ProfessorBainbridge.com

Comparing Tyco's Kozlowski and Deutsche Bank's Ackermann

There is an interesting parallel set of prosecutions going on in the US and Germany. In the latter, the WSJ (sub. req'd) is reporting that Deutsche Bank CEO Josef Ackermann (and some other supervisory board members of Mannesmann AG) have been charged with approving bonuses for Mannesmann executives following approval of Mannesmann's acquisition by Vodafone. In the US, as CNNfn is reporting, the trial of former Tyco CEO Kozlowski began today.

The two cases illustrate a striking difference between US and German law. In US law, executive compensation typically is an issue for private litigation, typically involving shareholder derivative litigation charging waste of corporate assets. Kozlowski's case is a very rare exception to that rule, in which prosecutors are charging that Kozlowski stole from the corporation. The key charge in the indictment is that Kozlowski borrowed money from Tyco and then stole it by causing the "loans to be forgiven without the board's knowledge." If Kozlowski can prove that the board knew and approved the loan forgiveness, I don't see how the charges can stick. Indeed, I'm not convinced the charges will stick even if all Kozlowski can prove is that the loans were properly processed by corporate subordinates (specifically the firm's accounting department).

In contrast, under German law, criminal prosecutions over allegedly excessive executive compensation are a lot easier. The Economist explains that "Paragraph 87 of Germany's securities law says that [bonuses] to board members should bear a 'reasonable relationship to their duties'." I gather that such prosecutions are pretty rare in Germany and that this prosecution is especially controversial.

Personally, I think criminalizing the issue of excessive executive compensation is just nuts. But prosecuting not just the executives who got paid too much but also the board members who approve the payments is really crazy. Public corporations are finding it increasingly difficult to recruit and retain qualified independent directors. Relatively low pay, compensation in stock rather than cash, and increased time demands and liability exposure have all combined to render board service far less attractive than it once was. Criminalizing their executive compensation decisions, which are among the most controversial decisions a board makes, however, would make an bad situation almost impossible. What sane person would be willing to sit on a corporate board?

Pine Ridge Cabernet Sauvignon Rutherford (Napa Valley) 2000

I picked up a case of this wine last spring when we visited the Napa Valley. Fortunately, a Wine Spectator tasting note (subscription req'd) warned me that: "Intensity tails off on the finish, making this a good bet for near-term consumption." I tend to agree; this wine lacks the stuffing for long-term cellaring. In the short-term, however, wow!

Medium-deep purple-red shading to ruby at the rim. Big nose -- great blast of Napa cabernet fruit: currants, milk chocolate, and a whiff of the humidor. The palate follows the nose: smooth tannins, dark fruits, herbs, tobacco, lead pencil shavings. Short finish, though. Grade: B++

The Influence of Catholic Social Thought on My Scholarship

One of my principal scholarly interests is Catholic social teaching on corporations and the economy. In fact, I am the only person I know who came to Catholicism through economic analysis of corporate governance. A couple of years ago I wrote a series of law review articles about participatory management – i.e., employee involvement in corporate governance. One of the questions in which I got interested was whether employees have a right to participate in corporate decisionmaking, which lead to an inquiry into natural law, which in turn stimulated an interest in faith-based analyses of corporate governance. At the time, I was an evangelical disgruntled with the state of evangelical scholarship (Mark Noll, who I regard as the doyen of evangelical scholars and church historians, wrote a great book on this problem: The Scandal of the Evangelical Mind, which I keep meaning to review). Catholic social teaching struck me as the only well-developed faith-based account around. I relied on it in writing Corporate Decisionmaking and the Moral Rights of Employees: Participatory Management and Natural Law, 43 Villanova Law Review 741 (1998). Reading the papal encyclicals on the economy, especially John Paul II’s Centesimus Annus, and Michael Novak’s books, especially Toward a Theology of the Corporation (which I also keep meaning to review), in doing the research on that project got me interested in Catholicism. (I’m also a longtime reader of the fabulous magazine First Things, which probably lay the groundwork.) One thing lead to another—i.e., RCIA–and my wife and I eventually were received into the Catholic church.

My first post-conversion attempt at merging my interest in Catholic social teaching and corporate governance was The Bishops and the Corporate Stakeholder Debate, 4 Villanova Journal of Law and Investment Management 3 (2002). That essay critiqued Catholic social teaching on corporate social responsibility. Specifically, it focused on one of the policy recommendations made by the U.S. Bishops in their pastoral letter on economic justice, Economic Justice for All: Pastoral Letter on Catholic Social Teaching and the U.S. Economy. In that document, the Bishops addressed the long-running stakeholder debate; i.e., they claimed that decisionmaking by directors of public corporations should take into account the interests of corporate constituencies other than shareholders. My article evaluated three ways in which the Bishops’ position might be translated into public policy: (1) directors could be given nonreviewable discretion to make trade-offs between shareholder and stakeholder interests; (2) directors could be given reviewable discretion to make such trade-offs; or (3) directors could be required to make such trade-offs subject to judicial (or regulatory) oversight. None of these approaches, I argued, is an improvement on current law; to the contrary, all are worse. The first approach would be toothless, the second would increase agency costs, and the third would either prove unworkable or pose an unwarranted threat to economic liberty (or both).

It might seem somewhat churlish to have dissented so soon after switching sides. In my view, however, it is the task of Catholic intellectuals to exercise critical reflective judgment with respect to society, the Church, and the relationship between the two. Of course, I recognize that there is a fine line between the exercise of critical evaluative judgment and illegitimate dissent. With respect to the stuff I write about, however, I don’t think this is a problem. When it comes to issues such as the degree of state intervention in the economy, the Church outlines basic principles but recognizes substantial latitude with respect to their translation into public policy. Nowhere, for example, does the Church state what percentage of the economy should by controlled by the state, which leaves a great deal of room for prudential judgment by the Catholic laity. In promulgating their pastoral letter, moreover, the Bishops expressly acknowledged that their “prudential judgments” about specific policy recommendations were not made “with the same kind of authority that marks our declarations of principle.” (xii.) More to the point, perhaps, in Centesimus Annus (para. 43), the Pope reminded us that the Catholic “church has no models to present.”

Anyway, since one of the main purposes of this blog (besides relentless self-promotion) is writing up ideas that I don’t want to write a 50+ page law review article about, you can expect the occasional posting about Catholic social teaching on corporate governance.

Who was the Greatest US Supreme Justice? A Corporate/Securities Law Perspective

I was recently given a copy of Bernard Schwartz's entertaining book, A Book of Legal Lists, which includes lists of both the 10 greatest and 10 worst US supreme court justices. Those chapters reminded me of an article I wrote with my friend (and, regretably, former colleague) Mitu Gulati a few years ago, in which we had occasion to make an objective empirical evaluation of greatness on the part of modern supreme court justices.

As a proxy for the importance of cases decided by the Supreme Court, we looked at opinions that found their way into the casebooks. Specifically, we looked at thirty-eight currently used case books on Corporations, Business Associations, Securities Regulation, and Corporate Finance. For each casebook, we counted the number of securities and corporate opinions by the various Supreme Court justices. If the same case appeared in two casebooks, it was counted twice, and so on. We assumed more important cases would appear in more casebooks and that greatness would translate into a justice being assigned the most important (and most often reproduced) cases.

The table reveals a dramatic dominance effect for the late Justice Lewis Powell, both in terms of his overall number of securities and corporate cases in casebooks and his per year entry rate. In terms of total cases, Powell has sixty-one and only two other justices have more than 20 (White (22) and Blackmun (21); Marshall comes next closest with 19). A similar skew is present in the per year entry rates. Powell has an average of four securities or corporate cases entering the casebooks per year. The next closest number is 1.25. Finally, note that these are only comparisons for only those justices who have securities or corporate cases in the casebooks. Most have none. So, for our purposes, Lewis Powell ranks as the Greatest Supreme Court Justice. Your mileage, of course, may vary.

An alternate to the expertise/greatness hypothesis might be that Powell was simply a superior casebook opinion writer. While we did not test this alternate hypothesis, anecdotal evidence suggests that Powell did not having anything close to the same level of influence in other areas. He was an excellent opinion writer and among the more influential justices of his time. But his clear dominance was limited to the business areas. See Richard A. Posner, Cardozo: A Study in Reputation (1990) (commenting on Powell’s skill at opinion writing and comparing the influence levels of a set of different justices); Montgomery N. Koma, Measuring the Influence of Supreme Court Justices, 27 J. Legal Stud. 333 (1998) (ranking the justices according to influence levels as measured by citations).

Guttman v. Huang: Del VC Strine on audit committee due care standards

In recent years, increasing regulatory attention has been devoted to the role of the audit committee. In 1999, the major stock exchanges adopted new listing standards (after being prodded by then-SEC Chairman Arthur Levitt in a classic example of how the SEC uses (arguably, abuses) its “raised eyebrow” power) toughening the rules on audit committees. See generally 64 Fed. Reg. 71, 529 (Dec. 21,1999). Likewise, the SEC adopted new disclosure requirements, most notably requiring an annual Audit Committee Report in the proxy statement. Regulation S-K item 306; Schedule 14-A item 7(d)(3). Sarbanes-Oxley and the accompanying stock exchange listing standard amendments further ratcheted up the burdens on audit committees.

A (relatively) new Delaware chancery court opinion by Vice Chancellor Leo Strine sheds light on the state corporation law fallout from these developments. Guttman v. Huang, 823 A.2d 492 (Del. Ch. 2003). Strine is a very smart fellow, with a strong academic bent, who has written a number of important decisions of late. His opinion in Guttman is the best recent summary of the rules of audit committee liability.

Generally, corporate directors and officers owe their firm and its shareholders three basic fiduciary duties: care, loyalty, and good faith. See, e.g., Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 361 (Del. 1993). Of these, the duty of care is most relevant for present purposes. The duty of care requires corporate directors to exercise “that amount of care which ordinarily careful and prudent men would use in similar circumstances.” Graham v. Allis-Chalmers Mfg. Co., 188 A.2d 125, 130 (Del.1963). Central to the duty of care is an obligation for directors and officers to avail themselves, “prior to making a business decision, of all material information reasonably available to them.” Aronson v. Lewis, 473 A.2d 805, 811 (Del. 1984); see also Smith v. Van Gorkom, 488 A.2d 858, 872 (Del. 1985). Where the directors have so informed themselves, however, judicial review of their decisions and actions is precluded by the duty of care’s chief corollary—the business judgment rule. [NB: In addition to an informed decision, there are a number of other preconditions that must be satisfied in order for the business judgment to insulate a board’s decisions or actions from judicial review. See generally Stephen M. Bainbridge, Corporation Law and Economics 270-83 (2002) (discussing preconditions).]

The business judgment rule, of course, is a presumption that the directors or officers of a corporation acted on an informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the company. Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984). “While it is often stated that corporate directors and officers will be liable for negligence in carrying out their corporate duties, all seem agreed that such a statement is misleading. . . . Whatever the terminology, the fact is that liability is rarely imposed upon corporate directors or officers simply for bad judgment and this reluctance to impose liability for unsuccessful business decisions has been doctrinally labeled the business judgment rule.” Joy v. North, 692 F.2d 880, 885 (2d Cir. 1982). See also Kamin v. American Express Co., 383 N.Y.S.2d 807 (Sup.Ct.1976), aff’d, 387 N.Y.S.2d 993 (App. div.1976) (holding that the duty of care “does not mean that a director is chargeable with ordinary negligence for having made an improper decision, or having acted imprudently”); Bayer v. Beran, 49 N.Y.S.2d 2, 6 (Sup. Ct. 1944) (stating that “although the concept of ‘responsibility’ is firmly fixed in the law, it is only in a most unusual and extraordinary case that directors are held liable for negligence in the absence of fraud, or improper motive, or personal interest”).

In the leading In re Caremark Int’l case, then-Delaware Chancellor William Allen opined that the directors’ duty of care includes an affirmative obligation to ensure “that appropriate information will come to its attention in a timely manner as a matter of ordinary operations.” In re Caremark Int’l Inc. Deriv. Litig., 698 A.2d 959, 970 (Del. Ch. 1996). Yet, it is critical to recognize the distinction drawn by Chancellor Allen between allegations involving lack of oversight by directors and mere inadequate oversight. The business judgment rule is relevant only where directors have actually exercised business judgment; in other words, there rule provides no protection where directors have made no decision at all. See, e.g., Aronson v. Lewis, 473 A.2d 805, 813 (Del. 1984) (stating that “the business judgment rule operates only in the context of director action”).

In Caremark, the corporation had no program whatsoever of internal controls to ensure that the corporation complied with key federal statutes governing its operations. When the corporation ran afoul of one of those statutes and was obliged to pay a substantial fine, a derivative suit was brought against the directors. In reviewing the merits of that claim for purposes of evaluating the settlement, Chancellor Allen noted that decisions made deep in the interior of an enterprise by relatively junior employees can have devastating consequences for the firm. Allen also noted two concurrent regulatory trends. On one hand, federal law increasingly uses criminal sanctions to ensure corporate compliance with various regulatory regimes. On the other, the federal criminal sentencing guidelines mitigate sanctions where the corporate defendant had law compliance programs in place. In light of these considerations, Allen rejected the defendants’ argument that “a corporate board has no responsibility to assure that appropriate information and reporting systems are established by management . . . .” Caremark, 698 A.2d at 969-70. Instead, as we have seen, he imposed an affirmative obligation for management and the board to implement systems of internal control. Because the Caremark directors had failed to take any action, the business judgment rule did not insulate them from (potential) liability for this failure. Instead, the duty of care controlled.

Where the board and management have established systems of internal control, however, the business judgment rule becomes the relevant standard of review. [NB: Indeed, it may be plausibly argued that the business judgment rule would insulate directors from liability even if the board considered the issue and then affirmatively decided not to adopt a system of internal controls relevant to the issue at hand. In theory, after all, a decision not to act does not differ from a decision to take action. In Caremark, moreover, Chancellor Allen made clear that directors who act in good faith through proper procedures are not liable even if, in retrospect, they made the wrong decision. Caremark, 698 A.2d at 967-68. The business judgment rule, as typically formulated, would seem to protect directors who rationally adopt either a minimal compliance program or even no program at all after weighing the costs against the benefits. Bainbridge, supra, at 296.

Hence, when reviewing how the directors have exercised their oversight function through an extant system of internal controls—as opposed to entirely failing even to create such a system—the standard of review becomes one that a plaintiff-shareholder can satisfy only with great difficulty. Plaintiff must show the traditional grounds on which the business judgment rule is set aside: fraud, illegality, or self-dealing.

Vice Chancellor Strine’s decision in Guttman v. Huang seems to blur this important distinction. In that decision, Vice Chancellor Strine opined that:

[T]he Caremark opinion articulates a standard for liability for failures of oversight that requires a showing that the directors breached their duty of loyalty by failing to attend to their duties in good faith. Put otherwise, the decision premises liability on a showing that the directors were conscious of the fact that they were not doing their jobs.

823 A.2d at 506. Guttman thus seems to establish a single standard of liability for cases involving negligent oversight through an extant system of internal controls and for failures to exercise oversight by failing to create such a system. If so, in my view, Guttman blurs a doctrinal distinction I regard as critical to understanding Caremark. (The two standards perhaps can be reconciled by arguing that directors who are “conscious of the fact that they were not doing their jobs” have “abdicated their functions,” which is not protected by the business judgment rule. Aronson v. Lewis, 473 A.2d 805, 813 (Del. 1984).)

Fortunately, even if Guttman is correct, the standard remains one which a derivative suit shareholder-plaintiff can satisfy only with great difficulty. Vice Chancellor Strine approvingly quoted a key passage from Chancellor Allen’s Caremark opinion:

Generally where a claim of directorial liability for corporate loss is predicated upon ignorance of liability creating activities within the corporation ... in my opinion only a sustained or systematic failure of the board to exercise oversight—such as an utter failure to attempt to assure a reasonable information and reporting system exists—will establish the lack of good faith that is a necessary condition to liability. Such a test of liability—lack of good faith as evidenced by sustained or systematic failure of a director to exercise reasonable oversight—is quite high. But, a demanding test of liability in the oversight context is probably beneficial to stockholders as a class, as it is in the board decision context, since it makes board service by qualified persons more likely, while continuing to act as a stimulus to good faith performance of duty by such directors.

Caremark, 698 A.2d at 971 (emphasis supplied), quoted in Guttman v. Huang, 823 A.2d 492, 506 (Del. Ch. 2003). Hence, the Vice Chancellor indicated that a Caremark claim must plead facts showing that, inter alia, “that the company lacked an audit committee, that the company had an audit committee that met only sporadically and devoted patently inadequate time to its work, or that the audit committee had clear notice of serious accounting irregularities and simply chose to ignore them or, even worse, to encourage their continuation.” Guttman, 823 A.2d at 507.

The bottom line thus seems to be that audit committees still receive substantial protection. Mere negligence still shpu;d not result in liability. Instead, a systemic breakdown in oversight or conscious disregard of clear problems is required. In my view, however, Vice Chancellor Strine would have done better to make clearer that the business judgment rule still applies in full force to an audit committee’s oversight functions. I have written a law review article entitled The Business Judgment Rule as Abstention Doctrine, forthcoming in the Vanderbilt Law Review, in which I explain in detail why courts generally should abstain from reviewing board decisions. In my view, those arguments carry over in full force to review of how an audit committee carries out its functions.

In brief, there is the problem of judging by hindsight. Decisionmakers tend to assign an erroneously high probability of occurrence to a probabilistic event simply because it ended up occurring. Christine Jolls et al., A Behavioral Approach to Law and Economics, 50 Stan. L. Rev. 1471, 1523 (1998). If a jury knows that the plaintiff was injured, the jury will be biased in favor of imposing negligence liability even if, viewed ex ante, there was a very low probability that such an injury would occur and that taking precautions against such an injury was not cost effective. Even where duty of care cases are tried without a jury, as in Delaware, judges who know with the benefit of hindsight that a business decision turned out badly likewise could be biased towards finding a breach of the duty of care. Cf. Chris Guthrie et al., Inside the Judicial Mind, 86 Cornell L. Rev. 777, 799-805 (2001) (discussing empirical evidence that judicial decisionmaking is tainted by the hindsight bias). Hence, there is a substantial risk that judges will be unable to distinguish between competent and negligent management because bad outcomes often will be regarded, ex post, as having been foreseeable and, therefore, preventable ex ante.

Second, business decisions are frequently complex and made under conditions of uncertainty. Accordingly, bounded rationality and information asymmetries counsel judicial abstention from reviewing board decisions. Judges likely have less general business expertise than directors. They also have less information about the specifics of the particular firm in question. To be sure, the old adage that “judges are not business experts” cannot be a complete explanation for the business judgment rule. Yet, many old adages have more than a grain of truth. So too does this one. Justice Jackson famously observed of the Supreme Court: “We are not final because we are infallible, but we are infallible only because we are final.” Neither courts nor boards are infallible, but someone must be final. Otherwise we end up with a never ending process of appellate review. The question then is simply who is better suited to be vested with the mantle of infallibility that comes by virtue of being final—directors or judges?

Corporate directors operate within a pervasive web of accountability mechanisms. A very important set of constraints are provided by a competition in a number of markets. The capital and product markets, the internal and external employment markets, and the market for corporate control all constrain shirking by directors and managers. Granted, only the most naïve would assume that these markets perfectly constrain director decisionmaking. It would be equally naïve, however, to ignore the lack of comparable market constraints on judicial decisionmaking. Market forces work an imperfect Darwinian selection on corporate decisionmakers, but no such forces constrain erring judges. As such, rational shareholders will prefer the risk of director error to that of judicial error.

Finally, judicial review could interfere with—or even destroy—the internal team governance structures that regulate board behavior. Research on relational teams –which are what boards and board committees are – shows that they are not only hard to monitor, but that they also are hard to discipline. Stephen M. Bainbridge, Why a Board? Group Decision Making in Corporate Governance, 55 Vand. L. Rev. 1, 49 (2002). Instead of external review, relational teams are best monitored by a combination of mutual motivation, peer pressure, and internal monitoring. As I have explained elsewhere in more detail, however, judicial review might well destroy the interpersonal relationships that foster these forms of internal board governance. Id. at 49-50.

In sum, Guttman is an interesting development, but one the Delaware courts should promptly clarify as incorporating the classic business judgment rule. The justifications for the business judgment rule apply in full force to the present setting.

What is the appropriate motivation for director nominees?

Over at TheCorporateCounsel.net Blog, Broc poses the titular question, and comments:

One aspect of boardroom reform that has not been fully explored is what should be an acceptable motivation for someone who seeks to serve as a director. Historically, directors have agreed to serve principally for the prestige and clublike atmosphere. Some have done it for the money - although this is unlikely the case for those directors that earn big dollars as officers at other companies.

At the recent BRT Roundtable on Corporate Governance, Fannie Mae CEO Franklin Raines explained that he joined Pfizer's board to enhance his ability to be an innovator - which in turn would benefit his employer. This is an honest and understandable answer - but does it serve the needs of Pfizer's shareholders to whom he now owes fiduciary duties?

Personally, I think you want directors motivated by precisely what motivated Raines -- i.e., healthy self-interest. In The Wealth of Nations, Adam Smith famously remarked:

It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages. [Book I, Chap.2.]

[In the course of conducting business, a business person generally] neither intends to promote the public interest, nor knows how much he is promoting it. [Instead, the business person] intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good. [Book IV, Chap. 2.]

Of course, Smith also famously railed against joint stock companies, which we now know to be error, but even mighty Homer nods.

Independent directors are not a panacea for the ills of corporate governance, as I have argued elsewhere, but independent directors motivated by a healthy concern for the self-interest do have considerable incentives to actively monitor management and to discipline poor managers. If the company fails on their watch, for example, the independent directors’ reputation and thus their future employability is likely to suffer. Those incentives are not perfect, of course, as demonstrated by the failures of independent directors at Enron and its ilk. But no motivation besides self-interest is more likely to elicit whatever benefits director independence can provide.

Random stock traders and the ECMH; with a review of Malkiel's Random Walk

An article in Nature claims: "Stock market traders show signs of zero intelligence." It reports on research by J. Doyne Farmer, of the Santa Fe Institute, which purports to find that "that economic decision-making is so varied and complex that it is hard to distinguish it from random choices." They set up a theoretical model that assumes "traders place orders at random rather than on the basis of shrewd calculation and observation of economic trends." The results of running that model replicate many of the statistical features of a real world stock market (the London Stock Exchange in the period 1998-2000). Not being a fan of theoretical modeling, I find this result less persuasive than if it were backed by actual empirical data on ivestor behavior.

The efficient capital markets hypothesis has long claimed that stock price movements are random. But in the ECMH model randomness refers not to trader behavior but to the proposition that stock price movements are serially independent. Randomness does not mean that the stock market is like throwing darts at a dart board. Stock prices go up on good news and down on bad news. If a company announces a major oil find, all other things being equal, the stock price will go up. Randomness simply means that stock price movements are serially independent: future changes in price are independent of past changes. In other words, investors can not profit by using past prices to predict future prices. Randomness in the ECMH thus is not inconsistent with the proposition that stock market actors are informed rational self-maximizers. In contrast, Nature claims that Farmer's research is inconsistent with that proposition: "by dispensing with even a restricted form of rationality, the new model is daring"

Like Tyler, I think Nature overstates the extent to which the standard ECMH model requires hard assumptions of rationality on the part of investors. Much recent work has been done on incorporating insights from noise theory and behavioral finance into the ECMH. (See also HERE.) Most economists simply do not believe in the extreme version of the ECMH that Nature lays out (as the Nature article itself acknowledges). To this extent, the article is arguing against a strawman. Instead, most economists and economically-minded lawyers who still adhere to ECMH now fall back on the old rule that "it takes a theory to beat a theory." In this view, the ECMH is a first approximation that does a better job of predicting market behavior than any other theory out there. When a theory comes along that generates profitable trading strategies inconsistent with ECMH that will be the day that the ECMH has been disproved. But this study is not that theory.

In RANDOM WALK DOWN WALL STREET, Burton Malkiel sets out the basics of modern corporate financial theory in a way accessible to the law reader. As a teacher of corporate finance to law students, I have recommended this book to my students for over 10 years. Numerous alumni have told me that was the best advise they got in law school (a sad commentary on American legal education, but that's another story).

Two basic theories are expounded here. First, modern portfolio theory (MPT), which elucidates the relationship between risk and diversification. Because investors are risk averse, they must be paid for bearing risk, which is done through a higher expected rate of return. As such, we speak of a risk premium: the difference in the rate of return paid on a risky investment and the rate of return on a risk-free investment. In the real world, we measure the risk premium associated with a particular investment by subtracting the short-term Treasury bill interest rate from the risky investment's rate of return. The risk premium, however, will only reflect certain risks. MPT differentiates between two types of risk: unsystematic and systematic. Unsystematic risk might be regarded as firm-specific risk: The risk that the CEO will have a heart attack; the risk that the firm's workers will go out on strike; the risk that the plant will burn down. These are all firm-specific risks. Systematic risk might be regarded as market risk: risks that affect all firms to one degree or another: changes in market interest rates; election results; recessions; and so forth. MPT acknowledges that risk and return are related: investors will demand a higher rate of return from riskier investments. In other words, a corporation issuing junk bonds must pay a higher rate of return than a company issuing investment grade bonds. Yet, portfolio theory claims that issuers of securities need not compensate investors for unsystematic risk. In other words, investors will not demand a risk premium to reflect firm-specific risks. Why? There is a mathematical proof, which relates to variance and standard deviation, but Malkiel explains it in a way that is quite intuitive. Investors can eliminate unsystematic risk by diversifying their portfolio. Diversification eliminates unsystematic risk, because things tend to come out in the wash. One firm's plant burns down, but another hit oil. Thus, even though the actual rate of return earned on a particular investment is likely to diverge from the expected return, the actual return on a well-diversified portfolio is less likely to diverge from the expected return. Bottom line? If you hold a nondiversified portfolio (say all Internet stocks), you are bearing risks for which the market will not compensate you. You may do well for a while, but it will eventually catch up to you (as it has recently for tech stocks).

The second pillar of Malkiel's analysis is the efficient capital markets theory (ECMH). The fundamental thesis of the ECMH is that, in an efficient market, current prices always and fully reflect all relevant information about the commodities being traded. In other words, in an efficient market, commodities are never overpriced or underpriced: the current price will be an accurate reflection of the market's consensus as to the commodity's value. Of course, there is no real world condition like this, but the securities markets are widely believed to be close to this ideal. There are three forms of ECMH, each of which has relevance for investors: **Weak form: All information concerning historical prices is fully reflected in the current price. Price changes in securities are serially independent or random. What do I mean by "random"? Suppose the company makes a major oil find. Do I mean that we can't predict whether the stock will go up or down? No: obviously stock prices generally go up on good news and down on bad news. What randomness means is that investors can not profit by using past prices to predict future prices. If the Weak Form of the hypothesis is true, technical analysis (a/k/a charting)-the attempt to predict future prices by looking at the past history of stock prices-can not be a profitable trading strategy over time. And, indeed, empirical studies have demonstrated that securities prices do move randomly and, moreover, have shown that charting is not a long-term profitable trading strategy. ** Semi-Strong Form: Current prices incorporate not only all historical information but also all current public information. As such, investors can not expect to profit from studying available information because the market will have already incorporated the information accurately into the price. As Malkiel demonstrates, this version of the ECMH also has been well established by empirical studies. Implication: if you spend time and effort studying stocks and companies, you are wasting your time. If you pay somebody to do it for you, you are wasting your money. ** Strong Form holds that prices incorporate all information, publicly available or not. This version must be (and is) false, or insider trading would not be profitable.

In the last section of RANDOM WALK, Malkiel distills all this theory into an eminently practical life-cycle guide to investing. As one may infer, it has two basic principles. First, diversification. Second, no one systematically earns positive abnormal returns from trading in securities; in other words, over time nobody outperforms the market. Mutual funds may outperform the market in 1 year, but they may falter in another. Once adjustment is made for risks, every reputable empirical study finds that mutual funds generally don't outperform the market over time. Malkiel's recommendation: put your money into no-load passively managed index mutual funds. You will see lots of anonymous reviews of RANDOM WALK claiming Malkiel is wrong. Odds are, most of those folks are have either been misled by the long bull market or, even more likely, are brokers or other market professionals who make a living selling active portfolio management. In sum, buy it, read it, believe it, and practice it.

A Theory of the Firm: Governance, Residual Claims, and Organizational Forms by Michael C. Jensen

Michael Jensen is one of the founders of the agency cost economics branch of the New Institutional Economics. A Theory of the Firm collects eight articles by Jensen and various co-authors that, collectively, represent the seminal body of work in this field. (I wonder how his various co-authors felt about being left of the spine of this book?) While his contributions to agency cost theory are the work for which he is best known, Jensen also figures prominently in the intellectual history of the nexus of contracts theory of the firm, as several of the articles collected here demonstrate.

U.S. public corporations are characterized by a separation of ownership and control: the firm's nominal owners, the shareholders, exercise virtually no control over either day to day operations or long-term policy. Instead, control is vested in the hands of professional managers, who typically own only a small portion of the firm's shares. The separation of ownership and control characteristic of U.S. corporations has costs: "The separation of ownership from control produces a condition where the interests of owner and of ultimate manager may, and often do, diverge . . . ." (Berle and Means, 1932). Modern scholars refer to the consequences of these divergences as agency costs, following Jensen and Meckling (1976), which are conventionally defined as the sum of the monitoring and bonding costs, plus any residual loss, incurred to prevent shirking by agents. In turn, shirking is conventionally defined to include as any action by a member of a production team that diverges from the interests of the team as a whole. As such, shirking includes not only culpable cheating, but also negligence, oversight, incapacity, and even honest mistakes. In other words, shirking is simply the inevitable consequence of bounded rationality and opportunism within agency relationships. The classic Jensen & Meckling article is reprinted herein.

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

Jensen recognizes this tension in several of the articles collected here, which in general are less lex-centric than those of many of his intellectual progeny. In other words, Jensen is less likely to believe that regulation is an appropriate solution to a given problem. Instead, his work focuses on market solutions to agency cost problems. The articles on takeovers and leveraged buyouts are good examples.

As a practical criticism, I should note that newcomers and generalists may find the text heavy going in places, while us old-timers have already read all of these articles in their original publications. Yet, it still belongs on the shelf of any economically literate corporate lawyer.

Ronald Coase, The Firm, the Market, and the Law

Lawrence Solum has an excellent post today on Nobel laureate economist Ronald Coase and the famous Coase theorem. The Coase theorem is a principal foundation of modern neoclassical law and economics, of course; indeed, arguably the principal foundation. Solum's post is highly recommended.

Solum's post reminded me that I have been meaning to review Coase's book The Firm, The Market, and the Law. This is principally a collection of Coase's seminal works, although it does contain some useful new material. In particular, the opening chapter is entirely new and shows how a consistent theory of firms and markets, as well as a unique conception of economics and economically-oriented scholarship, runs through Coase's work from the 1930s to the late 1980s (when the book was published).

Coase is best known for two seminal articles. The earlier article "The Theory of the Firm" is the seminal work on the so-called nexus of contracts theory of the firm, as well as an early source for the transaction cost branch of the New Institutional Economics. The nexus of contracts model treats the firm not as an entity, but as an aggregate of various inputs acting together to produce goods or services. Employees provide labor. Creditors provide debt capital. Shareholders initially provide equity capital and subsequently bear the risk of losses and monitor the performance of management. Management monitors the performance of employees and coordinates the activities of all the firm's inputs. The firm is simply a legal fiction representing the complex set of contractual relationships between these inputs. Besides emphasizing the importance of examining the various contracts making up the firm, however, Coase's fundamental insight was that the contractual nature of the firm does not preclude an element of command and control absent from market transactions. If a corporate employee moves from department Y to department X he does so not because of change in relative prices, but because he is ordered to do so. In other words, markets allocate resources via the price mechanism but firms allocate resources via authoritative direction. The set of contracts making up the firm consists in very large measure of implicit agreements, which by definition are both incomplete and unenforceable. Under conditions of uncertainty and complexity, the firm's many constituencies cannot execute a complete contract, so that many decisions must be left for later contractual rewrites imposed by fiat. It is precisely the unenforceability of implicit corporate contracts that makes it possible for the central decisionmaker to rewrite them more-or-less freely. The parties to the corporate contract presumably accept this consequence of relying on implicit contracts because the resulting reduction in transaction costs benefits them all.

Even better known, and even more central to transaction cost economics, however, is Coase's later article "The Problem of Social Cost," which also is reprinted in full here. In that article, Coase laid a critical foundation of modern law and economics - the so-called Coase theorem. The Coase theorem has been formulated in various ways, but one useful statement might be that: "When the parties can bargain successfully, the initial allocation of legal rights does not matter." Suppose a steam locomotive drives by a field of wheat. Sparks from the engine set crops on fire. Should the railroad company be liable? In a world of zero transaction costs, the initial assignment of rights is irrelevant. If the legal rule we choose is inefficient, the parties can bargain around it. Put another way, according to the Coase theorem, rights will be acquired by those who value them most highly, which creates an incentive to discover and implement transaction cost minimizing governance forms.

The Coase theorem has been widely criticized. The second major set of new material in this book is a chapter entitled "Notes on the Problem of Social Cost," in which Coase answers the more serious criticisms. That essay provides a useful intellectual history of the Coase theorem, as well as a trenchant defense of its main claims. One of the less-well informed criticisms of Coase is that he assumes transaction costs are zero. He does not, as this new essay makes clear. Indeed, as Coase points out, the interesting cases are those in which transactions costs are non-zero. In a world of positive transaction costs, however, the parties may not be able to bargain. This is likely to be true in our example. The railroad travels past the property of many landowners, who put their property to differing uses and put differing values on those uses. Negotiating an optimal solution will all of those owners would be, at best, time consuming and onerous. Hence, the allocation of legal rights becomes quite important.

In any event, this is a book that clearly belongs on the shelf of any economically-minded lawyer or legal-minded economist.

UPDATE: Brian Leiter writes:

I've heard it said by various people, including, as I recall, Cooter, that Ellickson's book Order Without Law (1991) shows that the Coase theorem is false (or, more precisely, that the predictions that would be generated from the theorem are false). Comment? I'm genuinely curious about this.

Robert Ellickson’s book “Order Without Law” to which Brian Leiter refers is a deep and very important study of how ranchers and their neighbors in Shasta County, California, resolve disputes -- mainly territorial (such as cattle wandering onto a neighbor’s property, where they do damage. I do not think Ellickson regards his study as disproving the Coase Theorem. I don’t read Ellickson as denying that the Coase Thoerem holds under conditions of zero transaction costs. I read Ellickson as arguing that one important source of transaction costs is learning about one’s initial legal entitlements. For most residents of Shasta County, learning about the true law of property was too costly, let alone the cost of resorting to formal dispute resolution systems. (There is a dispute in the literature as to whether the relevant transaction costs are real or not. In other words, is the ranchers’ ignorance rational or a form of cognitive error?) So they resorted to informal common-sense norms to resolve disputes among themselves. Ellickson then summarizes his dispute with Coase as follows: "Coase overstates the influence of law. His error lies in his implicit assumption that people can effortlessly learn and enforce their initial legal entitlements, and that they confront transaction costs only when they attempt to bargain from their legal starting positions. In a world of costly information, however, one cannot assume that people will both know and honor law." (Order Without Law at 281.)

Actually, in an odd way, I think Ellickson reaffirms the Coase theorem. One implication of the Coase theorem is that, if transactions costs are zero, the actual content of legal rules does not matter. The usual move by law and economics scholars (and it is one I have made myself) is to recognize that transaction costs are often non-trivial. In such contexts, we typically argue that the government should facilitate private ordering by selecting the majoritarian default. As I read Order Without Law, however, Ellickson is saying that if parties face a high transaction cost barrier to learning what the formal rules of law are, the actual content of the rules again does not matter. People will just ignore the law and solve disputes by accepted community norms. The odd way in which this reaffirms the Coase Theorem is as follows: When transaction costs are high, the initial assignment of legal rights does matter, just as Coase predicts. Unlike Coase, however, Ellickson says that the relevant assignment of rights is effected by social norms rather than formal law. After which, bargaining occurs when the majoritarian default norm does not work for the particular parties in question. In sum, its just a question of whether law or social norms provides the relevant assignment of rights.

Finally, I should point you or interested readers to the Cooter-Ulen web site, where they assert: “In a result that comes down somewhere between the Coase Theorem and its critics, Ellickson’s study found that social custom, rather than the law, governed the relationships in Shasta County between farmers and cattlemen.” http://www.cooter-ulen.com/property.htm

UPDATE 2: Put another way, to the extent that the Coase theorem is understood to say that when transaction costs are high the content of formal law matters, Ellickson disproves it. To the extent the Coase theorem is understood to say that when transaction costs are high the content of the relevant rule -- whether law or social norm -- matters, he does not.

I should also note that part of the confusion is engendered by the so-called "Coasean parable" a.k.a. the "Parable of the Cattle." In The Problem of Social Cost, Coase told the following parable: A rancher's cattle wanders onto a farmer's land and harms some crops. Coase posited that, provided the parties could bargain with one other at low cost, the legal rule had only distributional consequences -- i.e., it affected who paid for the damages -- but not allocational consequences -- i.e., it did not affect whether the land was used for grazing or crops. Coase's parable, of course, tracks the situation Ellickson studied in Shasta County quite closely. Ellickson finds that the legal rule had neither allocational nor distributional consequences. Instead of being determined by the content of formal rules, the distributional issues were decided by social norms. Hence, the parable is "disproved" to that extent.

UPDATE 3: Reader JI writes:

For those concerned about Ellickson's "disproof" of the Coase Theorem, I would strongly recommend Daniel Farber, "Parody Lost/Pragmatism Regained: The Ironic History of the Coase Theorem", 83 Va. L. Rev. 397 (1998).

In short, Farber's point is thus: The so-called Coase Theorem was intended as a parody of neoclassical economics, and their assumptions of zero transaction costs. In case this pint was not clear from "The Problem of Social Costs", Coase explained this point at greater length in "Notes on The Problem of Social Costs" in his collection "The Firm, the Market and the Law". Guido Calabresi, among others, also makes this point in "The Pointlessness of Pareto: Carrying Coase Further", 100 Yale L.J. 1211 (1991). See also Jeanne L. Schroeder, "The End of the Market: A Psychoanalysis of Law and Economics", 112 Harvard L. Rev. 483 (1998-9). The list goes on, but back to Farber and Ellickson.

Neoclassical economics, following Arthur Pigou, felt that the ideal world that should exist, in which transactions will be most efficient, is a world without transaction costs. Their (influential) policy recommendations were therefore based on the premise that the government should strive to eliminate transaction, or "social", costs, thereby making the market more efficient by having it emulate, as much as possible, a market without transaction costs.

Coase attacked this position on two grounds. First, he argued that transaction costs are often reciprocal. Take the case of the sparks from the train burning wheat in the surrounding field. The typical neoclassical solution to this social cost would be to tax the train the amount of damage caused to the wheat farmer. But the more economic efficient outcome might be to have the farmer not plant wheat in such close proximity to the train tracks. In fact, forcing the railroad to reimburse the farmer for damaged wheat may encourage the farmer to plant surplus wheat, that would not otherwise be profitable for him to plant, in close proximity to the railroad in order to collect damages from the railroad.

Coase's second, and most important argument, is one of empiricism. He argued that neoclassical economics' "solution" to the problem of social costs, indeed economic analysis as a whole, was/is too theoretical. Pigou's solution to the problem of social costs was based completely on theory, and a one-size-fits-all theory to boot. Coase argued that economics and economic policy recommendations should be based on empirical, pragmatic observation fo the situiation at hand. To fruther the cause of empirical, pragmatic economics, he founded the Journal of Law and Economics, which is mostly devoted to such study (see, for example, Morrison, Winston and Watson, "Fundamental Flaws of Social Regulation: The Case of Airplane Noise", 42 J. Law & Econ. 723 (1999)).

Back to Farber. Since Coase was an advocate of empirical, pragmatic economics, he used the theorem later on dubbed the Coase Theorem as a parody of the neoclassical economic world of supposing no transaction costs. The outcome of such a model is ludicrous - legal entitlements don't matter, and the most efficient outcome is always attained. This is similar to physics without friction. However, since the hard-core neoclassicists were so engrosed in their own theories, they failed to notice the parody in the Coase Theorem. But since they did realize that accepting the Coase Theorem proved how ridiculous their models were, they set out to prove the Coase Theorem wrong. The way to prove the Coase Theorem wrong was to go out and show that in real life situations initial entitlements DO matter. So by failing to grasp the parody in the Coase Theorem (Parody Lost), these econmists inadvertently wound up engaging in pragmatic, empirical economic study (Pragmatism Regained) - which is the type of study Coase advocated - without adopting, or even understanding, Coase's arguments. What these neoclassical economists failed to realize is that it is impossible to empricially disprove the Coase Theorem, since it exists in a decidedly non-empirical world. In the real world, there will ALWAYS be transaction costs (see, for instance, Calabresi, "Transaction Costs, Resource Allocation and Liability Rules - A Comment", 11 J. Law & Econ. 67 (1968)).

One further point. Ironically, a correct understanding of the Coase Theorem can lead one towards libertarianism (Coase) or towards more advocacy of further governmental intrusion into the market (Calabresi). But on second thought, this isn't so ironic. Coase advocated empiricism and pragmatism - tools which are far less wont to lead to forgone conclusions than theory (witness the monotony of the academic eltie).

I think JI's comment is insightful, but I take issue with it in at least one respect. I tend to think that Farber (and JI) overstate the case in treating the Coase theorem as a "parody," at least to the extent they ascribe intentionality to Coase in that regard. Coase himself said in "The Firm, the Market, and the Law" that his intent "was not to describe what life would be like in such a world [i..e, one without transaction costs] but to provide a simple setting in which to develop the analysis and, what was even more important, to make clear the fundamental role which transaction costs do, and should, play in the fashioning of the institutions that make up the economic system." (13) Having said that, however, it is certainly true that Coase objected strenuously to the tendency among later economists to describe "the world of zero transaction costs ... as a Coasian world." (174)

Review: Easterbrook and Fischel's Economic Structure of Corporate Law

Easterbrook and Fischel collected a series of law review articles into the classic text on the contractarian theory of corporate law: The Economic Structure of Corporate Law. During the 1980s, Easterbrook and Fischel were two of the corporate law academy's enfants terribles. Their articles were provocative, yet insightful. They raised a lot of hackles, yet did ground-breaking work. Both went on to bigger and better things. Easterbrook is now a judge on the US 7th Circuit. Fischel was a prominent expert witness/consultant and dean of the UChicago law school. The Economic Structure of Corporate Law stands as their legacy for corporate law.

Like other contractarians, Easterbrook and Fischel model the firm not as an entity, but as an aggregate of various inputs acting together to produce goods or services. Employees provide labor. Creditors provide debt capital. Shareholders initially provide equity capital and subsequently bear the risk of losses and monitor the performance of management. Management monitors the performance of employees and coordinates the activities of all the firm's inputs. The firm is simply a legal fiction representing the complex set of contractual relationships between these inputs. In other words, the firm is not a thing, but rather a nexus or web of explicit and implicit contracts establishing rights and obligations among the various inputs making up the firm.

The nexus of contracts model has important implications for a range of corporate law topics, the most obvious of which is the debate over the proper role of mandatory legal rules. As a positive matter, contractarians contend that corporate law in fact is generally comprised of default rules, from which the parties to the set of contracts making up the corporation are free to depart, rather than mandatory rules. As a normative matter, contractarians argue that this is just as it should be. Easterbrook and Fischel devote the bulk of this text to tweaking out these implications across an array of important topics, such as limited liability and insider trading.

Their analysis is not flawless. As but a single example, they consistently opt for the so-called majoritarian default. Their basic thesis is that by providing the rule to which the parties would agree if they could bargain, society facilitates private ordering. Majoritarian defaults are not always desirable, however, even if a potentially dominant one can be identified. Sometimes penalty defaults are preferable. Penalty defaults are designed to impose a penalty on at least one of the parties if they fail to bargain out of the default rule, thereby giving at least the party subject to the penalty an incentive to negotiate a contractual alternative to the penalty default. They force the parties to choose affirmatively the contract provision they prefer. Penalty defaults are appropriate where it is costly for courts to determine what the parties would have wanted. In such cases, it may be more efficient for the parties to negotiate a term ex ante than for courts to determine ex post what the parties would have wanted.

Outsider reverse veil piercing

In outsider reverse veil piercing, a personal creditor of the shareholder seeks to disregard the corporation's separate legal existence. Unlike regular veil piercing, in which a creditor of the corporation is trying to reach the personal assets of a shareholder, in this situation a creditor of the shareholder wants to reach the assets of the corporation in order to satisfy the creditor's claims against the shareholder. A number of courts have recognized such a cause of action. I think it’s a pernicious and evil doctrine that should be cast into the outer darkness where there is weeping and gnashing of teeth.

This post is specifically prompted by C.F. Trust, Inc. v. First Flight L.P., 580 S.E.2d 806 (Va.2003), in which the Virginia supreme court recently recognized outsider reverse piercing as valid under Virginia law. (For those who want even more information on regular veil piercing, reverse veil piercing, and/or outsider reverse veil piercing, you can buy my Corporation Law and Economics text and flip to Chapter 4.)

The CF Trust court opined “that there is no logical basis upon which to distinguish between a traditional veil piercing action and an outsider reverse piercing action. In both instances, a claimant requests that a court disregard the normal protections accorded a corporate structure to prevent abuses of that structure.” Au contraire. The problem presented by outsider reverse veil piercing is reminiscent of the issues raised by the old "jingle rule" of partnership law. Section 40 of the UPA (1914) provides that personal creditors of a partner have priority with respect to the partner's personal assets and creditors of the partnership have priority with respect to partnership assets. The "jingle rule," however, has been superseded for all practical purposes by section 723 of the federal Bankruptcy Code. That section provides that the firm's creditors will be paid out of firm assets and then have equal rights to participate with personal creditors in dividing up personal assets. The rationale for this change seems to have been that prospective creditors of the partnership rely on the creditworthiness of the individual partners in making lending and contracting decisions. In response to the federal law, UPA (1997) section 807 de facto repealed the jingle rule.

UPA (1997) thus does not allow a personal creditor of a partner direct access to partnership assets. Section 502 limits the partner's "transferable interest" in the firm to "the partner's share of the profits and losses of the partnership and the partner's right to receive distributions." Section 504 then allows a "judgment creditor" of a partner to "charge the transferable interest of the judgment debtor to satisfy the judgment." In effect, the creditor thus gets a lien on the partner's interest. Although a creditor who has foreclosed on that lien may seek judicial dissolution of the partnership, a court will only grant dissolution if "it is equitable to wind up the partnership business." UPA (1997) section 801(6).

Corporate law does not contain comparable provisions, but essentially the same result obtains through application of the standard judgment collection rules. Courts that accept outsider reverse veil piercing, however, disrupt this scheme by allowing personal creditors of a shareholder direct access to corporate assets.

To the extent that outsider reverse veil piercing effectively gives priority to personal creditors in the corporate setting, it seems just as problematic as the old jingle rule, albeit for slightly different reasons. As with the jingle rule question, the issue is: whose creditors shall have priority with respect to which assets? Outsider reverse veil piercing allows the creditor to avoid the more demanding proof required by traditional theories of conversion or fraudulent transfer. Outsider reverse veil piercing also effectively bypasses the standard approach to collecting a judgment against a corporate shareholder, in which the creditor attaches the debtor's shares in the corporation rather than the assets of the corporation itself. Unsecured creditors who relied on firm assets in lending to the corporation are thus disadvantaged. Similarly, if there are other shareholders, their interests are adversely affected if the corporation's assets can be directly attached by the personal creditor of one shareholder. In contrast, in ordinary (i.e., forward) veil piercing cases, a creditor may reach only the assets of the controlling shareholder who is determined to be the corporation's alter ego.

Mark Roe's "Strong Managers, Weak Owners"

In their 1932 classic, THE MODERN CORPORATION AND PRIVATE PROPERTY, Berle and Means brought to popular attention the separation of ownership and control in U.S. corporations: shareholders exercised virtually no control over either day to day operations or long-term policy; instead, control was vested in the hands of professional managers. Separation of ownership and control occurred, according to Berle and Means, because important technological changes during the 1800s, especially the development of modern mass production techniques, gave great advantages to firms large enough to achieve economics of scale, which in turn gave rise to giant industrial corporations. These firms could be financed only by aggregating many small investments. Modern corporate governance scholars refer to the consequences of separating ownership and control as agency costs, but Berle and Means had identified the basic problem over forty years before the current terminology was invented: "The separation of ownership from control produces a condition where the interests of owner and of ultimate manager may, and often do, diverge ...."

In STRONG MANAGERS, WEAK OWNERS, Mark Roe strikes out in a new direction, by attacking the origins of the agency cost problem. The question Roe poses is the foundational one of whether Berle and Means were correct in assuming that the separation of ownership and control is an inherent aspect of large public corporations. Roe contends that dispersed ownership was not the inevitable consequence of impersonal economic forces, but rather the result of a series of political decisions motivated by a fear of concentrated economic power. Investments could have been channeled to industrial enterprises through large financial intermediaries, such as banks, insurance companies, and mutual and pension funds. Put another way, while it was necessary to aggregate and tap the savings of large numbers of individual investors in order to fund major industrial corporations, such aggregation could have taken place in financial institutions specifically designed to provide savings opportunities. In turn, it would have been those institutions that invested in industrial corporations. American corporate governance did not evolve along these lines because the law created a series of obstacles to financial intermediaries. If those obstacles had not existed, ownership might not have fragmented and thus might not have separated from control. The implication of this thesis, of course, is that while economic forces shaped modern corporate governance, they did so within the parameters set by law. As such, the governance structure of U.S. public corporations may not be optimal in an absolute sense, but only relative to the set of possibilities defined by our legal system.

If I ever get around to working up the "Corporate Canon" blog "a reader" requested, Roe's book defintely would be on it. It is a major and important contribution to our understanding both of (a) how American corporate law/governance evolved, describing in detail the forces that affected that evolution, and (b) comparative corporate law analysis across diverse economic systems, especially the US, Germany, and Japan. This is not too say that I don't disagree with parts of Roe's analysis. I set out my critique in the extended post below. For even more gore details, you can download a law review article-length book review I wrote some years ago here.

Roe focuses on legal rules preventing institutional investors from acting as financial intermediaries between the investing public and the management of public corporations. The first third of STRONG MANAGERS is devoted to a historical review of the rules that preclude institutions from playing a significant role in corporate governance. In the second third, he reviews recent developments, which perpetuated the legal obstacles to governance activism by institutions. In the final part, he addresses the essential policy implication of his analysis: should the legal system encourage institutions to take a more active governance role?

One can quibble with portions of Roe's historical argument. There is, for example, good evidence that ownership and control separated long before most of the rules Roe blames for the separation went on the books. At the very latest, ownership and control of large corporations had separated by the middle of the nineteenth century. In contrast, the rules with which Roe is concerned mostly came into existence only after 1900. Granted, banks fragmented in the first third of the 18th century, but a number of critical restrictions did not come into play until the New Deal. Insurers were largely unregulated until after 1906. Mutual funds, albeit long of little importance, likewise were essentially unregulated until the New Deal. Given this free market environment, why did these or other financial intermediaries not step into the economic niche opened when ownership and control separated during in the early and mid-1800s?

In other words, Roe has not proven that the Berle-Means corporation would not have evolved in the absence of the constraints on financial intermediaries he describes. But, at a minimum, Roe does demonstrate that politics did nothing to impede the development of the Berle-Means corporation, perhaps facilitated its evolution, and certainly helped sustain it by preventing financial intermediaries from taking active governance roles. In and of itself, that showing is a formidable accomplishment and a valuable contribution to the literature.

Although the first two sections of STRONG MANAGERS are notable in their own right, the book takes on importance mainly because of the significance of the policy questions to which the final section is addressed. Space does not permit one to do full justice to Roe's argument, which is nuanced and well-crafted. Suffice it to say that relatively little has changed since STRONG MANAGERS was published. Despite increased activism in recent years, institutions still are mostly passive. Even the most active institutional investors spend only trifling amounts on corporate governance activism. Institutions devote little effort to monitoring management, rarely conduct proxy solicitations, do not to try to elect directors, and rarely coordinate their activities. And, perhaps, this is a good thing. As Roe concedes, there is good evidence that bank-dominated finance has harmed that Japanese and German economies by impeding venture capital. Moreover, institutional investors may well abuse control by self-dealing. Even if institutional investors are entirely self-less, greater control on their part would still be undesirable if the separation of ownership and control mandated by U.S. law has substantial efficiency benefits. Here is where Roe and I part company-I suspect the Berle-Means corporation has significant economic advantages over its alternatives; he is skeptical. Perhaps only time will tell, as competition in increasingly global markets puts various systems of economic organization to the test. In the meanwhile, Roe's book belongs in the library of anyone interested in corporate law or governance.

Does state corporate law really race to the top?

The Michigan legislature recently amended the state’s control share acquisition statute to make it easier for the Taubman family to fend off the hostile bid for Taubman Centers from Simon Property Group and Westfield America Trust (I describe these statutes and the Michigan amendment in the Extended Post below). Several readers have written or used the comment feature to ask how I square these statutes with the race to the top hypothesis I have espoused in earlier posts. A fair question, indeed, but the two can be squared.

According to the standard race to the top account, investors will not purchase, or at least not pay as much for, securities of firms incorporated in states that cater too excessively to management. Lenders will not make loans to such firms without compensation for the risks posed by management's lack of accountability. As a result, those firms' cost of capital will rise, while their earnings will fall. Among other things, such firms thereby become more vulnerable to a hostile takeover and subsequent management purges. Corporate managers therefore have strong incentives to incorporate the business in a state offering rules preferred by investors. Competition for corporate charters thus should deter states from racing to the bottom. (The competing “race to the bottom” hypothesis argues that states compete in granting corporate charters. After all, the more charters the state grants, the more franchise and other taxes it collects. According to the race to the bottom theory, because it is corporate managers who decide on the state of incorporation, states compete by adopting statutes allowing corporate managers to exploit shareholders.)

The evidence on the race to the top versus race to the bottom dispute is not free from controversy, but I think the weight of the evidence clearly favors the race to the top. Roberta Romano’s event study of corporations changing their domicile by reincorporating in Delaware, for example, found that such firms experienced statistically significant positive cumulative abnormal returns. Roberta Romano, Law as a Product: Some Pieces of the Incorporation Puzzle, 1 J. L. ECON. & ORG. 225 (1985). In other words, reincorporating in Delaware increased shareholder wealth. This finding strongly supports the race to the top hypothesis. If shareholders thought that Delaware was winning a race to the bottom, shareholders should dump the stock of firms that reincorporate in Delaware, driving down the stock price of such firms. As Romano found, and all of the other major event studies confirm, there is a positive stock price effect upon reincorporation in Delaware. See generally ROBERTA ROMANO, THE ADVANTAGE OF COMPETITIVE FEDERALISM FOR SECURITIES REGULATION 64-73 (2002) (discussing the relevant studies and criticisms thereof).

The event study findings are buttressed by a well-known study by Robert Daines in which he compared the Tobin’s Q of Delaware and non-Delaware corporations. (Tobin’s Q is the ratio of a firm’s market value to its book value and is a widely accepted measure of firm value.) Daines found that Delaware corporations in the period 1981-1996 had a higher Tobin’s Q than those of non-Delaware corporations, suggesting that Delaware law increases shareholder wealth. Robert Daines, Does Delaware Law Improve Firm Value?, 62 J. FIN. ECON. 525 (2001). Although subsequent research suggests that this effect may not hold for all periods, Daines’ study remains an important confirmation of the event study data.

Additional support for the event study findings is provided by takeover regulation. Compared to most states, which have adopted multiple anti-takeover statutes of ever-increasing ferocity, Delaware’s single takeover statute is relatively friendly to hostile bidders. An empirical study of state corporation codes by John Coates confirms that the Delaware statute is the least restrictive and imposes the least delay on a hostile bidder. John C. Coates IV, An Index of the Contestability of Corporate Control: Studying Variation in Takeover Vulnerability (June 30, 1999). Given the clear evidence that hostile takeovers increase shareholder wealth, this finding is especially striking. See generally Stephen M. Bainbridge, Corporation Law and Economics 612-14 (2002). The supposed poster child of bad corporate governance, Delaware, turns out to be quite takeover-friendly and, by implication, equally shareholder-friendly. (Indeed, check out this headline: "Beware Delaware." The article goes on to argue that: "Since last summer, the Delaware Supreme Court has issued at least five decisions of great concern to the corporate bar. Each was remarkable not only because it found against directors and in favor of shareholders, but also because it reversed a lower court ruling that went the other way.")

This takes us to the Michigan anti-takeover statute. Given that state takeover regulation demonstrably reduces shareholder wealth but that most states have nevertheless adopted anti-takeover statutes, what are we to make of that data point? In my view, we must concede that state regulation of corporate takeovers appears to be an exception to the rule that efficient solutions tend to win out. But so what? Nobody claims that state competition is perfect. The question is only whether some competition is better than none. Delaware’s relatively hospitable environment for takeovers suggests an affirmative answer to that question.

In other words, the Michigan statute proves a central point of public choice theory. The incentives of legislators and regulators are driven by rent-seeking and interest group politics. In turn, the incentives of directors and managers who lobby state legislators vary by context. In most contexts, the financial incentives of directors and managers are aligned with those of shareholders for the reasons discussed above. In the hostile takeover context, however, the incentives of directors and managers deviate from those of the shareholders. Hostile takeovers are frequently followed by management purges, especially at the top management and board levels. Nobody likes to be fired, so it is hardly surprising that directors and managers try to use the legislative process to protect their jobs. Neither, however, does it disprove the race to the top hypothesis; it only shows that there is an exception to every rule.

Control share acquisition statutes rely on the states' traditional power to define corporate voting rights as a justification for regulating the bidder's right to vote shares acquired in a control transaction. A "control share acquisition" is typically defined as the acquisition of a sufficient number of target company shares to give the acquirer control over more than a specified percentage of the voting power of the target. The triggering level of share ownership is usually defined as an acquisition which would bring the bidder within one of three ranges of voting power: 20 to 33 1/3%, 33 1/3 to 50% and more than 50%. Most control share acquisition laws provide that shares acquired in a control share acquisition shall not have voting rights unless the shareholders approve a resolution granting voting rights to the acquirer's shares. See chapter 8 of my Mergers and Acqusitions text for more details.

Members of the Taubman family formed a group to pool their shares’ voting powers to oppose the Simon Property and Westfield hostile bid. Once aggregated, their combined shares exceeded the 33 1/3% threshold. Under the Michigan statute as then worded, the formation of the group constituted a control share acquisition as defined by statute (even though they did not acquire more shares in the usual sense of buying some), or so a federal court held back in May. Accordingly, the formation of the group required approval by Taubman Center’s other shareholders. The new bill amends the control share acquisition statute to permit shareholders to form such a group without triggering the voting requirement.

The stated purpose of control share statutes is providing shareholders with an opportunity to vote on a proposed acquisition of large share blocks which may result in or lead to a change in control of the target. These statutes are premised on the assumption that individual shareholders are often at a disadvantage when faced with a proposed change in control. If the target's shareholders believe that a successful tender offer will be followed by a purchase by the offeror of non tendered shares at a price lower than that offered in the initial bid, for example, individual shareholders may tender their shares to protect themselves from such an eventuality, even if they do not believe the offer to be in their best interests.

By requiring certain disclosures from the prospective purchaser and by allowing the target's shareholders to vote on the acquisition as a group, control share acquisition statutes supposedly provide the shareholders a collective opportunity to reject an inadequate or otherwise undesirable offer. For example, since control share acquisition statutes generally require the offeror to disclose plans for transactions involving the target that would be initiated after the control shares are acquired, shareholders presumably would be unlikely to approve a creeping tender offer or street sweep which would be followed by a squeezeout back end merger at a price less than or in a consideration different than that paid by the acquirer in purchasing the initial share block.

Al Hunt on Grasso and the NYSE

Al Hunt’s op-ed in today’s Wall Street Journal (subscription req’d) uses the Grasso pay imbroglio to recycle virtually every grievance in the current left-liberal talking points guide, but lets stick to our knitting – i.e., corporate governance. Hunt complains that Grasso’s salary of $140 million is “indefensible” relative to what the “average worker” gets paid. (In a particularly invidious move, Hunt drags in the case of a wounded GI who had to reimburse the government for food during his hospital stay. While deplorable, its not clear what that case has to do with Grasso specifically or even executive compensation generally.) All of which raises the question: in thinking about executive compensation is the comparison to what average workers make a valid one or just a debater’s cheap shot?

If comparing what Grasso makes to the pay of an average worker is okay, then don’t we also have to compare what Shaquille O’Neal makes to that worker’s pay? If Hunt wants to argue that there is a dollar amount of annual earnings that nobody should be allowed to exceed, that’s one thing. But I doubt even Paul Krugman would go that far. Indeed, Hunt says that some folks – naming Tiger Woods, Kevin Costner, and Bill Gates – deserve their compensation, just not Grasso: "Most Americans are upwardly mobile and celebrate the riches of the truly successful and deserving, whether it's Michael Jordan, Kevin Costner, or Bill Gates. But in a time when sacrifices are being made by firefighters, schoolteachers and Marine staff sergeants, many of these same Americans resent the Dick Grassos." I don’t know why he thinks people resent Grasso's pay, but not Costner's. Has Hunt seen any of Costner’s recent movies? I mean, really. If any of the four he names should be joining firefighters et al. making sacrifices, it is Costner. Did you see "Waterworld"? or "The Postman"? Whereas nobody seriously doubts that Grasso was, at the very least, competent and most concede he was doing a good job.

But lets get serious about this for a minute. How much you get paid depends in large part on the thickness of the market for your services. In a thick market, wages tend to be low because there are many potential employees – all more or less fungible – competing for jobs. In a thin market, however, wages tend to be high because many employers are competing to hire a small number of eligible workers. The market for burger flippers is very thick. The market for law professors is relatively thick (so, for that matter, is the market for pundits -- if blogging has done nothing else, it has proven that people like Glenn Reynolds or Eugene Volokh can do punditry at a very high level even though they lacked access to a national medium until recently -- so maybe Hunt's mad because he's in for a paycut?). The market for CEOs of Fortune 500 companies (which is what the NYSE essentially is) is thin. I’d guess the number of people who have what it takes to run a Fortune 500 company isn’t much larger than the number of people who can run a NBA fast break. Its just supply and demand, folks.

Having said that, there are some important differences between Grasso’s and Shaq’s contracts, which do cut against the former. First, although I don't have the citations at the tip of my fingers, I have seen a couple of recent studies to suggest that boards erroneously believe the CEO market is thinner than it actually is, which tends to artificially inflate CEO salaries. Boards tend to want proven track records (picking an unproven CEO who tanks is bad for the board’s reputation), which limits the pool through the “Experience Required” phenomenon. Boards also tend to pick CEO candidates who resemble the prevailing demographics of the directors, which further artificially limits the pool.

Second, and more pertinent, Shaq is accountable in ways that Grasso was not. Shaq is subject to constant evaluation by Phil Jackson and Jerry Buss – neither of whom are shrinking violets. One has little doubt they make darn sure they are getting what they pay for. In contrast, although Grasso was nominally subject to evaluation by the NYSE board, that board was comprised in large part of ceremonial “public” directors who we now know did not take the job as seriously as they should have and representatives of the seat-holders who we have long known have various conflicts of interest. The board itself, moreover, was accountable to no one. So it all comes back to governance. In fairness to Hunt, he does devote a section in the middle of the screed to the governance issues. Contra the main thrust of Hunt’s column, however, the problem is not the dollar amount. The problem is that NYSE’s current governance structure had no mechanism for ensuring that the Exchange got back value commensurate with whatever amount it paid. Everything else is just so much populist agitprop.

Mercuro and Medema's Economics and the Law

What is law and economics? It is the school of jurisprudence in which the tools of microeconomic analysis are used to study law. Those of us who practice economic analysis have a deceptively simple task. We translate some legal doctrine into economic terms. We then apply a few basic principles -- cost-benefit analysis, collective action theory, decision-making under uncertainty, risk aversion, and the like -- to the problem. Finally, we translate the result back into legal terms.

Law and economics unquestionably is the most successful form of intellectual arbitrage in the history of jurisprudence. Why? Traditional forms of legal scholarship were mostly backward looking. One reasoned from old precedents to decide a present case, seemingly without much concern (at least explicitly) for the effect today's decision would have a future behavior. Yet, law is necessarily forward looking. To be sure, a major function of our legal system is to resolve present disputes, but law's main job is to regulate future behavior. The law and economics movement succeeded because it recognized that judges cannot administer justice solely retrospectively. They must also consider what rules their decisions will create to guide the behavior of other actors in the future. Even more important, however, law and economics gives judges systematic mechanisms for predicting how rules will affect behavior.

Mercuro and Medema's Law and Economics offers a comprehensive overview of law and economics. Unlike many texts, it is not limited to the Chicago School (as exemplified by such stalwarts as Manne, Easterbrook, and Posner). They also describe the New Haven school (classically exemplified by Calabresi), the public choice theory of Arrow, Buchanan, and others, as well as both the traditional and new institutional economics. By reminding us that law and economics is not a homogeneous field, and providing a fair commentary on each of the major traditions within the larger discipline, they offer an excellent introduction to this important area of jurisprudence.

One nice touch, which makes the text useful for a wide audience, is that it does not assume familiarity with either economics or law. The introduction offers a brief historical overview of basic jurisprudence, as well as an appendix explaining basic economic principles. Consequently, the book will serve well the interests both of lawyers who need to brush up on economics and economists interested in law.

Criticisms: There is little in the way of critical evaluative judgment. Indeed, Mercuro and Medema disavow any effort at criticism. As a result, the reader is left to his own devices. Second, I am not persuaded by Mercuro and Medema's decision to include a rather lengthy chapter on critical legal studies. Criticism of law and economics has been a major project of CLS scholars, but CLS scholarship has had no influence of any significance on any of the dominant strains of law and economics thinking. In this case, moreover, the failure to exercise critical evaluative judgment means that the generalist reader may have difficulty assessing the (bogus) claims made by CLS. In general, while maintaining facial neutrality on their own part, Mercuro and Medema give far more attention to CLS and Marxist critiques of law and economics than they do to conservative critiques thereof or to law and economics criticisms of CLS.