this special protection?

Justice Jackson famously observed of the U.S. Supreme Court: "We are not final because we are infallible, but we are infallible only because we are final." Neither courts nor boards of directors are infallible, but someone must be final. Otherwise we end up with a never-ending process of appellate review. The question then is a simple one: Who is better suited to be vested with the mantle of infallibility that comes by virtue of being final—directors or judges?

Judges necessarily have less information about the needs of a particular firm than do that firm's directors. A fortiori, judges will make poorer decisions than the firm's board. As one court decision put it:

"[C]ourts recognize that after-the-fact litigation is a most imperfect device to evaluate corporate business decisions. The circumstances surrounding a corporate decision are not easily reconstructed in a courtroom years later, since business imperatives often call for quick decisions, inevitably based on less than perfect information. The entrepreneur's function is to encounter risks and to confront uncertainty, and a reasoned decision at the time made may seem a wild hunch viewed years later against a background of perfect knowledge."[3]

Put another way, judges are no less subject to bounded rationality than any other decision makers. Just as the limits on cognitive competence impede the ability of market actors to write complete contracts, those same limits necessarily impede judicial review. Only with the benefit of hindsight will judges be able to make better decisions than boards, but we have already seen that hindsight review is problematic. While market forces work a sort of Darwinian selection on corporate decision makers, moreover, no such forces constrain erring judges. As such, rational shareholders will prefer the risk of managerial error to that of judicial error.

The posited preference for managerial error, however, only extends to decisions motivated by a desire to maximize shareholder wealth. Given that market forces encourage directors to make such decisions carefully, such a preference makes sense. Where the directors' decision was motivated by considerations other than shareholder wealth, as where the directors engaged in self-dealing or sought to defraud the shareholders, however, the question is no longer one of honest error but of intentional misconduct. Despite the limitations of judicial review, rational shareholders would prefer judicial intervention with respect to board decisions so tainted. As Delaware Chief Justice Veasey observes, "investors do not want self-dealing directors or those bent on entrenchment in office. ... Trust of directors is the key because of the self-governing nature of corporate law. Yet the law is strong enough to rein in directors who would flirt with an abuse of that trust."[4] The affirmative case for disregarding honest errors thus simply does not apply to intentional misconduct. To the contrary, given the heightened potential for self-dealing in an organization characterized by a separation of ownership and control, the risk of legal liability may be a necessary deterrent against such misconduct.

The function of the business judgment rule thus is to act as a filter for self-dealing and fraud. As long as the board made an informed decision untainted by conflicts of interest, the court will defer to the board's judgment. Directors are thus allowed to take business risks without fear that an error in judgment or even an act of God might result in liability being imposed on them. Conversely, however, the rule will not allow directors to cheat and self-deal.

Giving Michael Ovitz $140 million to go away after a mere 14 months on the job might not have been the smartest decision a board of directors made, but absent evidence that the board acted from conflicted interests, it is precisely the sort of decision that courts leave to the discretion of directors.

Precisely the same thing can be said of a board's decision to adopt and implement a risk management program. It is a core matter of business judgment and deserves the same respect any other business judgment would get.

 

[1] Brehm v. Eisner, 746 A.2d 244 (Del. 2000).

[2] See, e.g., Dodge v. Ford Motor Co., 170 N.W. 668, 684 (Mich. 1919).

[3] Joy v. North, 692 F.2d 880, 886 (2d Cir. 1982), cert. denied, 460 U.S. 1051 (1983).

[4] E. Norman Veasey, An Economic Rationale for Judicial Decisionmaking in Corporate Law, 53 Bus. Law. 681, 694 (1998).

An Uptick in Muddy Thinking

While keeping the Delaware Senate seat warm for Joe Biden's kid, Senator Ted Kaufman's decided to monkey about with the capital markets:

Continuing his efforts to restore confidence in America's financial markets, U.S. Senator Ted Kaufman (D-DE) introduced bipartisan legislation today that will reinstate the "uptick rule," which aided market stability for 70 years. Since the uptick rule's repeal in July 2007, the abuse of naked short-selling – selling stock that the trader does not own – has added fuel to the fire of distressed stocks and markets.

"Abusive short selling is tantamount to fraud and market manipulation and must be stopped – now," Sen. Kaufman said on the Senate floor this evening. "The uptick rule should have never been repealed. To permit people to sell shares they don't have and won't be able to deliver turns investment into pure speculation. The time has come for this practice to stop."

There's some seriously shoddy thinking in those couple of paragraphs. First, naked short selling and the uptick rule have nothing to do with one another. In traditional short selling, the seller borrows securities from a current shareholder and delivers them to a buyer. The seller, of course, eventually must return the borrowed shares to the lender. The seller anticipates that the price will fall, however, permitting him to buy shares on the market at a price lower than the price he got from the buyer. As such, short selling is a basic form of speculation, in which the short seller is gambling that the price will go down.

In naked short selling, the short seller does not borrow the shares. Instead, he simply "sells" shares to a buyer, hoping that the price will drop quickly, so that he can acquire shares at a lower price before he is obliged to deliver them to the buyer. Naked short selling is thought to be problematic in that it increases the risk of failed transactions.

The SEC has regulated naked short selling through Regulation SHO and special emergency rules adopted during the financial crisis of 2008.

The uptick rule does not address the question of whether the short seller has borrowed the shares being sold short. Instead, the uptick rule for bids selling shares short on a downtick (i.e., at a price lower than the last traded price) or a zero minus tick:

A zero minus tick transaction occurs when a listed stock trades at the exact same price as the previous price, but at a lower price than the last different price. A zero minus tick is also referred to as a zero downtick. For example, a zero minus tick occurs if a stock trades at $9.05, $9.00 and $9.00. The first $9.00 transaction is a minus tick, however, the last $9.00 transaction is a zero minus tick since it was executed at the same price as the previous trade, but at a lower price than the last different price.

Bringing back the uptick rule thus does nothing to address the purported problem of naked short selling.

Second, naked short selling is economically indistinguishable from regular short selling: "In permissible short selling, the party owed shares is the security lender (who used to own the shares before lending them for short selling), while the party owning the shares is the new buyer. In naked short selling, the party owed the shares is the new buyer, while the party owning the shares is (still) the current owner. The buyer in both cases is the same, so the price should not be different. The only difference is who acts as the effective lender of the security: in permissible short selling, the lender is the current owner; in naked short selling, the new owner acts as the effective lender. From a price perspective, it is difficult to see how that matters." In short, the hysteria over naked short selling is, well, hysterics.

Third, Even if naked short selling were a problem, it is not in any way related to the present financial crisis: "Repeat after me: The trouble is not with short-sellers. The trouble is not with short-sellers. The trouble is with an over-levered financial system built on a house of cards comprised of under-collateralized toxic paper that was applauded all the way up by "housing is the American dream" nutters who couldn't see that vast expansions in thinly-traded credit are a path to economic ruin."

Lastly, the uptick rule has always been—and remains—a bad idea. The United States and Hong Kong are the only countries to have ever adopted an uptick rule. Regulators of all of the capital markets have recognized that the uptick rule significantly impedes liquidity.

Short selling had nothing--nada, zilch--to do with the falling value of CMOs, inter-bank lending rates, or any of the other real problems exposed by the financial crisis. All short selling does is promote market liquidity and efficiency by helping prices adjust to new information faster, which is a good thing. The uptick rule simply makes that desirable process less efficient.

Academic research on the uptick rule has found that it confers no benefits and has significant costs. There is no evidence that the uptick rule prevents market manipulation, while there is plenty of evidence that it interferes with the process of orderly price discovery and market liquidity.

There simply is no sound economic reason for bringing back the uptick rule. It is pure populist posturing.

Update: Bipartisan populist posturing at that. (See Senator Johnny Isakson R-Ga.) God save us from politicians who simply refuse to learn anything about how markets work.

Making Moral Choices in the Corporate Workplace

Hilzoy recently wrote:

The Washington Post has a story about people who accidentally leave their kids in the car, where they die from the heat. I often say that things are worth reading, but this one is more than usually so: for the detail, the understanding, the neurological explanation for how this could happen even to loving and attentive parents, the stories of how, incomprehensibly, the parents who do this go on living. It's really, really good, and really, really tough to read. But it's worth it. …

Here's one detail from the article:

"For years, Fennell [head of a group called Kids and Cars -- ed.] has been lobbying for a law requiring back-seat sensors in new cars, sensors that would sound an alarm if a child's weight remained in the seat after the ignition is turned off. Last year, she almost succeeded. The 2008 Cameron Gulbransen Kids' Transportation Safety Act -- which requires safety improvements in power windows and in rear visibility, and protections against a child accidentally setting a car in motion -- originally had a rear seat-sensor requirement, too. It never made the final bill; sponsors withdrew it, fearing they couldn't get it past a powerful auto manufacturers' lobby."

Can you imagine being the lobbyist who went to work against that? Or the executive who decided to hire that lobbyist? How would you explain to yourself, let alone to others, that you have deliberately tried to block a measure that would prevent infants and toddlers from being cooked alive in cars? Unless adding a sensor would cause some truly horrific problem for the car, it's hard to see how you could look yourself in the mirror.

Hilzoy's post prompted this followup from Mark Kleiman:

Hilzoy offers a useful take on the baby-baked-in-the-back-of-the-car problem.

If, she asks, you were one of the corporate executives who told his lobbyists to fight the proposal to make it mandatory for to equip car seats with $40 devices to warn the driver if the engine is off and there's a baby in the carseat, or if you were one of the lobbyists who carried out those orders, and then you read the horrific details of what happens between fifteen and twenty-five times a year — mostly to parents not otherwise neglectful — how could you live with yourself?

Good question. It has two answers.

One is that the adversarial ethic of the courtroom is now widely accepted: just as a lawyer has an obligation to defend a murderer, a corporate executive is thought to have an obligation to defend corporate practices that horribly kill infants. Steven Bainbridge is within the mainstream of thinking among corporation-law professors in claiming that executives in such a situation have no right to let their personal moral beliefs interfere with their efforts to make as much money for their stockholders as possible. Defending the morally indefensible is part of their jobs.

The other answer is that, if you salary depends on not seeing a moral problem, you're very likely not to see it.

Mark sent me an alert on the post, which contains some additional interesting thoughts on the "fundamental attribution error," and asked what I made of the corporate governance question.

My initial reaction is that using the "baby-baked-in-the-back-of-the-car problem" to debate the role of ethics in the workplace is a bit like using the ticking nuclear bomb scenario to debate the morality of torture. Extreme cases may make a useful test suite for determining how far one is willing to push one's position, but they differ so much in degree from the ordinary run-of-the-mill case that they don't provide much guidance for day-to-day decision making.

To extend the torture example, my own view is that torture out to be illegal. If a terrorist knew the location of the proverbial ticking nuclear bomb, however, I would have no moral qualms about letting the government torture him to get the information and having the President pardon those who did so. This is so, of course, because my position on extreme cases like these tends to be pragmatic and consequentialist. YMMV.

Let's turn to a more typical case. General Motors operated two factories in the Township of Ypsilanti, Michigan, known as Hydra-Matic and Willow Run Assembly. Hydra-Matic employed about 9,000 persons. Willow Run employed approximately 4,500 persons.

In 1974, the state of Michigan passed a law authorizing municipalities to offer property tax abatements to industries as a supposed means of retaining and adding employment opportunities. Within days after the bill passed, General Motors formed a group of managers to work on getting tax abatements from Ypsilanti Township. As explained by John T. Lynch, a GM public relations manager who was involved, the group invited township officials to visit the plant for a presentation, a plant tour, and lunch. During the presentation, the GM managers emphasized the employment benefits to be had from the plant improvements that would be undertaken if the tax abatement was approved.

Ypsilanti Township agreed. The pattern set by GM's managers in this first round of negotiations was followed repeatedly between 1975 and 1990. During that period, GM's managers extracted 11 abatements from the township providing over $1.3 billion in tax relief.

In 1981, during negotiations over one of the tax abatements, a township trustee (i.e., a city councilman) named Wesley Prater, who later to become the town's Supervisor, expressed concern that GM make a commitment to retain employment at the plants. In response, G. W. Griffith, the plant manager at Hydra-Matic, sent the township a letter, which stated in part:

The purpose of this letter is to reassure you that it is not our intention to transfer production operations to other Hydra-Matic Division plant locations; the net affect of which would have a negative impact on the employment levels at our Ypsilanti location. In this case, as in the past, we are dedicated to retain and/or increase jobs at Ypsilanti and will maintain this dedication in the future. We intend to keep this facility a viable operation for the community and General Motors. If approved, the impact of this particular application will be to sustain approximately 1,500 jobs and there will be a favorable tax impact to the Township of approximately $2.0 million per year over a twelve year period without any increase in township services.

As with every other abatement application made by GM during the relevant period, Ypsilanti township thereupon approved the request.

In connection with a 1988 abatement application, General Motors Comptroller Hughes and Willow Run plant manager Williams likewise stated: "Upon completion of this project and favorable market demand, it will allow Willow Run to continue production and maintain continuous employment for our employees." They also reviewed employment figures with town leaders, emphasizing the stability of employment at Willow Run. In supporting GM's application, the township assessor stated: "Based on the past history in dealing with the people of General Motors they've always done what they said they would do and they've kept the jobs there and they've kept the plant operating as an operational facility."

Unfortunately for both GM and Ypsilati township, demand for the Caprice sedan being assembled at Willow Run declined. At that time, the Caprice was assembled at two plants: Willow Run and a second factory in Arlington, Texas. Caprice sales, which GM had projected would total 330,000 per year, in fact had been running at only about 275,000 a year and slipped below 100,000 in late 1991. Due to this declining demand, neither plant was operating at full capacity. In response, GM announced plans to consolidate assembly operations at one of the two plants.

In February 1992, General Motors Vice President Joseph Spielman decided to transfer automobile assembly operations from the Willow Run plant to the plant in Arlington. The Willow Run facility would close after production of 1993 models ended. Believing that GM had made a contract to keep the Willow Run plant open in return for the numerous tax abatements, the township sued. The trial court stated:

There would be a gross inequity and patent unfairness if General Motors, having lulled the people of the Ypsilanti area into giving up millions of tax dollars which they so desperately need to educate their children and provide basic governmental services, is allowed to simply decide it will desert 4500 workers and their families because it thinks it can make these same cars cheaper somewhere else.

Accordingly, the trial court found that GM had made a legally enforceable promise to continue production of the Caprice line in Willow Run as long as the company produced the Caprice.

On appeal, the appellate court reversed. If the township had wanted GM to contractually obligate itself to maintain a certain level of employment in Ypsilanti in return for tax abatements, the township should have made GM sign a contract expressly committing to do so. The court explained:

The fact that a manufacturer uses hyperbole and puffery in seeking an advantage or concession does not necessarily create a promise. For example, statements such as "We're partners" and "We look forward to growing together" were found not to constitute a promise to keep a collective bargaining agreement in force for the foreseeable future so as to create by promissory estoppel a continuing duty of the employer to honor an expired agreement. Nor did exhortations for union concessions in order to keep a foundry open constitute promises under promissory estoppel to prevent a foundry from closing. Similarly, exhortations to its employees to increase productivity and assurances that a plant would not be closed, as long as it was profitable, did not establish by promissory estoppel an obligation on a steel company to keep open a plant. Turning to the case at bar, almost all the statements the trial court cited as foundations for a promise were, instead, expressions of defendant's hopes or expectations of continued employment at Willow Run.

With the litigation at an end, GM closed the Willow Run plant and 4,000 workers lost their jobs.

If I had been in GM Vice President Joseph Spielman's shoes, would I have closed the plant?

The article Mark cites reflects not my thinking on the moral choice but on the legal norm to be applied by a court reviewing my decision.

As a Catholic, my thinking on the moral choice is informed by the wealth of learning from Catholic social thought. To keep the analysis at the level of Mere Christianity, however, I'll simply note that scripture makes clear our moral responsibility to those around us, especially the poor:

At the end of every seven-year period you shall have a relaxation of debts, which shall be observed as follows. Every creditor shall relax his claim on what he has loaned his neighbor; he must not press his neighbor, his kinsman, because a relaxation in honor of the LORD has been proclaimed. You may press a foreigner, but you shall relax the claim on you kinsman for what is yours. Nay, more! since the LORD, your God, will bless you abundantly in the land he will give you to occupy as your heritage, there should be no one of you in need. If you but heed the voice of the LORD, your God, and carefully observe all these commandments which I enjoin on you today, you will lend to many nations, and borrow from none; you will rule over many nations, and none will rule over you, since the LORD, your God, will bless you as he promised.

If one of your kinsmen in any community is in need in the land which the LORD, your God, is giving you, you shall not harden your heart nor close your hand to him in his need. Instead, you shall open your hand to him and freely lend him enough to meet his need. Be on your guard lest, entertaining the mean thought that the seventh year, the year of relaxation, is near, you grudge help to your needy kinsman and give him nothing; else he will cry to the LORD against you and you will be held guilty. When you give to him, give freely and not with ill will; for the LORD, your God, will bless you for this in all your works and undertakings. The needy will never be lacking in the land; that is why I command you to open your hand to your poor and needy kinsman in your country. (Deuteronomy 15:1-11.)

The Catholic Church refers to this obligation as the "preferential option for the poor." Its roots lie in the earliest Biblical commandments:

When you make a loan of any kind to your neighbor, you shall not enter his house to receive a pledge from him, but shall wait outside until the man to whom you are making the loan brings his pledge outside to you. If he is a poor man, you shall not sleep in the mantle he gives as a pledge, but shall return it to him at sunset that he himself may sleep in it. Then he will bless you, and it will be a good deed of yours before the LORD, your God.

You shall not defraud a poor and needy hired servant, whether he be one of your own countrymen or one of the aliens who live in your communities. You shall pay him each day's wages before sundown on the day itself, since he is poor and looks forward to them. Otherwise he will cry to the LORD against you, and you will be held guilty. . . .

You shall not violate the rights of the alien or of the orphan, nor take the clothing of a widow as a pledge. For, remember, you were once slaves in Egypt, and the LORD, your God, ransomed you from there; that is why I command you to observe this rule.

When you reap the harvest in your field and overlook a sheaf there, you shall not go back to get it; let it be for the alien, the orphan or the widow, that the LORD, your God, may bless you in all your undertakings. When you knock down the fruit of your olive trees, you shall not go over the branches a second time; let what remains be for the alien, the orphan and the widow. When you pick your grapes, you shall not go over the vineyard a second time; let what remains be for the alien, the orphan, and the widow. For remember that you were once slaves in Egypt; that is why I command you to observe this rule. (Deuteronomy 24:10-22.)

In sum, Israel was commanded to be protect those members of the community who were vulnerable to oppression or poverty: widows, orphans, debtors, strangers, and slaves. Christ commanded that we love our neighbors as ourselves. At the heart of a Christian's moral duties thus is the obligation to treat each member of the community fairly and to respect each member's human dignity.

I think it would be perfectly appropriate for a Catholic business person to take those values into the workplace and to allow them to inform his/her thinking. Our working life is the principal arena in which we work out our calling from God. Leaving our faith at home in the morning is not an option.

When applied to the hypothetical at hand, however, it's not at all clear to me what course of conduct is the correct moral choice. As Michael Novak, probably the leading modern Christian thinker on the economy, has written: "Like all other fields, business is fraught with patches of moral ambiguity, and clear lines between good and evil are difficult to draw."

Spielman, who was charged with making the plant closing decision, faced a set of tragic choices. GM could not continue losing billions of dollars a year and remain a viable business. If GM had not staunched the losses, the ripple effects on all of its stakeholders—not just shareholders—would have been enormous. Suppose GM had gone bankrupt. Think about the countless thousands of additional GM employees who would have lost their jobs, the suppliers and creditors who would have suffered, the communities that would have lost tax revenues, and so on. In that light, did Spielman really have any other choice? (Consider here the lessons of the Parable of the Talents. While Christ used this parable to make a theological point, its religious significance depended upon the illustration's secular validity. Here, the parable was effective because its hearers understood that the servants were fiduciaries of the master and that the departed master retained his ownership rights even though the stewards had been entrusted with control over the property.)

Yet while I think closing the plant can be squared with morality, I think the tragic choice here calls out for mitigation. I think it would have been perfectly appropriateand probably even morally necessaryfor GM to ameliorate the lot of those workers who would lose their jobs. Just as the ancient Israelites were to care for the needy, GM could—and should—care for those affected by its decision. If I was in Spielman's shoes, it would be wholly appropriate for me to argue to my bosses that GM should invest resources in helping workers find new jobs or relocate to Arlington. Just as the Israelite farmer was to leave some sheaves in the corner of the field, GM could – and should – have softened the blow on its workers.

Turning to the analysis in the article Mark cited, it raises the question of whether moral choices should be free from legal consequences. The article argues that the shareholder wealth maximization norm is the optimal decision-making principle by which to measure the performance of corporate directors and officers. At the same time, however, the article recognizes that departures from that norm normally will have no legal consequence. This is so, because the business judgment rule insulates most director and officer decisions from judicial review.

There is, however, a class of cases not protected by the business judgment rule; namely, cases involving managerial conflicts of interest. Suppose GM had decided not to close the Ypsilanti plant. One year later, GM is subject to a hostile takeover bid. The bidder's Schedule 14D-1 discloses an intent to close obsolete GM plants and shift production overseas. Suppose GM's board rejected the bid, citing the potential impact on workers and places like Ypsilanti.

While an honest concern for the threatened workers may have motivated the directors' decision, so too might a concern for their own positions and perquisites. Indeed, corporate managers are much more likely to suffer losses as a result of takeovers than are other nonshareholder constituencies. Accordingly, it is not at all difficult to imagine a target board using nonshareholder interests as nothing more than a negotiating device to extract side payments from the bidder. Under current law, the business judgment rule would not protect the directors' decision unless they could show that it also benefited the shareholders. The directors will be held to a standard of shareholder wealth maximization. I favor this. A rule allowing directors to take into account the interests of other stakeholders in this context is too risky. It would permit managers to play one constituency off against another, with the result that the accountability provided by current law would be lost. Hence, such a rule is less likely to transfer wealth from shareholders to nonshareholder constituencies than it is to transfer wealth from both shareholders and nonshareholders to managers.

Agency Costs

U.S. public corporations are characterized by a separation of ownership and control: the firm's nominal owners, the shareholders, exercise virtually no control over either day to day operations or long-term policy. Instead, control is vested in the hands of professional managers, who typically own only a small portion of the firm's shares. As Professors Berle and Means observed, the separation of ownership and control characteristic of U.S. corporations has costs: "The separation of ownership from control produces a condition where the interests of owner and of ultimate manager may, and often do, diverge . . . ." Modern scholars refer to the consequences of these divergences as agency costs, following Jensen and Meckling, which are conventionally defined as the sum of the monitoring and bonding costs, plus any residual loss, incurred to prevent shirking by agents. In turn, shirking is conventionally defined to include as any action by a member of a production team that diverges from the interests of the team as a whole. As such, shirking includes not only culpable cheating, but also negligence, oversight, incapacity, and even honest mistakes. In other words, shirking is simply the inevitable consequence of bounded rationality and opportunism within agency relationships.

Although agency cost theory undeniably is critical to understanding the modern corporate form, too many agency cost theorists have narrowly focused on agency costs to the exclusion of other institutional considerations, which easily can distort one's understanding. Corporate managers operate within a pervasive web of accountability mechanisms that substitute for monitoring by residual claimants. Important constraints are provided by a variety of market forces. The capital and product markets, the internal and external employment markets, and the market for corporate control all constrain shirking by firm agents. In addition, the legal system evolved various adaptive responses to the ineffectiveness of shareholder monitoring, establishing alternative accountability structures to punish and deter wrongdoing by firm agents, such as the board of directors. An even more important consideration, however, is that agency costs are the inevitable consequence of vesting discretion in someone other than the residual claimant. We could substantially reduce, if not eliminate, agency costs by eliminating discretion; that we do not do so suggests that discretion has substantial virtues. A complete theory of the firm thus requires one to balance the virtues of discretion against the need to require that discretion be used responsibly. Neither discretion nor accountability can be ignored, because both promote values essential to the survival of business organizations. Unfortunately, they are ultimately antithetical: one cannot have more of one without also having less of the other - the power to hold to account is the power to decide. Managers cannot be made more accountable without undermining their discretionary authority. Establishing the proper mix of discretion and accountability thus emerges as the central corporate governance question.

Re-regulating Global Investment and Financial Markets

I was recently invited to serve as commentator on a panel at the American Society of International Law 2009 Research Colloquium: Current Research on International Economic Law. The principal papers were:

• Tim Canova (Chapman University School of Law): Financial Market Failure and the Economics of Control: Rethinking a New Bretton Woods
• Efraim Chalamish (Latham & Watkins LLP): Rethinking Global Investment Regulation in the SWF Era
• Jeffrey Atik (Loyola Law School, Los Angeles): Basel II and Extreme Risk Analysis

My remarks follow:

The root cause of the financial crisis of 2008 was a systematic failure of risk management. Both private sector actors and government regulators failed adequately to identify, prevent, prepare for, and respond to the numerous risks facing the financial system in recent years. What all of the papers presented today have in common, at least to some degree, is figuring out how to do a better job of managing risk next time.

Professor Atik's paper addresses the Basel II accords, which provide a set of international regulatory guidelines for determining the minimum acceptable levels of capital financial institutions need to protect themselves from market, credit, and operating risk. Although the Basel II framework was designed for banks and Atik's paper thus focuses on risk management by banks, it's worth noting that Basel II has become extremely influential in the risk management industry generally.

As Atik suggests, some argue that even top risk managers could not have anticipated the financial crisis that struck in 2008. As the argument goes, risks fall into three broad categories: known problems, known unknowns, and unknown unknowns. "There is a view that the financial crisis—while clearly a high-impact; rare-event risk—was unpredictable and possibly unmanageable, an unknown unknown." In fact, however, there were warning signs of an approaching crisis in the housing market, including "easy home-mortgage credit terms combined with rapidly accelerating home prices and reportedly lax credit standards," which in turn signaled risks for the financial services industry and then the economy as a whole.

Evaluating such extremely low probability but very high magnitude risks is challenging because the outcomes associated with such risks do not follow a normal distribution. Instead, they tend to have long or fat tails. Because risk management is focused on extreme events, requiring one to quantify the probability and magnitude of severe loss events, an uncertainty generating such a fat- or long-tailed distribution poses "a severe problem for risk managers." Indeed, there is considerable evidence that such risks are approached in "a sort of lax, undisciplined way" that results in them being "undermanaged before they first occur and overmanaged afterward." Nonetheless, "it is simply unacceptable to chalk such an event up to 'not manageable' and focus on the more predictable, tameable and probably less-severe risks."

Professor Atik focuses on one possible solution to the problem of extremely low probability but very high magnitude risks; namely, a lender of last resort that would store additional capital outside individual institutions and would make such capital available in response to extreme conditions. Clearly correct, I think.

Yet, as his conclusion perhaps suggests, additional risk management techniques deserve consideration. In general, firms have four tools for managing risk: (1) transferring risk to third parties through hedging and insurance, (2) avoiding risk by choosing to refrain from certain business activities, (3) mitigating operational risk through preventive and responsive control measures, and (4) accepting that certain risks are necessary to generate the appropriate level of return.

Because there are limits on the ability of capital requirements to deal with extreme events, a Basel III accord needs to engage all four of these strategies. Consideration might be given, for example, to the question of whether certain firms should be prohibited from engaging in lines of business that pose particularly high magnitude operational risks. Should banks whose depositors are protected by federal deposit insurance, for example, be allowed to invest in high risk securities where losses caused by rogue traders might threaten the viability of the enterprise.

At the same time, however, we must be conscious of Professor Atik's concluding warning that we need to avoid "over-engineering and fighting last wars."

Corporate and financial scandals are always good news for proponents of an expansive regulatory state. After every bubble bursts, going all the way back to the South Sea Bubble, new laws have been enacted. After all, there is nothing a politician or regulator wants more than to persuade angry investors that he or she is "doing something" and being "aggressive" in rooting out corporate fraud.

Bubble laws typically have the following characteristics:

• Panic leads to populism which is captured by long-standing interest group pressures
• Because "SOMETHING MUST BE DONE RIGHT NOW" there is no careful balancing of the costs and benefits of regulation.
• They fight the last war: Regulators more likely to react to past market mistakes than to prevent future mistakes
• Post-bust regulators ignore benefits of market flexibility and, therefore, impede risk-taking and innovation

Which leads me the papers by Chalamish and Canova.

A year ago at this time, a lot of pundits were deeply worried about sovereign wealth funds. Even though sovereign wealth funds accounted for only 2-3% of globally traded securities, they were being set up as the next villains of international finance.

This always seemed implausible. Investing abroad for profit is hard enough: recall Japanese companies' bubble-era forays into Hollywood and New York. Investing abroad for political power is even harder. It's a recipe for huge losses rather than world domination: look at the history of France's Crédit Lyonnais or China's state-owned banks.

Today, in any event, sovereign funds seem passé. Like the rest of us in the investment world, sovereign funds have suffered immense losses. Persian Gulf sovereign funds, for example, are estimated to have lost 27% of the value of their assets in the last year.

Not surprisingly, sovereign funds are becoming more risk averse. Chinese funds, for example, have been selling Fannie Mae and Freddie Mac bonds and buying Treasuries. Gulf state funds have been switching out of equities into cash and gold.

Third, in many countries, the ongoing financial crisis is forcing sovereign funds to switch from global to local investments, so as to bail out local businesses.

Finally, with oil prices and those of other raw materials having fallen dramatically, sovereign funds in places like the Gulf and Russia have substantially less surplus cash to invest.

Given all this, it is hardly surprising that sovereign funds have largely fallen off the regulatory radar screen. Having said that, however, there was a serious risk this time last year that many countries would respond to the influx of sovereign fund investments with the sorts of financial protectionism Chalamish identifies in his paper. In the current environment, with economic nationalism again rearing its head, there is a risk that the sort of sovereign fund barriers that were under consideration back then might be enacted now as part of a larger protectionist package. Chalamish's paper thus offers a useful reminder of the international legal rules that will govern such efforts.

Turning now to the last of the three papers; Professor Canova's is the most ambitious in its policy aspirations. A 21st Century Basel Accord is one thing; a 21st Century Bretton Woods pact is quite another.

Canova's argument begins by seeking to rehabilitate the general concept of Keynesian financial regulation, so as to clear the way for regulating "such significant international economic institutions and conventions as hedge funds, derivative financial instruments, hot money capital flows, exchange rate regimes, and international accounting and capital standards."

Canova starts with a response to the economic analysis of the New Deal proffered by a number of libertarian economists, who contend that New Deal policies actually delayed economic recovery in the 1930s.

This debate inevitably reminds one of Harry Truman's search for a one-handed economist. The answer you get depends a lot on how you frame the question. Your choice of metrics inevitably colors your conclusion.

The libertarian critique of the New Deal, however, does not rest solely—or even mainly—on economic data. The better argument is that the New Deal—particularly, but not exclusively during the first Roosevelt term in office—was less Keynesian than it was corporatist.

Corporatism views free competition as a destructive force that has to be both controlled and channeled through institutions that practice fair, but not free, competition under the watchful, mediating power of the government. In corporatism, fair competition means the "stabilization of business" with prices at levels that simultaneously assure fair wages, yield an adequate return on invested capital, and support high levels of employment.

The high water mark of New Deal corporatism, of course, was the passage of the National Industrial Recovery Act as the centerpiece of the early New Deal.

The Act was administered by the National Recovery Administration, whose leaders were committed corporatists. They sought to replace the individualistic—and supposedly selfish, hyper-competitive—free market system with one based on concerted activity under government supervision.

Eventually, of course, the Act's political base became unstable. It had rested on an untenable alliance of New Deal corporatists and old school antitrusters.

The Act, in sum, was terminal even before it was put to rest by the Supreme Court in Schechter. But corporatism did not die with it. Full-blown corporatist policies returned with World War II in response to the need for increases in production of war machinery. Given the exigencies of the war, Roosevelt replaced the NIRA's soft sanctions with heavy-handed, authoritarian sanctions. The war policies included wage and price controls and a low tolerance for even lawful work stoppages by unions. When dispute resolution failed, the government had a new policy option to help the parties resolve their disputes: executive orders allowing the government to seize companies.

The United States never became a truly corporatist state, of course. American interest groups have been too diverse. Government has itself been fragmented, divided at each level among executive, legislative, and judicial branches and dispersed among the national, state, and local levels in a federal constitutional system. Lastly, the American economy is vast and complex. To bring it within the effective control of a few hierarchical, noncompetitive peak associations, is almost unthinkable.

Nevertheless, recent American history has brought forth a multitude of little corporatisms, arrangements within subsectors, industries, or other partial jurisdictions. National emergencies create conditions in which government officials and private special-interest groups have much to gain by striking political bargains with one another. The government gains the resources, expertise, and cooperation of the private parties, which are usually essential for the success of its crisis policies. Private special-interest groups gain the application of government authority to enforce compliance with their cartel rules, which is essential to preclude the free-riding that normally jeopardizes the success of every arrangement for the provision of collective goods to special-interest groups. Crisis promotes extended politicization of economic life, which in turn encourages additional political organization and bargaining.

In U.S. history, quasi-corporatism has risen and fallen over the course of national emergencies, but each episode has left legacies, accretions of corporatism embedded in the part-elitist, part-pluralist structure of American government. By now these accretions, taking the form of disaggregated neocorporatist arrangements scattered throughout the economy, add up to a significant part of the political economy. All of which libertarians would find objectionable even if it lead to an economic utopia.

Turning to Canova's proposal, there is an odd dichotomy between his effort to rehabilitate Keynes and the history of the original Bretton Woods system. The conference that gave birth to that system was dominated by two rival plans developed, respectively, by Keynes and Harry Dexter White of the U.S. Treasury. The compromise that ultimately emerged was much closer to White's plan than to that of Keynes. Bretton Woods itself thus might be characterized as Bastard Keynesian.

In any case, the post-war optimism that characterized Bretton Woods proved utterly Panglossian. Monetary relations after the war were anything but stable, the transitional period anything but brief, the Fund's initial resources inadequate to cope with emerging payments difficulties. Hence after a short burst of activity during its first two years, IMF lending shrank to an extremely small scale for over a decade. Instead, the burden was shifted to the one actor at the time with the financial and economic resources needed to shoulder responsibility for global monetary stabilization; namely, the United States.

For reasons of its own, the United States was not only able but willing to take on that responsibility, in effect assuming the role of global monetary hegemon: money manager of the world.

Though multilateral in formal design, therefore, the Bretton Woods system in practice quickly became synonymous with a hegemonic monetary regime centered on the dollar, much in the same manner as the classical gold standard of the nineteenth century had come to be centered on Britain's pound sterling. For gold exchange standard, many said, read dollar exchange standard.

A 21st Century Bretton Woods must find a way to deal with the political and economic realities that drove both the classical gold standard and Bretton Woods to rely on a single global hegemon. Like it or not, the present era seems to be one of increasing multi-polarism. Would the BRIC—Brazil, Russia, India and China—tolerate US financial hegemony in the long-term?

In sum, something does need to be done to choke off the resurgence of economic nationalism. No one wants a return to the disastrous trade and financial policies of the interwar period. I am not persuaded, however, that neo-Bretton Woods-ism is the right answer.

Thank you.

More on Citigroup

Chancellor Chandler's opinion in the Citigroup case is getting well-deserved attention in the corporate law blogosphere.

Larry Ribstein notes:

As discussed in a Wachtell, Lipton, Rosen & Katz client memorandum posted here last week, and by Francis Pileggi here, the Citigroup decision reaffirms business judgment protection in Delaware by emphasizing the “extremely high burden” plaintiffs face in suing directors for breach of Caremark oversight duties. In this case, Chancellor Chandler held that merely claiming that directors made a bad business decision by failure to monitor business risk was not enough to excuse demand in a derivative suit.

Larry then offers a detailed discussion of three aspects of the case: "the indeterminacy of corporate fiduciary law, the weakness of this law and other corporate monitoring devices in addressing the recent breakdown in corporate governance; and how these cases relate to Delaware jurisprudence on unincorporated business entities."

Peter Atkins also offers an analysis, in which he argues that "the Court emphasizes the continuing vitality and primacy of the business judgment rule presumption as a key protector of our system of private capital investment."

Saffron Couscous Paella with Shrimp

1 tablespoon olive oil
1 red bell pepper, diced
1 yellow bell pepper, diced
1 medium yellow onion, diced
4 cloves garlic, minced
1 teaspoon sea salt
1/2 teaspoon black pepper
1/2 teaspoon dried thyme leaves
1/2 teaspoon dried red pepper flakes
1/2 teaspoon ground turmeric
1 can (14 1/2-ounce) organic, low sodium chicken broth
pinch saffron threads
1 cup warm water
1 package (10 ounce) frozen peas
1 1/2 pounds large shrimp, peeled and deveined
1/2 cup sweet grape tomatoes, cut in half
1 box (10-ounce) plain couscous

Soften saffron threads in the warm water and set aside.

Heat the oil over medium heat in a large paella pan (All Clad makes a great one). Add the bell peppers and saute for about 5 minutes. Add the onion and saute until the vegetables are softened but not browned (about 8 minutes). Do not let them brown! Add the garlic and cook 1 more minute. Add the salt, black pepper, thyme, pepper flakes and turmeric; stir and cook 1 more minute. Add the broth, water and saffron, and the peas. Simmer, covered, for 5 minutes. Add the shrimp and tomatoes. Simmer, covered, 3 minutes.

Remove from heat. Stir in the couscous; recover; and let stand 5 minutes.