"What we will not tolerate is the Republican efforts to privatize Medicare." That was the voice of Sen. Ted Kennedy, announcing a no-compete clause for all of Medicare amid the recent debate. It is the voice of the modern Democratic Party, which when you stand back and take a long look, appears not to want to compete at much of anything these days, other than winning the presidency. But even here the people running for the Democratic presidential nomination seem mostly intent on signing up the whole country to a non-compete clause. Medicare, the public schools, trade, affirmative action, the environment, even the federal judiciary--persons of competitive or entrepreneurial instincts need not apply....
For decades, the Democrats kept their party's ideological seesaw balanced at one end with socialists and the other with Wall Street admirers of government's promise, such as Felix Rohatyn, Robert Rubin and Cyrus Vance. Of late, however, the party has increasingly sounded as if it's become psychologically alienated from the private sector.
Nick Schulz recently posted a chart showing that while Henninger's point held true generally for Democratic Presidents, Obama has taken it to a remarkable extreme that perhaps even Henninger might not have anticipated:
Can we be surprised that Barack Obama would chose a Cabinet so unreflective of America?
After all, Barack Obama thinks that raising capital gain taxes will not harm economic growth; he taunts bankers with the prospect of pitchforks coming towards them; he condemns "greedy" doctors; who thinks imposing massive costs for each additional hire (think health care, think rules and regulations); he trumpets cap and trade as a panacea leading towards growth (well..at least in Al Gore's wallet).
He also thinks that empowering unions who engage in thuggish tactics is the way to encourage business to invest. He believes a regulatory regime will not discourage business optimism. He thinks increased taxes will stimulate a work ethic and spending by consumers - and believes all this and more (particularly hectoring and insulting rhetoric) is a way to encourage growth.
Can one wonder why the Chamber of Commerce, representing small businesses throughout the nation, has some problems with the President and his team who disfavor and disdain the world on free enteprise?
But remember-we were all told how "brilliant" he was, and how his unparalleled judgment would lead us to peace and prosperity.
The lack of private sector experience in his cabinet - the biggest dearth in history - is indicative of Obama's attitude toward free enterprise.
It's a fair cop. How can we trust a bunch of ivory tower academics, trust fund babies, and NGOers to run a capitalist economy? Soeaking as an ivory tower academic who's spent too much of his life in faculty meetings and committees, I don't want either myself or any of my colleagues (with all due deference to any reading this) running any political entity more complicated than a sewer district. I'd much rather have the economy run by people who actually make stuff for a living.
It is an age-old academic aphorism that your dean can't read but he can count. In other words, at least insofar as internal matters like promotions and raises are concerned, quantity matters more than quality.
Now we have some empirical evidence that the old saying is true. Paul Caron passes along an NBER paper, which finds that:
Using evidence for academic economists, we find that, conditional on its impact, the quantity of output has no or even a negative effect on each of a number of proxies for reputation .... Data on mobility and salaries show, on the contrary, substantial positive effects of quantity, independent of quality.
In other words, prolific publication--even of crap--has a positive effect on an academic's salary. Which means deans really can count but can't read.
Larry Ellison is known for forward thinking. With his new business model, though, the billionaire chief executive of software maker Oracle Corp. is taking a page from the past.
Mr. Ellison plans to buy Sun Microsystems Inc. and transform Oracle into a maker of software, computers, and computer components -- a company more like the U.S. conglomerates of the 1960s than the fragmented technology industry of recent years. ...
Mr. Ellison is among the executives reviving "vertical integration," a 100-year-old strategy in which a company controls materials, manufacturing and distribution. Others moving recently in this direction include ArcelorMittal, PepsiCo Inc., General Motors Co. and Boeing Co.
The reasons vary. Arcelor, the world's largest steelmaker, wants more control over its raw materials. Pepsi wants more authority over distribution. GM and Boeing are moving by necessity, to assure quantity and quality of vital parts from troubled suppliers. Some are repurchasing businesses they only recently shed.
"The pendulum has shifted from disintegration to integration," says Harold Sirkin, global head of the Boston Consulting Group's operations practice. He attributes the change to volatile commodity prices, financial pressures at suppliers and quests for new revenue -- challenges exacerbated by the recession. ...
The moves toward vertical integration are a departure from the past half-century, when companies increasingly specialized, shifting functions like manufacturing and procuring raw materials to others. Steelmakers in the 1980s sold their mining operations; in the 1990s, auto giants spun off their parts suppliers. Tech companies stopped making every piece of a computer system and specialized in chips, data storage or software. ...
While many companies, such as Coca-Cola Co. and Toyota Motor Corp., are content to stick to their current business models, others find they have little choice but to vertically integrate. In the past two years, Boeing bought a factory and a 50% stake in a joint venture that make parts for its troubled 787 Dreamliner jet. The moves partially reversed Boeing's aggressive outsourcing strategy to assemble the Dreamliner from parts made by hundreds of suppliers. Supply and assembly problems have knocked the Dreamliner more than two years behind schedule. Boeing CEO Jim McNerney says the company is still committed to outsourcing.
Likewise, GM in October took a minority stake in Delphi Automotive LLP, its biggest parts supplier, and purchased four factories and Delphi's steering business as the supplier emerged from bankruptcy. GM, which spun off Delphi in 1999, wanted to assure uninterrupted supply, a spokeswoman for the company says. ...
Perhaps the most dramatic reversal is taking place in the tech industry, where specialization and outsourcing had dominated for decades.
At the outset, let's clear up one misconception in the article. What is happening here is not a revival of 1960s-style conglomerates. They were a very different beast.
Around the middle of the 20th Century, the idea grew up that good managers could manage anything. This view was operationalized via conglomerate mergers, in which companies intentionally sought to diversify their product lines and business activities horizontally across a wide array of unrelated businesses. The theory was that a cyclical manufacturer could buy a noncyclical business, making the combined company stronger because some division would always be doing well. Diversification necessarily reduces the maximum gains a conglomerate can produce. When one segment is doing well, it is being pulled down by a segment that is doing less well. To be sure, diversification reduced the conglomerate's exposure to unsystematic risk. But so what? Investors can diversify their portfolios more cheaply than can a company, not least because the investor need not pay a control premium. Management of a conglomerate may be better off, because their employer is subject to less risk, but the empirical evidence is compelling that intra firm diversification reduces shareholder wealth. The self correcting nature of free markets is demonstrated by what happened next: during the 1980s there was a wave of so called "bust up" takeovers in which conglomerates were acquired and broken up into their constituent pieces, which were then sold off. The process resulted in a sort of reverse synergy: the whole was worth less than the sum of its parts.
The 1960s-style conglomerate was thus characterized by horizontal integration; i.e., mergers across industries. What's happening here is the revival of vertical integration; i.e., mergers and acquisitions within a single industry's supply chain.
Unlike conglomerates, vertically integrated firms have a strong efficiency story. A common efficiency based justification for vertical integration, for example, is the elimination of appropriate quasi-rents. Quasi-rents arise where investments in transaction specific assets create a surplus subject to expropriation by the contracting party with control over the assets. See Benjamin R. Klein et al., Vertical Integration, Appropriable Rents, and the Competitive Contracting Process, 21 J. L. & Econ. 297, 298 (1978). A transaction specific asset is one whose value is appreciably lower in any other use than the transaction in question. Once a transaction specific investment has been made, it generates quasi-rents--i.e., returns in excess of that necessary to maintain the asset in its current use. If such quasi-rents are appropriable by the party with control of the transaction specific asset, a hold up problem ensues.
A canonical example is the fact that historically newspapers owned their own printing presses while book publishers did not. The time pressures of newspaper publishing makes them quite sensitive to opportunism by printers. Suppose the newspaper needed to put out an extra edition, for example. An independent printer might refuse to cooperate, without an extra payment. The printer thus is holding up the newspaper in hopes of getting a bigger share of the available quasi-rents.
Granted, there are contractual solutions to the hold up problem. At the same time, however, history seemed to teach that the intra-firm command and control system allows for discipline of the sort that is not possible outside the firm. Ownership of the asset equates to a higher degree of control. So newspapers vertically integrated—they brought ownership of the press within the same firm as the editorial part of the operation.
Vertical integration thus brings both parties within a single firm and, accordingly, is a common solution to the hold up problem. The Boeing and GM examples cited in the article likely are consistent with this explanation for vertical acquisitions.
The agency cost/opportunism story supporting vertical integration raises questions about why firms turned so heavily in recent decades to outsourcing. Outsourcing inherently creates the risk of opportunism, because it separates control over transaction specific assets and thus creates quasi-rents.
The conventional explanation for the rise in business outsourcing is that falling interaction costs have changed this balance by opening new markets where firms can source economic inputs for less. This Article offers a second account, however, for the outsourcing phenomenon - one that is rooted in agency theory. Like many other economic relationships, outsourcing projects generate agency risk because a vendor makes decisions that affect the wealth of the outsourcing firm.
This Article argues that business outsourcing has thrived in recent years not only because globalization has unlocked inexpensive production markets, but also because it is becoming easier for firms to monitor and prevent the agency costs of outsourcing. Drawing upon a detailed analysis of outsourcing contracts, it explores several strategies to minimize agency costs - shedding new light on the structure and terms of a typical outsourcing project. It then contends that the same forces that are opening new markets are also making it economical for firms to mitigate outsourcing agency risk. Taken together, this work adds another important, but previously neglected, context for understanding the essential tradeoffs that arise when economic ownership is divorced from control.
Specifically, Geis argued that:
First, cheaper communication costs and standardized business processes simplify the drafting of detailed work descriptions and performance obligations. Obviously, it will cost less to write a comprehensive (though still incomplete) agreement when expensive international phone calls and business trips are replaced with distributed voice and video networks. Second, the standardization of business processes allows parties to pull performance criteria “off the rack” instead of haggling over the right way to assess execution of the business activity. For example, the metrics to appraise performance in an internet hosting project are now routinely defined to include packet transmission rates, bit-loss frequency, response rates for service calls, and so on. This makes it easier to draft a service level agreement to govern this type of outsourcing project. Furthermore, in addition to economizing drafting costs, standardized metrics simplify efforts to monitor compliance with these SLAs once they are in place. ... Third, cheaper communication, better technology, and standardized business processes make it easier to design and coordinate multiple agent structures or to leave part of an outsourced activity under the principal’s control. ... Finally, falling interaction costs help principals use incentive compatible compensation, control rights, and exit provisions more effectively.
Geis' argument made great sense. If the revival of vertical integration proves a lasting and significant phenomenon, however, we'll have to revisit the agency cost analysis. It may be that contractual solutions to the risk of opportunism inherent in outsourcing are not as effective as Geis and those of us who found his article persuasive (as I did) thought.
Another possibility is that the technological story Geis tells can also be told about vertically integrated firms. Consider that publicly held US firms have had to grapple for years with the enhanced internal control requirements imposed by Sarbanes-Oxley. Most firms have used technological monitoring systems as a key part of their internal control systems. Perhaps technology has reduced the cost of monitoring one's own employees at least as much as it has that of monitoring contractual counterparties. Once firms realized this, maybe the agency cost story for vertical integration started making sense again.
Just as some consumers have to have the latest product fads, some managers seem to have to have the latest industrial relations fad. As a result, some firms repeatedly make radical shifts in the way their firms make decisions.
The post then offers a behavioral economics explanation for why managers adopt fads.
Anyway, for those of us who work in mergers and acquisitions, this is clearly a trend worth keeping an eye on. Something very interesting may be happening here.
Updates:
Larry Ribstein ponders the potential impact a revival of vertical integration might have on his work on uncorporations (see his excellent new book The Rise of the Uncorporation)
Gordon Smith argues against "privileg[ing] one form of organization over the other in all circumstances," making a very fair point.
This essay reviews The Nature of the Common Law by Melvin A. Eisenberg (Harvard University Press, 1988). Professor Eisenberg's stated goal therein "is to develop the institutional principles that govern the way in which the common law is established in our society." In the course of doing so, Eisenberg addresses the functions of courts in American society, modes of legal reasoning and the process of overturning prior precedents. Yet Eisenberg never loses sight of his central thesis, namely that "all common law cases are decided under a unified methodology, and under this methodology social propositions always figure in determining the rules the courts establish and the way in which those rules are extended, restricted, and applied."
The Nature of the Common Law is one of the most thought-provoking books ever written on common law adjudication. Eisenberg's belief in social morality as a workable guide to decisionmaking surely invites further debate. So too does his concomitant belief that law is more than merely the personal moral and policy preferences of the judge. Indeed, one might almost say that The Nature of the Common Law deserves to be controversial, for Eisenberg has given us a report that is both normatively appealing and descriptively accurate. The Nature of the Common Law succeeds because it is both an attractive vision of how courts should function and a perspicuous account of the real world in which courts actually function.
I am a second year student at [Ed.: name of law school deleted] and a member of the [Ed.: name of law review deleted]. I am writing a student note about the [Ed.: name of case deleted] case this semester. I was concerned about the comments about the [Ed.: name of case deleted] case you wrote at your website.
I’m wondering if you could please expand upon your analysis of [Ed.: deleted]. Do you think this is a compelling issue ... I would appreciate any assistance you could offer me. Thank you very much for your time.
It's a better question than most of these emails, the gist of which seem to be: "You wrote the case book I had to buy for class, so tell me what to write for my law review note."
I will be happy to answer these sorts of requests, provided you: (1) can prove that you have bought at least one copy of each of my books; (2) you swear a blood oath to cite at least one of my books and my blog in your comment; and (3) you pay my usual hourly rate of [Ed.: outrageous figure, which nobody ever pays him anyway, deleted]. PS: Half-price for UCLA students!
No. I scored a 67 out of 100 on the Mises Institute's "Are You an Austrian Quiz," which I gather means I am closest to the Chicago School in my economic views. Of course, as severalpeoplehave pointed out, this quiz really measures not your economic preferences but the extent to which you agree with Murray Rothbard and Lew Rockwell. Thank goodness, the answer in my case is a rather decisive "no." Whew.
Nicholas Kristof offers up an individualized argument for Obamacare:
John is a sawmill worker from Yamhill County, Ore., where I grew up. He was a foreman at a mill, he felt strong and healthy, and he had very basic insurance coverage through his job. On April 18, he was married, at age 23, and life was looking up.
Ten days after the wedding, he was walking in his backyard carrying a neighbor’s dog — and he suddenly blacked out. That led, after rounds of CAT scans, M.R.I.’s and other tests, to the discovery that the left parietal lobe of his brain has a cavernous hemangioma. That’s an abnormal growth of blood vessels, and in John’s case it is chronically leaking blood into his brain. ...
Perhaps the worst is the pain — blinding, incapacitating headaches that have left him able to sleep only in short intervals. He vomits daily when the pain surges. “The pain is constant,” John said. “It’s a 7 or 8 on a scale of 10, and then it hits the high peaks and makes me vomit.”
With John unable to work, he lost his job — and his insurance coverage. Esther had insurance for herself and for her two children (from a previous marriage) through her job building manufactured homes. But she couldn’t add John to her plan because of his pre-existing condition.
Without insurance, John has been unable to get surgery or even help managing the pain. When he collapses or suffers particularly excruciating headaches, Esther rushes him to the emergency room of one hospital or another, but an E.R. can’t do much for him. One hospital has told them not to come back unless he gets insurance, they say. ...
If a senator strolled indifferently by as John retched in pain, we would think that person pitiless. But isn’t it just as monstrous for politicians to avert their eyes, make excuses and deny coverage to innumerable Americans just like John?
As far as individual morality is concerned, the Parable of the Good Samaritan seems wholly apt here. We have an obligation to those we encounter in life who need our help.
As an argument in favor of a specific social policy--namely, Obamacare--Kristof's column is riddled with fallacies.
Appeal to pity: Substituting a story designed to elicit pity for evidence
Spotlight: Creating the impression that those who receive the most media attention actually represent the groups they belong to.
Cherry picking: Finding cases that support your argument while ignoring those that don't
Probably the most egregious problem in Kristof's argument, however, is his invocation of the broken window fallacy. Frederic Bastiat explained that we all too often focus on consequences that are easy to see, while ignoring those that are hard to see:
In the department of economy, an act, a habit, an institution, a law, gives birth not only to an effect, but to a series of effects. Of these effects, the first only is immediate; it manifests itself simultaneously with its cause - it is seen. The others unfold in succession - they are not seen: it is well for us, if they are foreseen. Between a good and a bad economist this constitutes the whole difference - the one takes account of the visible effect; the other takes account both of the effects which are seen, and also of those which it is necessary to foresee. Now this difference is enormous, for it almost always happens that when the immediate consequence is favourable, the ultimate consequences are fatal, and the converse. Hence it follows that the bad economist pursues a small present good, which will be followed by a great evil to come, while the true economist pursues a great good to come, - at the risk of a small present evil.
In fact, it is the same in the science of health, arts, and in that of morals. It often happens, that the sweeter the first fruit of a habit is, the more bitter are the consequences. Take, for example, debauchery, idleness, prodigality. When, therefore, a man absorbed in the effect which is seen has not yet learned to discern those which are not seen, he gives way to fatal habits, not only by inclination, but by calculation.
Kristof here invokes a single but attractive and sympathetic example as an argument for a major shift in national policy. Presidents do this when they invite a symbolic figure to sit next to the first lady at the State of the Union address. Congressmen do this when they decide who to invite to legislative hearings. Trial lawyers do it when they select the most piteous victim to be the named plaintiff in mass tort class action.
It's effective because who amongst us wants to seem like the priests in the Parable of the Good Samaritan. It's analytically flawed, however, because it fails to take into account the interests of the mass of other individuals who may be adversely affected by the change of policy in question.
Sure, it would be great if John had health care insurance. But at what cost to everybody else? Should women under 50 be denied mammograms so as to hold down health costs so that John can have government-subsidized insurance? How about men over 70 with slow acting prostate cancer? Should we deny them treatment on the assumption that something else will kill them first, so that the government can afford to insure John?
The point is that Kristof and his ilk are basically running a con. They want you to focus on the most sympathetic cases, while ignoring the large and amorphous mass of individuals who will be adversely affected.
Resources are scarce. There ain't no such thing as a free lunch. Hard decisions have to be made.
Let's at least make sure that, as Bastiat urged, we count both the effects that are seen and those that are unseen.
Congressional Democrats are using several budget gimmicks to disguise the cost of their health care overhaul, claiming the House and Senate bills would cost only (!) about $1 trillion over 10 years. Now that critics have begun to correct for those budget gimmicks, supporters of ObamaCare are firing back.
One gimmick makes the new entitlement spending appear smaller by not opening the spigot until late in the official 10-year budget window (2010–2019). Correcting for that gimmick in the Senate version, Sen. Judd Gregg (R-NH) estimates, “When all this new spending occurs” — i.e., from 2014 through 2023 — “this bill will cost $2.5 trillion over that ten-year period.”
Another gimmick pushes much of the legislation’s costs off the federal budget and onto the private sector by requiring individuals and employers to purchase health insurance. When the bills force somebody to pay $10,000 to the government, the Congressional Budget Office treats that as a tax. When the government then hands that $10,000 to private insurers, the CBO counts that as government spending. But when the bills achieve the exact same outcome by forcing somebody to pay $10,000 directly to a private insurance company, it appears nowhere in the official CBO cost estimates — neither as federal revenues nor federal spending. That’s a sharp departure from how the CBO treated similar mandates in the Clinton health plan. And it hides maybe 60 percent of the legislation’s total costs. When I correct for that gimmick, it brings total costs to roughly $2.5 trillion (i.e., $1 trillion/0.4). ...
When we correct for both gimmicks, counting both on- and off-budget costs over the first 10 years of implementation, the total cost of ObamaCare reaches — I’m so sorry about this — $6.25 trillion. That’s not a precise estimate. It’s just far closer to the truth than President Obama and congressional Democrats want the debate to be.
Predictably, leftist blogs have dismissed all this as hype and lies. Yet, The Economist is reporting much the same sort of findings as Cannon:
...all manner of budgeting chicanery is being used to reduce the apparent cost and keep the CBO “score” to below $900 billion. For example, the Senate bill assumes that payments to doctors and hospitals by Medicare, the government health plan for the elderly, will be magically cut by over a fifth in two years’ time—though Congress has always lacked the backbone to make supposedly obligatory cuts of this kind in the past.
Even so, let's make the heroic assumption that the proponents of Obamacare aren't lying about what it will cost. The government's track record with projecting the long term costs of major entitlement programs isn't reassuring, as a report for Senator Brownback details:
Since the end of World War II, major health care reform proposals have generally always cost more-sometimes significantly more-than the highest cost estimates published while the legislation was pending…
…Medicare (entire program). In 1967, the House Ways and Means Committee predicted that the new Medicare program, launched the previous year, would cost about $12 billion in 1990. viii Actual Medicare spending in 1990 was $110 billion-off by nearly a factor of 10.
A certain level of error in cost projections is to be expected, especially regarding sectors as complicated as health care. But ... health care appears to be an area with great room for overly optimistic assumptions regarding changes in the behavior of patients and providers, technological innovation, the practice of medicine, program take-up rates, future health cost inflation, and the likely success of proposed cost-control mechanisms.
…Whatever the causes, it seems there is a kind of Murphy’s Law of health care legislation: “If it can cost more than the highest available official estimate, it probably will.”
In sum, we can't trust the Obama numbers on healthcare. Anybody committed to good government would see the need for cautious, prudential, incremental reform rather than sweeping surgery on 16% of the economy. Unfortunately, prudence and caution are not hallmarks of our current rulers. As things stand, the odds are that we're headed for a massive increase in the federal deficit.
I'd feel better about Obamacare if the Democrats had dared take on some of their key constituencies. For example, Obamacare won't do squat about the problem of defensive medicine and sky high malpractice insurance costs caused by runaway medical malpractice litigation. As Trial Lwyer, Inc. documents:
While the excesses of the litigation industry alone cannot explain America’s mounting medical costs, litigation is a large, and growing, contributor to our health-care bill. As the graph below shows, medical malpractice liability—the “tort tax” on doctors and hospitals, whose costs constitute the majority of health expenses—has grown much faster than health-care inflation.[4] Indeed, medical-malpractice liability alone constitutes over 10 percent of the entire U.S. tort tax, which by 2003 represented over $3,300 for a family of four.[5]
Although medical-malpractice liability provides Trial Lawyers, Inc. with its largest health-care sector revenue stream, litigation over pharmaceuticals and medical devices exacts a staggering cost on an increasingly important part of the U.S. economy. Wyeth’s massive reserve for Fen-Phen litigation is $21 billion,[6] and Merck’s exposure to Vioxx lawsuits may total as much as $50 billion.[7] Such figures are astronomical in comparison with these companies’ individual budgets, representing nine to twelve times each company’s annual research and development costs.[8] In fact, since each drug was only widely used for about four years, the approximate annualized liability cost of these two drugs comes to almost $18 billion—equivalent to 10 percent of the annual revenues for the pharmaceutical industry as a whole.[9]
As this report will detail, far from limiting its attacks to doctors and drug makers, the plaintiffs’ bar is attacking all levels of the health-care distribution chain. Some of Trial Lawyers, Inc.’s favorite targets, nonprofit hospitals and nursing homes, are the health-care providers that minister to our nation’s most vulnerable—the poor and the elderly. And as if its effects on health costs were not bad enough, the litigation industry has focused its crosshairs on managed- care providers, who, while politically unpopular, are crucial to dispersing risk and providing for health care at affordable cost.
It is also important to emphasize that the direct costs of healthcare litigation only begin to scratch the surface of the toll that these predatory lawsuits exact on our economy—and on our health itself. Med-mal lawsuits tend to inflate health-care costs by encouraging “defensive medicine”—unnecessary procedures and referrals that doctors and hospitals prescribe in order to limit their exposure to future litigation. Studies suggest that defensive medicine costs are several times higher than the direct liability costs themselves.[10]
Nor are we made safer by product-liability litigation over drugs and medical devices. Such suits inevitably drive innovation from the marketplace that would lead to net health improvements not only for U.S. society but for the entire world. Since any drug manufacturer might be held accountable for unanticipated liability of the magnitude of Vioxx and Fen-Phen, every drug company will consider such numbers in its research and investment decisions, and many drugs that would otherwise save lives or improve the quality of lives will never reach the market.
If Obama and his Congressional allies had been at all serious about bending the curve, they would have tackled this enormous problem. Instead, they gave the trial lawyers a pass. Indeed, to the contrary, as David Frum observes, they're trying to give trial lawyers a boost:
Small but sophisticated interest groups use big political battles to gain special advantages. Health care reform is, of course, the biggest battle of them all, with trillions of dollars at stake.
On Saturday night with the House vote in favor of the health reform bill, the trial lawyers sliced themselves a nice little piece of that bonanza.
It's Section 2531 of the bill -- to be precise Section 2531(4)b -- and it provides as follows:
The new health bill will empower the Secretary of Health and Human Services to make grants to states that reform their medical malpractice systems. There are just two conditions: Those reforms must not "limit attorneys' fees or impose caps on damages."
Which is like saying that we're going to encourage you to develop a personal weight loss plan that includes neither exercise nor changes in diet.
In sum, it's a massive increase in government control that won't reduce costs but rather is likely to bankrupt our posterity.
I'm getting ready to go teach fiduciary duties of close corporation shareholders. In the new edition of KRB, we've included the Massachusetts Supreme Judicial Court's decision in Brodie v. Jordan. In doing so I'm puzzling over how the doctrine it announces interacts with the Wilkes standard.
In Wilkes, four investors--Wilkes, Riche, Quinn, and Pipkin (who was replaced by Connor)—formed a corporation to own and operate a nursing home. They each worked for the corporation, drew a salary, and owned equal shares in it. The firm did not pay dividends. A dispute arose and three of the inves¬tors fired the fourth, Wilkes. The three continued to collect their salaries (for which they did in fact perform some services), while Wilkes did not. They offered to buy Wilkes’s stock at a low price. Wilkes sued the corporation and the other three investors.
Held: Judgment for Wilkes; the other three investors breached their fiduciary duty to him. A close corporation is much like a partnership. Hence, the Massachusetts courts impose on shareholders in close corporations a fiduciary duty that approximates the duty that partners owe to each other (Donahue v. Rodd Electrotype). Yet because investors need some latitude in managing the firm, this Donahue rule is too strict. Accordingly, the following test applies:
Shareholders in close corporations owe each other a duty of strict good faith.
If challenged by a minority shareholder, a controlling group in a firm must show a legitimate business objective for its action.
A plaintiff minority shareholder can nonetheless prevail if he or she can show that the controlling group could have accomplished its business objective in a manner that harmed his or her interests less.
In Brodie, Mary Brodie inherited one-third of the shares of Malden corp. from her husband, Walter. Two other shareholders, Jordan and Barbuto, each owned one-third of the shares. Walter had been a founder of the firm and had served from 1979 to 1992 as its president, but in 1992 was voted out as president; in the two years before his death in 1997 he was not receiving compensation of any sort from the corporation. Jordan received a salary. Barbuto received director fees until 1998 and owned “the building that houses Malden’s corporate offices and receive[d] rent from the corporation.” The corporation never paid dividends. Mary Brodie sought unsuccessfully to join the board of directors. Her request for “financial and operational information” was refused. “The defendants … failed to hold an annual shareholdler’s meeting for the … five years” preceding the filing, in 1998, of Ms. Brodie’s suit.
Held: The lower court finding of liability was not contested. Only the remedy was formally at issue. The SJC holds that a forced buyout of plaintiff's shares was not permissible, which seems correct.
The interesting wrinkle is presented by this passage in the opinion:
“[S]tockholders in [a] close corporation owe one another substantially the same fiduciary duty in the operation of the enterprise that partners owe to one another” (footnotes omitted), [Donahue v. Rodd Electrotype Co. of New England, Inc., 328 N.E.2d 505 (1975)]...,, that is, a duty of “utmost good faith and loyalty,” id., quoting Cardullo v. Landau, 329 Mass. 5, 8, 105 N.E.2d 843 (1952).
Majority shareholders in a close corporation violate this duty when they act to “freeze out” the minority. We have defined freeze-outs by way of example:
The squeezers [those who employ the freeze-out techniques] may refuse to declare dividends; they may drain off the corporation’s earnings in the form of exorbitant salaries and bonuses to the majority shareholder-officers and perhaps to their relatives, or in the form of high rent by the corporation for property leased from majority shareholders ...; they may deprive minority shareholders of corporate offices and of employment by the company; they may cause the corporation to sell its assets at an inadequate price to the majority shareholders....
Donahue v. Rodd Electrotype Co. of New England, Inc., supra at 588-589, 328 N.E.2d 505, quoting F.H. O’Neal & J. Derwin, Expulsion or Oppression of Business Associates 42 (1961). What these examples have in common is that, in each, the majority frustrates the minority’s reasonable expectations of benefit from their ownership of shares.
We have previously analyzed freeze-outs in terms of shareholders’ “reasonable expectations” both explicitly and implicitly. ... sA number of other jurisdictions, either by judicial decision or by statute, also look to shareholders’ “reasonable expectations” in determining whether to grant relief to an aggrieved minority shareholder in a close corporation.
In the present case, the Superior Court judge properly analyzed the defendants’ liability in terms of the plaintiff’s reasonable expectations of benefit. The judge found that the defendants had interfered with the plaintiff’s reasonable expectations by excluding her from corporate decision-making, denying her access to company information, and hindering her ability to sell her shares in the open market. In addition, the judge’s findings reflect a state of affairs in which the defendants were the only ones receiving any financial benefit from the corporation. The Appeals Court determined that the findings were warranted, and the defendants have not sought further appellate review with respect to liability. Thus, the only question before us is whether, on this record, the plaintiff was entitled to the remedy of a forced buyout of her shares by the majority. We conclude that she was not so entitled.
Curiously, there is no mention of the Wilkes three prong test, although later Massachusetts cases continue to apply that test, so it clearly survives Brodie.
This leaves me with two questions:
Why are Marie Brodie's expectations relevant at all? She was not the original investor whose expectations might have been known to the defendants. Shouldn’t it be Walter’s expectations as to how his widow would be treated after his death that are the relevant ones? And how in the world do you divine that state of mind? Is it reasonable to suppose that he expected his widow to serve on the board, for example, if she had no relevant business experience?
Does conduct that defeats an investors reasonable expectations constitute an illegal freezeout? Or can the majority frustrate reasonable expectations if they have a legitimate business purpose for doing so? My impression from a quick scan of the Massachusetts cases is that the answer to the latter question is "yes." In other words, you first ask whether the majority shareholders' conduct frustrated the minority shareholder's reasonable expectations on the sorts of issues identified by the court as constituting freezeouts. You than ask whether the majority had a legitimate business purpose for doing so. And so on with the rest of the Wilkes test.
With respect to the latter set of questions, I'm pretty confident that I've read the Massachusetts cases correctly. But I would welcome correction (or confirmation, for that matter) from any Massachusetts law expects in the reading audience.
BTW, in prior editions of the KRB teacher's manual, we claimed that the Louis E. Wolfson who figures so prominently in Smith v. Atlantic Properties was the Louis E. Wolfson of Abe Fortas and securities law infamy. It turns out that our Wolfson was a prominent Massachusetts medical doctor. It seems appropriate to clear his name, but it also makes me sad. Somehow the case just became much less interesting.
Apparently there's some fuss in DC about who was invited and who was not invited to the State Dinner with the Prime Minister of India. Whatever.
In perusing the official menu for the State Dinner, however, I came away appalled. It offers a choice of two entrees:
Roasted Potato Dumplings with Tomato Chutney, Chick Peas and Okra or Green Curry Prawns, Caramelized Salsify, With Smoked Collard Greens
Okra? Collard greens? Not exactly haute cuisine. But that's not my concern. It's good American fare, so more power to them.
My problem is the wine they propose to serve: "2007 Granache, Beckmen Vineyards, Santa Ynez, California." In the first place, they misspelled the grape variety: It's grenache, not granache. (The same mistake appears to have been made on the menu cards on the table.) But given how lousy a speller I am, let's give them a pass on this one.
In the second place, grenache is a red wine. It is used primarily as a blending grape. It's fruity, fleshy, but generally doesn't produce great wines, although there are a few French, Aussie, and US exceptions to that rule. For example, Beckmen Vineyard is one of the Rhone Rangers who are making premium Grenache. Their Grenache wines tend to be high alcohol (15+ plus), with flavor associations including kirsh, licorice, spices, earth, and game. Robert Parker typically scores them in the high 80s or low 90s.
I suspect the Grenache will be a very nice match for the potato entrée. As long as the entree skews towards Fall flavor associations, the grenache should be okay.
As a match for Curried Prawns, however, it will be an unmitigated disaster. The tannins and the heat of the curry will bring out the worst in each other. The high alcohol won't help with the spice either. High alcohol wines tend to taste hot to begin with. Coupled with the spice heat, the match will not be at all refreshing.
And then we add prawns to the mix. Red wine is almost never a good match for shrimp or any other shellfish. True, a bunch of chefs in the nouvelle cuisine tradition insist on trying it, but it almost never works out very well. A high alcohol, high tannins wine with earthy flavors is NOT what I would want to drink with a delicate food like prawns.
All in all, not a very impressive outing by the White House sommelier.
Joe Lieberman says he will vote no on any health care bill containing any form of public option:
Rather, his objection is based on fiscal risk: "Once the government creates an insurance company or plan, the government or the taxpayers are liable for any deficit that government plan runs, really without limit," he says. "With our debt heading over $21 trillion within the next 10 years...we've got to start saying no to some things like this."
He's got a point. It was the implicit government guarantee of Fannie Mae and Freddie Mac that let them get away with the financial shenanigans that helped lead to last year's financial crisis. Everybody knew that the taxpayer was ultimately on the hook, which let Fannie and Freddie borrow cheaply and take risks that a private actor wouldn't take. Just so, the taxpayer de facto will be on the hook for any losses suffered by a public option plan, no matter what the law purports to say de jure.
I am wondering how those of you teaching Business Associations and Corporations have integrated the financial crisis into your classes.
I'm sure that the crisis will make my end-of-the semester class on Corporate Social Responsibility even more lively. I wish I had remembered, but I meant to talk about why Bear Stearns didn't just abandon their two hedge funds in the context of my veil piercing classes. Moral or implicit recourse seems an important lesson; just because shareholders have protection of the corporate veil, doesn't mean they will use it. The crisis also came up in the context of executive compensation and the Disney and Jones v. Harris cases.
The progression in the Klein Ramseyer {Bainbridge interjects here to ask, "what am I, chopped liver?} book from Disney to Jones v. Harris also allowed a brief discussion on unintended consequences of corporate law reform. We talked a little bit about how option based compensation resulted from a desire to cure management entrenchment and better align management incentives with those of shareholders. We then talked a bit about the lesson of being careful in designing options or other compensation or you might stimulate short-term decision-making and accounting gamesmanship.
Jones v. Harris (subject of the Glom's forum two weeks ago) provided an opportunity to talk about how the rise of institutional shareholders was supposed to play a key role in corporate governance. We also discussed how institutional investing just pushes the agency costs to another level.
Casebook adopters can also get my Sarbanes-Oxley supplement for use in conjunction with KRB, complete with PowerPoint slides. Next summer I plan to work up a similar supplement to address the financial crisis and the Obama era of corporate governance.
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