ProfessorBainbridge.com

Speech on Director Primacy in Nonprofit Corporations

I'm off to Northern California to give a speech on Director Primacy in Nonprofit Corporations, which looks at the theory and practice of current issues in not for profit corporate governance. Here's the PowerPoint show for my presentation:

Does better corporate governance result in higher stock prices?

The Economist claims that South Korea's allegedly weak corporate governance rules are responsible for South Korea's allegedly underperforming equitiy market:

So what is the source of the “Korea discount”, which means that the KOSPI has a forward price-to-earnings ratio of under ten, below most other Asian stockmarkets (see chart)? There are a few possibilities. The national economic model is still built on exports, often in highly cyclical industries such as shipbuilding. The capital structure of South Korean firms has historically been debt-heavy.

But the prime cause of the discount is more likely to be poor corporate governance at the family-run chaebol conglomerates that dominate the economy. Nefarious schemes to pass on control to sons, avoid taxes and exploit company assets for the benefit of family members are widely discussed in private.

What I know about South korean corporate governance would not take very long to recite, but even so I read the Economist article with some skepticism.

While superior corporate governance logically ought to lead to superior stock performance, the evidence of such an effect is weak. Indeed, event studies (at least in the US) generally don't show much of a link between the two:

Virtually all of the important mechanisms of corporate governance have been subjected to event study analysis. These include boards of directors, shareholder proposals, derivative lawsuits, and executive compensation. Although all of these devices have been posited to perform a critical function of reducing the agency costs of the separation of ownership and control in the U.S. public corporation, empirical studies do not provide strong support for this viewpoint. Neither shareholder proposals nor lawsuits have a significant positive price effect. A positive stock price effect is associated with appointment of an independent director to the board, but board composition has not been found to impact positively on performance. 

Sanjai Bhagat & Roberta Romano, Event Studiesand the Law: Empirical Studies of Corporate Law, 4 Am. L. & Econ. Rev. 380, 401 (2002).

There are, I suppose, two possible explanations for that finding. First, superior corporate governance rules either do not affect stock prices or have such a minor effect that they are swamped by other factors. Second, conventional wisdom about what constitutes superior corporate governance is wrong. Both explanations suggest that The Economist's recommendation that South Korea adopt such rules may not corret the alleged problem. As Bhagat and Romano observed of their findings: "These findings suggest that widely shared beliefs concerning what are essential components for effective corporate governance may be mistaken and that affirmative policies to foster such devices ought to be reconsidered."

Another reason I'm skeptical of The Economist's account is my understanding that chaebol “can be thought of as the brainchild of the government.” Sung-Hee Jwa, The Evolution of Large Corporations in Korea: A New Institutional Perspective on the Chaebol 19 (2002). “Basically, the formation and growth of the chaebol was a result of the interaction between the government's industrial policies and the chaebol's responses to them.” Id. at 27. According to Gilson and Milhaupt, "important bilateral monopoly qualities of the government-chaebol relationship remain to this day." 59 AMJCL 227, 249 (2011).

One therefore wonders whether state meddling is more to blame than poor governance.

Prosociality and the eye of the beholder

Brett McDonnell has an interesting post on the inherent ambiguity of "prosocial" behavior. His points are important, but I would like to rephrase and broaden one of them. Brett argues that "the question is prosocial behavior in whose favor?  What if there are conflicting possible groups towards whom one might be loyal?"

As I understand the point he's making, it is a version of the broader problem that whether something is prosocial depends on your definition of the good society. On many issues, I suspect Brett and I would have very different definitions of the good society. He might think the good society promotes reproductive choice, while I might think the good society respects all lives whether they have been born yet or not. From this perspective, when you or I call something "prosocial" all we're really doing is using a 50-cent word that really means "pro how I think the world should be run."

To my mind, that pretty much evisverates any utility one might claim for the concept of "prosociality."

Shaming as sanction

David Zarig comments on the UK government's decision to strip former Royal Bank of Scotland CEO Frederick Goodwin of his knighthood:

... perhaps Britain is showing the way with regard to imposing sanctions, but not resorting to the criminal code.

It reminds me of the debate a few years ago about shaming as an alternative sanction. There's a very interesting paper by Dan Kahan on the subject, which stands as one of the few cases I know of in which a prominent legal scholar so publicly changed his mind on such a significant issue. I also highly recommend David Skeel's paper on shaming as a corporate law sanction. 

Update: The Economist's Schumpeter blog makes a good point:

Galling as it is to imagine Mr Goodwin insisting on being called Sir Fred at his local corner shop, or offering his hand to be kissed at the bus stop, no power flowed from his title. Shame is an important sanction when very well-paid people screw up, but Mr Goodwin’s reputation was already in the gutter, following the bank’s failure and a nasty, public row over his pension entitlement. Knighthood or not, he was not about to walk back into public life.

It is why commenter KG16's observation below about jail time has traction. 

Kodak's implications for director primacy theory

In an article entitled Unocal at 20, I built upon my "director primacy model of corporate governance and law" to argue that "Unocal strikes an appropriate balance between two competing but equally legitimate goals of corporate law: on the one hand, because the power to review differs only in degree and not in kind from the power to decide, the discretionary authority of the board of directors must be insulated from shareholder and judicial oversight in order to promote efficient corporate decision making; on the other hand, because directors are obligated to maximize shareholder wealth, there must be mechanisms to ensure director accountability. The Unocal framework provides courts with a mechanism for filtering out cases in which directors have abused their authority from those in which directors have not."

As I read today's WSJ, however, I was prompted to wonder whether my analysis left enough room for the market for corporate control to do its part in the process of creative destruction that makes capitalism work.

In a 1999 University of Cincinnati Law review article, my friend Bill Carney explained how my friend Henry Manne made the breakthrough argument about the critical role the market for corporate control plays in a capitalist economy:

[Manne’s article] Mergers and the Market for Corporate Control [73 J. Pol. Econ. 110 (1965)] was the natural culmination of Manne's writing and thinking on the role markets played in constraining managers. … Manne noted that shareholders were primarily interested in having managers maximize profits, and that stock prices reflected the success of their efforts.

In 1962 Manne’s article] The Higher Criticism introduced the notion that weak management that caused profits to decline would also cause share prices to decline, which would in turn attract outsiders as buyers because of the votes attached to the shares. These buyers would in turn use the votes they had purchased with their shares to seek better management and the rewards of higher earnings and stock appreciation. In this first article, Manne had made the critical linkage between share voting and share transferability, which he would develop more fully in 1964 and 1965.

In 1964 [Manne’s article] Some Theoretical Aspects of Share Voting first developed the notion that there were positive returns to acquiring voting control of firms, and that these returns come from improved management. Manne described shares as consisting of a bundle of rights--one being the investment and the other being the right to vote. He noted that the value of the share vote rose as the value of the share itself declined from poor management, and that the difference represented the control premium that outside management teams would be willing to pay for control. … It was this 1964 article that first introduced the phrase, “the market for corporate control.”

But it was Mergers and the Market for Corporate Control that gained the most attention in this remarkable series. … The returns from acquiring control, Manne argued, were from improving management. Improving management would, in turn, increase cash flows that would be capitalized by the market. …

In the context of mergers, Manne recognized the value of the veto power held by managers over this form of takeover, and the likelihood that this veto would encourage side payments to management to persuade it to allow shareholders to accept a premium for their shares. This observation has obvious implications, of which we all became acutely aware later on. First, if managers can extract a part of the economic rents available to shareholders in a target corporation, returns to target shareholders in mergers should be smaller than in tender offers. Later evidence has borne this out. Second, if changes of control are efficient and are furthered by management acquiescence, how much power should target-management possess in order to extract part of the gains? The struggles of the Delaware courts in attempting to delineate how much corruption is too much in this setting have occupied corporate lawyers for the past fifteen years. But the outline of the problem has been present for the last 34 years.

The … most important contribution of this article was its description of the market for corporate control as a serious constraint on management misbehavior. As Manne wrote:

Only the take-over scheme provides some assurance of competitive efficiency among corporate managers and thereby affords strong protection to the interests of vast numbers of small, non-controlling shareholders. Compared to this mechanism, the efforts of the SEC and the courts to protect shareholders through the development of a fiduciary duty concept . . . seem small indeed.

What prompted me to ruminate on all this was the Journal's coverage of Kodak's rumored bankruptcy filing. Kodak long was a great success story. But all things--including corporations--have a life cycle. Kodak got old. It became a mature cash cow. Managers of mature cash cows all too often succumb to a mid-life crisis. The firm must be revitalized. It needs the corporate equivalent of botox. Just as Hollywood types with too much money to spend on plastic surgery all too often end up with duck lips and chipmunk cheeks, corporate managers with too much free cash flow often end up with bloated, dysfunctional conglomerates.

Kodak's sad story is a classic example of the phenomenon:

The company ... invented the digital camera—in 1975—but never managed to capitalize on the new technology.

Casting about for alternatives to its lucrative but shrinking film business, Kodak toyed with chemicals, bathroom cleaners and medical-testing devices in the 1980s and 1990s, before deciding to focus on consumer and commercial printers in the past half-decade under Chief Executive Antonio Perez.

None of the new pursuits generated the cash needed to fund the change in course and cover the company's big obligations to its retirees. A Chapter 11 filing could help Kodak shed some of those obligations, but the viability of the company's printer strategy has yet to be demonstrated, raising questions about the fate of the company's 19,000 employees.

A viable market for corporate control might well have prevented Kodak from spending the last few decades flailing from one failed strategy to another. Back in the 1980s, before Martin Lipton invented the poison pill, bankers like Michael Milken and buyout boutiques like KKR put Manne's theories to the test by taking on the economic dinosaurs of that day--i.e., conglomerates. Managers of that era thought good managers could manage anything. They also thought intrafirm diversification was superior to diversification at the shareholder level. Looser antitrust rules on horizontal acquisitions than on vertical acquisitions further encouraged the building of huge conglomerate empires by imperially-minded CEOs. The result was bloated businesses that did everything from -- as the Kodak case exemplifies -- film to "chemicals, bathroom cleaners and medical-testing devices" to  "consumer and commercial printers." Those managers were wrong. Just as Kodak's managers have been wrong in more recent times.

The conglomerates suffered from a form of reverse synergy. They worth more broken up into pieces with the various lines of business sold off as individual firms. And that's precisely what happened because the market for corporate control worked.

Sometimes the process of breaking up conglomerates included the sad but necessary task of killing off lines of business that had outlived their expiration date. If it were not for the creative destruction process, after all, buggy whip companies would still be in business because we'd all still be driving buggies.

Kodak has outlived its expiration date. The cash cow of film has died. The cupboard is empty. If we had a functioning market for corporate control, somebody would buy the shell, sell off whatever assets remain of value, and kill the rest.

I feel badly for the people who work at Kodak. Ideally, public policy would provide mechanisms for retraining and transitioning of employees adversely affected by corporate takeovers. After all, if corporate takeovers really are Kaldor-Hicks efficient, there should be some money available for the state to redistribute to those who suffer from the externalities of that market. But Kodak still should die.

All of which leaves me with a coupe of basic questions to ponder: Did Unocal at 20 properly strike the balance between protecting director primacy and preserving an functional market for corporate control? And does current delaware law do likewise?

Ponder. Not blog. Not yet.

The Fundamental Error: Shareholders & Ownership

Broc Romanek posts:

Bob Monks is one of the long-time warriors in the battle for corporate governance reform. Ever since creating ISS a long time ago, Bob has been on the front lines to get corporate governance even considered when the need for some type of market reform seemed necessary. That's why I find his recent piece where he asks " What does it mean to be a shareholder or owner in 2011?" so interesting. Under that umbrella question, he also asks these four questions:

1. What do owner and shareholder mean in regards to corporations and governance?

2. Can we lump all stock owners together or do we need multiple classes of stock to accommodate owners with different levels of interest and participation?

3. To whom does management owe fiduciary duty when considering the interest of owners? Does having one class of ownership work in management's favor because it keeps shareholders from ever truly working together to enact change?

4. How can you have "shareholder responsibility" when there is no possibility of shareholders having a common interest and working together. Because there are today so many different classes and categories of shareholders - arbs, derivatives, borrowed stock, etc - that common purpose is impossible.

The middle two questions are very thought provoking and deserve extended analysis at some point in the future. As for numbers 1 and 4, however, they are old bugbears here at PB.com.

How Many Times Must I Say It? Shareholder Do Not Own the Corporation!

Ownership implies a thing capable of being owned. To be sure, we often talk about the corporation as though it were such a thing, but when we do so we engage in reification. While it may be necessary to reify the corporation for semantic convenience, it can mislead. Conceptually, the corporation is not a thing, but rather simply a set of contracts between various stakeholders pursuant to which services are provided and rights with respect to a set of assets are allocated.

Because shareholders are simply one of the inputs bound together by this web of voluntary agreements, ownership is not a meaningful concept in nexus of contracts theory. Someone owns each input, but no one owns the totality. Instead, the corporation is an aggregation of people bound together by a complex web of contractual relationships.

As I explain in detail in my article The Board of Directors as Nexus of Contracts, the shareholders' contract with the firm has some ownership-like features, including the right to vote and the fiduciary obligations of directors and officers.

Even so, however, shareholders lack most of the incidents of ownership, which we might define as the rights to possess, use, and manage corporate assets, and the rights to corporate income and assets. For example, shareholders have no right to use or possess corporate property. Cf. W. Clay Jackson Enterprises, Inc. v. Greyhound Leasing and Financial Corp., 463 F. Supp. 666, 670 (D. P.R. 1979) (stating that “even a sole shareholder has no independent right which is violated by trespass upon or conversion of the corporation’s property”). Management rights, of course, are assigned by statute solely to the board of directors and those officers to whom the board properly delegates such authority. Indeed, to the extent that possessory and control rights are the indicia of a property right, the board is a better candidate for identification as the corporation’s owner than are the shareholders. As an early New York opinion put it, “the directors in the performance of their duty possess [the corporation’s property], and act in every way as if they owned it.” Manson v. Curtis, 119 N.E. 559, 562 (N.Y. 1918).

This remains true even if a single shareholder (or cohesive group) owns a majority of the corporation's voting stock. To be sure, ownership of such a control block gives shareholders substantial de facto control by virtue of their ability to elect and remove directors, yet this still does not confer either possessory or management rights on such shareholders. Indeed, an effort by such a shareholder to exercise such rights might well constitute a breach of fiduciary duty by the controlling shareholder. In appropriate instances of such misconduct by a controlling shareholder, the board may well have a fiduciary duty to the minority to take steps to dilute the majority shareholder's control (as by issuing more stock). See, e.g., Delaware Chancellor Allen's opinion in Mendell v. Carroll, 651 A.2d 297, 306 (Del. Ch. 1994), in which he suggested that the board of directors could "deploy corporate power against the majority stockholders" to prevent "a threatened serious breach of fiduciary duty by the controlling stock." Granted, as I haveobserved elsewhere on this blog, "corporate law is far more tolerant of hegemony than constitutional law," but Allen's dicta would make no sense if majority voting control equalled ownership.

Let me offer another illustration. As I discuss in my article Unocal at 20, if shareholders own the corporation, the board of directors of a target corporation would have no proper role in reponding to a tender offer. The shareholders' decision to tender their shares to the bidder would no more concern the institutional responsibilities or prerogatives of the board than would the shareholders' decision to sell their shares on the open market or, for that matter, to sell their homes. Both stock and a home would be treated as species of private property freely alienable by their owners. Yet, as we all know, corporate law confers an effective gatekeeping function on the target's board of directors by allowing them to deploy potent takeover defenses.

In discussing corporations, it is easy to lose sight of the overriding fact—that firms are nothing more than groups of people. We often find ourselves using jargon like owners, monitors, team members, agent, principal, partner, manager, employee, and shareholder. We also often find ourselves engaged in a form of reification—treating firms as though they were things having an existence separate from the people who comprise them—when we say things like “General Motors did so and so.” General Motors is a firm; it is pure fiction to say General Motors did anything. Reification is often useful, or even necessary, because it permits us to utilize a form of shorthand—it is easier to say General Motors did so and so than to attempt in conversation to describe the complex process which actually may have taken place. Indeed, it is very difficult to think about large firms without reifying them. Reification, however, can be dangerous. It becomes easy to lose sight of the fact that firms aren't things, they are simply a group of people for whom the law has provided an off-the-rack relationship we call the corporation. There simply is nothing there that can be owned.

Shareholder Activism and Heterogeneity

It's good to see long time shareholder activist Bob Monks has realized that shareholders are heterogenous. But does he realize the extent to which that observation undercuts the case for shareholder activism?

As my colleague Iman Anabtawi observed: “On close analysis, shareholder interests look highly fragmented.” Iman Anabtawi, Some Skepticism About Increasing Shareholder Power 4 (unpublished manuscript on file with author). She documents divergences among investors along multiple fault lines: short-term versus long-term, diversified versus undiversified, inside versus outside, social versus economic, and hedged versus unhedged. Shareholder investment time horizons are likely to vary from short-term speculation to long-term buy-and-hold strategies, for example, which in turn is likely to result in disagreements about corporate strategy. Even more prosaically, shareholders in different tax brackets are likely to disagree about such matters as dividend policy, as are shareholders who disagree about the merits of allowing management to invest the firm’s free cash flow in new projects.

Consequently, as I explain in The Case for Limited Shareholder Voting Rights, it is hardly surprising that the modern public corporation’s decision-making structure precisely fits Kenneth Arrow’s model of an authority-based decision-making system. Overcoming the collective action problems that prevent meaningful shareholder involvement would be difficult and costly, of course. Even if one could do so, moreover, shareholders lack both the information and the incentives necessary to make sound decisions on either operational or policy questions.  Under these conditions, it is “cheaper and more efficient to transmit all the pieces of information to a central place” and to have the central office “make the collective choice and transmit it rather than retransmit all the information on which the decision is based.”  Accordingly, shareholders will prefer to irrevocably delegate decision-making authority to some smaller group.

What is that group? The Delaware code, like the corporate law of virtually every other state, gives us a clear answer: the corporation’s “business and affairs ... shall be managed by or under the direction of the board of directors.”  Hence, as an early New York decision put it, the board’s powers are “original and undelegated.” Manson v. Curtis, 119 N.E. 559, 562 (N.Y. 1918). 

The central argument against shareholder activism thus becomes apparent. Active investor involvement in corporate decision making seems likely to disrupt the very mechanism that makes the public corporation practicable; namely, the centralization of essentially non-reviewable decision-making authority in the board of directors. The chief economic virtue of the public corporation is not that it permits the aggregation of large capital pools, as some have suggested, but rather that it provides a hierarchical decision-making structure well-suited to the problem of operating a large business enterprise with numerous employees, managers, shareholders, creditors, and other inputs. In such a firm, someone must be in charge: “Under conditions of widely dispersed information and the need for speed in decisions, authoritative control at the tactical level is essential for success.”  While some argue that shareholder activism “differs, at least in form, from completely shifting authority from managers to” investors, it is in fact a difference in form only. Shareholder activism necessarily contemplates that institutions will review management decisions, step in when management performance falters, and exercise voting control to effect a change in policy or personnel. For the reasons identified above, giving investors this power of review differs little from giving them the power to make management decisions in the first place. Even though investors probably would not micromanage portfolio corporations, vesting them with the power to review board decisions inevitably shifts some portion of the board’s authority to them. This remains true even if only major decisions of A are reviewed by B. The board directors of General Motors, after all, no more micromanages GM than would a coalition of activist institutional investors, but it is still in charge.

Ulen Festschrift

The University of Illinois Law Review has just published a symposium issue in honor of my friend and former UIUC colleague Tom Ulen:

Professor Ulen received a bachelor’s degree from Dartmouth College, a master’s from St. Catherine’s College, Oxford, and a Ph.D. in economics from Stanford University. He holds a Swanlund Chair, one of the highest endowed titles on the Urbana-Champaign campus, and is director of the College’s Program in Law and Economics. In addition, he is a research affiliate of the Environmental Council, a member of the Campus Honors faculty, and holds positions in the Department of Economics and the Institute for Government and Public Affairs.

Recently, Professor Ulen served as a visiting professor at the University of Bielefeld, and as the foreign chair in international and comparative law at the University of Ghent, Belgium. He has previously been a visiting professor in Belgium, Germany, Slovenia, and a Ford Foundation Professor in Shanghai, China.

As a scholar, Professor Ulen examines a variety of issues related to economics, legal scholarship, and legal education. He has recently completed work on two new books,Cognition, Rationality, and the Law (with Russell Korobkin; University of Chicago Press) and Foundations of Environmental Policy (with John B. Braden, Edward Elgar Publishers, Ltd.). His book, Law and Economics (with Robert Cooter), now in its fourth edition, has been translated into Chinese, Japanese, Spanish, Korean, French, and Russian.

A prolific writer and researcher, Professor Ulen has contributed four entries—on regulation generally, quantity regulation, price regulation, and quality regulation—for the Oxford Economic History of the United States and a chapter entitled, “The Limits of Law for Imperfectly Rational Actors” for Law and Irrational Behavior (Francesco Parisi, ed., University of Chicago Press, 2003). In addition, he is editing a book of legal humor, and expanding his Illinois Law Review article, “A Nobel Prize in Legal Science,” into a book.

Professor Ulen was a member of the founding board of directors of the American Law and Economics Association and has served as a member of the editorial board of several professional journals. He is also a co-organizer, with Professor Tom Ginsburg and Professor Richard McAdams, of the Midwest Law and Economics Association Annual Meeting at the College of Law.

As John Colombo observed of Tom in his introduction to the symposium:

When one uses the phrase law and economics, it almost automatically invokes the name of Richard Posner, and there is no denying Pos- ner’s importance to the field. But Tom has been equally instrumental, perhaps even more instrumental, in making law and economics the wide- spread and widely studied discipline that it is. The Cooter and Ulen text on law and economics, now in its fifth edition and translated into a dozen different languages (including Chinese—which if nothing else goes to show how well Tom understands market economics), made law and eco- nomics a teachable discipline. The text has spawned two generations of students who “grew up” learning the discipline and has provided a framework for future thought in the field. And it is not just this text; Tom has written dozens of articles in the field pushing the boundaries of Law and Economics forward while recognizing its limitations. He has been a tireless advocate for the discipline, seeding it at universities throughout the world, and he is a constant ambassador for it everywhere he goes. 

There are several papers that will beof interest to regular readers of this blog, including:

Law and Economics in Japan
J. Mark Ramseyer   |   2011 U. Ill. L. Rev. 1455
Download PDF | Abstract

The Future of Law and Finance After the Financial Crisis: New Perspectives on Regulation and Corporate Governance for Banks
Dirk Heremans & Katrien Bosquet   |   2011 U. Ill. L. Rev. 1551
Download PDF | Abstract

Bail-Ins: Cyclical Effects of a Common Response to Financial Crises
Amitai Aviram   |   2011 U. Ill. L. Rev. 1633
Download PDF | Abstract

All in all, a well-deserved tribute to a wonderful scholar and great person. I'm glad I'm not at Illinois anymore for a lot of reasons (weather being prominent among them) but Tom is one of the things I miss about the place a lot.

The case for Alchian, Demsetz, and Klein

Maybe it's my UCLA bias or the fact that they wrote a lot about firms and governance, but I want to wholeheartedly endorse Josh Wright's argument that Armen Alchian, Harold Demsetz and Benjamin Klein Should Win the Economics Nobel Prize in 2011:

Alchian’s contributions to economics and law and economics are Nobel worthy. Armen’s classic paper with Harold Demsetz (AER, 1972) remains influential in the theory of the firm literature and is listed as the 12th most important paper in economics since 1970 by Kim et al.  Klein, Crawford and Alchian’s seminal analysis of vertical integration and the holdup problem (JLE, 1978) ranks #30 on this list.  With two hits in the top 30 economics papers since 1970, there is no doubt that Armen had impacted the field.  Susan Woodward, a former co-author of Alchian, has authored a wonderful chapter on Alchian’s contributions to law and economics that will appear in the Cohen & Wright Pioneers of Law and Economics volume (there will also be essays on Klein and Demsetz).  As I’ve written previously, Alchian also thrives by other measures of scholarly output.  Cite counts do not begin to do his body of work justice.  Consider, for example, that Armen’s teaching style is the stuff of legend (I say this having the great benefit of having Armen on my dissertation committee, but also sharing as colleagues two Bruin economists that studied under Alchian and knowing many more).  Tales are abound of the careers of economists-in-the-making that Armen influenced in one way or another. ...

As strong as the case for an Alchian Nobel is, the likelihood of a solo Nobel in the areas of the theory of the firm or property rights is unlikely.  And what better way to share the prize than with two co-authors who have made substantial and significant contributions, but individually and collectively, to economic problems involving the theory of the firm, property rights and transaction cost economics taking a similar methodological approach and bringing distinction to the UCLA School of economics.  I’ve written extensively about Klein’s contributions here.  But the most well known contributions (in addition to Klein, Crawford Alchian (1978) and the important exchange between Coase and Klein concerning asset specificity, vertical integration and contracting) include Klein & Leffler (1981), Priest & Klein (1984), Klein and Murphy (1988) and Klein (1995) and Klein (1996) ranging on topics from the role of reputation in the design and performance of contracts, the seminal model of litigation and settlement, vertical restraints, and the economics of franchising.

Demsetz’s contributions to economics are perhaps the most well known of the trio, including the coining of the phrase “Nirvana Fallacy,” but a cursory list as a refresher for the Nobel Committee:

• 1967, “Toward a Theory of Property Rights,” American Economic Review.
• 1968, “Why Regulate Utilities?” Journal of Law and Economics.
• 1969, “Information and Efficiency: Another Viewpoint,” Journal of Law and Economics.
• 1972 (with Armen Alchian, “Production, Information Costs and Economic Organization,” American Economic Review.
• 1973, “Industry Structure, Market Rivalry and Public Policy,” Journal of Law and Economics.
• 1979, “Accounting for Advertising as a Barrier to Entry,” Journal of Business.
• 1982. Economic, Legal, and Political Dimensions of Competition.
• 1988. The Organization of Economic Activity, 2 vols. Blackwell. Reprints most of Demsetz’s better known journal articles published as of date.
• 1994 (with Alexis Jacquemin). Anti-trust Economics: New Challenges for Competition Policy.
• 1995. The Economics of the Business Firm: Seven Critical Commentaries.
• 1997, “The Primacy of Economics: An Explanation of the Comparative Success of Economics in the Social Sciences” (Presidential Address to the Western Economics Association), Economic Inquiry.

And of course, most recently, Professor Demsetz released his newest book, From Economic Man to Economic System on Cambridge University Press.

Josh's post has lots of quotes from leading figures praising the trio, especially Alchian.

Smith on Shareholders

Gordon Smith has posted to SSRN an essay entitled The Role of Shareholders in the Modern American Corporation (August 13, 2011):

This chapter from the forthcoming Research Handbook on the Economics of Corporate Law (Claire Hill & Brett McDonnell, eds.) examines the role of shareholders in the modern American public corporation. The chapter starts with the Berle and Means (1932) problem of the separation of ownership and control, but notes that the rise of institutional investors has changed the situation. Shareholders have three main sets of rights through which they can protect themselves: the right to vote, to sell, and to sue. Each of these rights has evolved significantly in recent years. The chapter describes some of the changes and debates, and also briefly addresses the question of the proper beneficiaries of corporate decisions.

An excellent critical review of the key literature. A recommended read.

Corporate criminal liability

A very interesting new paper by Jennifer Arlen deals with the issue of corporate criminal liability. She writes:

This Chapter examines the existing structure of corporate criminal liability, providing empirical evidence on the types of firms convicted and the magnitude and nature of the sanctions imposed. It then examines whether existing U.S. enforcement practice is consistent with optimal corporate liability, especially for firms where ownership is separated from day-to-day control. The first part of this analysis determines the optimal structure of corporate liability. It shows that optimal corporate liability has different purposes, and thus a different structure, from individual criminal liability (Becker, 1968) whenever the optimal deterrence requires expenditures to detect and investigate corporate wrongdoing. This chapter also shows that the core purposes of corporate liability and optimal structure differ fundamentally from those articulated by the classic economic models of vicarious liability (Kornhauser, 1982; Sykes, 1984) and from analyses of corporate criminal liability that employ a similar model (Polinsky and Shavell, 1993). In contrast with these analyses, firms should not be strictly criminally liable for their employees’ crimes. Instead, corporate criminal liability should be duty-based, in that firms should be able to avoid criminal liability if they engage in optimal policing (monitoring, self-reporting, and cooperating). This structure is consistent with the current regime. Moreover, in contrast with classic analysis which holds that the state should reduce corporate criminal liability to reflect individual criminal liability and market sanctions, this Chapter shows, the state should not reduce the duty-based criminal sanction to reflect either sanctions imposed on individual wrongdoers or market-sanctions. The state generally should impose residual civil liability on all firms, even those that undertake optimal policing; the state should reduce (or eliminate) the residual civil sanction to the extent that the firm otherwise bears the full expected cost of crime as a result of individual liability or market sanctions. Finally, this Chapter examines the federal government’s current practice of using deferred and non-prosecution agreements to impose structural reforms on firms and discusses analysis showing that this practice can be consistent with optimal deterrence when corporate policing decisions are distorted by agency costs.

Arlen, Jennifer, Corporate Criminal Liability: Theory and Evidence (July 20, 2011). RESEARCH HANDBOOK ON CRIMINAL LAW, Keith Hylton and Alon Harel, eds., Forthcoming; NYU Law and Economics Research Paper No. 11-25. Available at SSRN: http://ssrn.com/abstract=1890733

The distinction between uncertainty and risk: A West Point perspective

Risk and uncertainty, of course, are bedrock principles/problems of business and business law. I just read an interesting paper on the distinction between the two, which fortunately is free at the moment at the Journal of Applied Corporate Finance but soon will be buried behind the Journal's paywall. Here's the abstract:

In this edited transcript of a presentation at the CARE/CEASA conference, a U.S. army officer who teaches economics and finance at West Point discusses the Army's approach to managing uncertainty and risk while reflecting on his own two tours of duty in Iraq. The U.S. military makes a clear distinction between risk and uncertainty. Whereas “risks” are threats to a mission or operation that can be identified, and at least to some degree controlled or mitigated, “uncertainty” applies to unknown or ambiguous hazards that resist any application of probability theory or quantitative methods. The risk mitigation process begins with assessments of the probability and severity of a given risk followed by the development of controls designed to limit that risk. Once the controls are implemented, the process becomes a continuous feedback loop in which the controls are evaluated and, if ineffective, either adjusted or eliminated. The Army has two main ways that it tries to mitigate uncertainty: the “information‐focused” solution and the “action‐focused” solution. The information‐focused solution aims to reduce uncertainty by getting better information, and processing and disseminating it more quickly than the enemy. It also aims to avoid the illusion of precision that can come from too detailed predictions and instead plans for a worst‐case scenario as well as a most‐likely scenario. The action‐focused solution acknowledges that, no matter how good your information, some uncertainty is unavoidable, and the aim of this part of the program is to develop, train, and maintain units that can fight and win in the face of uncertainty. Much of this capability is attributed to training and a mission command framework in which intensive strategic planning (involving “the who, what, when, where and why of an undertaking”) and communication of the plan to field commanders and subordinate leaders is combined with heavy emphasis on the exercise of initiative by those field commanders and leaders.

Do we really need the SEC?

Maybe not if a new paper by, inter alia, Brian Cheffins is correct. In it, he and his coauthors argue that:

This study of initial public offerings (IPOs) carried out on the Berlin and London stock exchanges between 1900 and 1913 casts doubt on the received “law and finance” wisdom that legally mandated investor protection is pivotal to the development of capital markets. IPOs that resulted in official quotations on the London Stock Exchange performed as well as Berlin IPOs despite the Berlin market being more extensively regulated than the laissez faire London market. Moreover, the IPO failure rate on these two stock markets was lower than it was with better regulated US IPOs later in the 20th century.

Citation: Chambers, David, Burhop, Carsten and Cheffins, Brian R., Is Regulation Essential to Stock Market Development? Going Public in London and Berlin, 1900-1913 (July 12, 2011). Available at SSRN: http://ssrn.com/abstract=1884190

Group decision making

Some years ago, I wrote an article entitled Why a Board? Group Decisionmaking in Corporate Governance. Vanderbilt Law Review, Vol. 55, pp. 1-55, 2002. Available at SSRN: http://ssrn.com/abstract=266683. In it, I argued that:

The default statutory model of corporate governance contemplates not a single hierarch but rather a multi-member body that acts collegially. Why? This article reviews evidence that group decisionmaking is often preferable to that of individuals, focusing on evidence that groups are particularly likely to be more effective decisionmakers in settings analogous to those in which boards operate. Most of this evidence comes not from neo-classical economics, but from the behavioral sciences. In particular, cognitive psychology has a long-standing tradition of studying individual versus group decisionmaking. This article contends that behavioral research, taken together with various strands of new institutional economics, sheds considerable light on the role of the board of directors. In addition, the analysis has implications for several sub-regimes within corporate law. Are those sub-regimes well-designed to encourage optimal board behavior? Two such sub-regimes are surveyed here: First, the seemingly formalistic rules governing board decisionmaking processes turn out to make considerable sense in light of the experimental data on group decisionmaking. Second, the adverse consequences of judicial review for effective team functioning turns out to be a partial explanation for the business judgment rule.

Ever since then, I've kept an eye out for interesting new research on group versus individual decision making. The latest to catch my eye is When Do Groups Perform Better than Individuals? A Company Takeover Experiment, which unlike many relevant studies has direct application to corporate governance:

It is still an open question when groups will perform better than individuals in intellectual tasks. We report that in a company takeover experiment, groups placed better bids than individuals and substantially reduced the winner’s curse. This improvement was mostly due to peer pressure over the minority opinion and to group learning. Learning took place from interacting and negotiating consensus with others, not simply from observing their bids. When there was disagreement within a group, what prevailed was not the best proposal but the one of the majority. Groups underperformed with respect to a “truth wins” benchmark although they outperformed individuals deciding in isolation.

Very interesting and very pertinent to those of us who try to figure out how to make boards more effective by improving group decision making processes.

Stochastic Process Models of Accounting Fraud

My friend Mike Guttentag has posted an ambitious and very interesting paper to SSRN etitled Stumbling into Crime: Stochastic Process Models of Accounting Fraud:

This book chapter introduces the use of stochastic process modeling to the analysis of how a sequence of minor and seemingly innocuous transgressions may lead to accounting fraud.

Wondering what "stochastic process modeling" is? Candidly, so was I:

Stochastic process models are a mathematical tool used to analyze a phenomenon in which observable “macroscopic” behavior is produced by the cumulative effect of numerous “microscopic” events. Such a model is especially useful when the “microscopic” events cannot be easily observed. This is likely the situation if seemingly minor and inconsequential transgressions lead to accounting frauds.

Three related types of stochastic process models are well-suited to describe the dynamics within a firm that could lead to accounting fraud. The first type of model is based on the movement of a random walker. To apply a random walk stochastic process model to accounting fraud, it is helpful to assume that the illegality of behavior within a firm can be measured along a single dimension and that movement along this “illegality” dimension is determined by a sequence of minor decisions. The resulting random walk stochastic process model of accounting fraud yields testable hypotheses about when and where accounting frauds are likely to occur.

However, a simple random walk model fails to incorporate several important aspects of the process by which minor transgressions might lead to accounting fraud. For one thing, a random walk model is non-stationary, so that over time the walker wanders farther and farther away from the starting point. However, one would not expect the level of lawful or unlawful activity within a firm to become more and more extreme over time. To account for the fact that the level of misbehavior within a firm usually stays within a given range, a mean-reverting force can be added to the simple random walk stochastic process model. The resulting stochastic process model is stationary, which may better describe the dynamics within a firm that lead the level of misbehavior to only occasionally become highly aberrant.

A second limitation of the simple random walk model is that it cannot be used to model a situation in which, once a certain boundary is crossed, it is difficult to return to where one has been. There are likely many instances during the process leading to accounting fraud in which actions are taken which are difficult to undo. For example, once a firm makes a public disclosure about its financial condition, the firm’s ability to restate past performance will be limited. To take into account the likelihood that certain behaviors (such as publicly reporting financial performance), once made, will be difficult to reverse, the random walk model can be supplemented with a running maximum. This is the third type of stochastic process model I consider in this Chapter.

News Corp and free cash flow

News Corp has decided not to go forward with its bid to buy the shares of BSkyB that it did not already own. As somebody who teaches mergers and acquisitions, I was struck by one aspect of the story:

News Corp. benefits from strong liquidity, with $11.8 billion of cash and over $2.5 billion of annual free cash flow. Additionally, credit metrics remain strong, with leverage of 2.7 times (x) at March 31, 2011, below Fitch's 3x target. News Corp. retains significant financial flexibility to pursue merger and acquisition (M&A) and share buyback activities without impacting its 'BBB+' ratings. ...

Fitch believes that News Corp. will seek to deploy much of its cash over the next 12-24 months, with the company stating multiple times that the high cash balance is inefficient. In Fitch's view, BSkyB had been the best possible use of this cash, given the free cash flow, geographical diversification, and recurring revenue associated with the acquisition.

Apparently News Corp also thought buying BSkyB was the best use for all that cash it had lying around, which brings us to the lesson of the day: Managers with too much free cash flow do dumb things.

Successful managers end up with a lot of cash for which they have no good use. In technical terms, they end up with cash flows greater than the positive net present value investments available to the firm. Disbursing these free cash flows to shareholders in the form of dividends would (a) be costly because of the double taxation on dividends and (b) increase management risks because a smaller asset pool increases the risk of firm failure in the event of financial reverses. Accordingly, even well-meaning managers have an incentive to retain free cash flow by making negative net present value investments.

Venal managers have even more incentives to abuse free cash flows. They can splurge on perks. The annals of American business corporations are replete with examples of both forms of shirking, ranging from congenital unluckiness, to incompetence, to outright theft.

They can protect their own interests through inefficient intra-firm diversification. 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. Unfortunately, managers with too much free cash flow still sometimes pursue this strategy.

They can engage in empire building. Bigger is typically better from management’s perspective. Just like putting oriental rugs down on the floor, bigger organizational charts on the wall are a management perk. If size reduces the chances of firm failure, management even has a financial incentive to pursue such acquisitions. As with acquisitions motivated by a desire for intra-firm diversification, empire building acquisitions doubtless reduce shareholder wealth. Free markets are self-correcting, however. Empirical studies confirm that bidders motivated by considerations other than shareholder wealth maximization themselves tend to become targets.

Managers with excess free cash flow thus have a couple of choices. They can spend it on negative net present value investments, like empire building, and hope that their poison pill and other takeover defenses can insulate them from the forces of the free market.

Or they can sop up that free cash flow by getting it out to the shareholders, typically via a share repurchase. Stock repurchase programs should have the desirable effect of supporting the company’s stock price by (1) lessening the number of outstanding shares and (2) acting as a signal that management is supportive of shareholder interests. As a high stock price is an excellent takeover defenses, such repurchase programs have become a common feature of corporate governance.

Interestingly, even though News Corp reincorporated in Delaware (from Australia) a few years ago for the express purpose of being able to adopt a poison pill, its management seemingly has decided that hiding behind the pill is not the right thing to do in this environment. So News Corp has announced that instead of buying BSkyB, its board of directors has approved a $5 billion stock repurchase to start later this year.

Given that News Corp has $2.5 in annual free cash flow, however, a one time repurchase is just a temporary solution. As a takeover defense, stock repurchases will be most effective when the corporation has a large amount of free cash (cash for which there are no positive NPV transactions), but no substantial free cash flows. If the corporation has on-going free cash flows, a one-time stock repurchase is unlikely to have a permanent stock price effect. In order to make such a target a less attractive takeover candidate, an on-going program of regular stock repurchases will be necessary.

It'll be interesting to see what News Corp does next.