ProfessorBainbridge.com

Catholic Church Leaders have to Lead

The LA Times reported yesterday that:

According to a recent ABC News-Washington Post poll, 88% of Catholics believe that it is morally acceptable to use birth control, and 67% believe that it is acceptable to have premarital sex. In addition, 62% believe that invoking the death penalty was morally acceptable. Homosexual relations are morally acceptable for 48% of Catholics, and having the right to abortion was acceptable to 30% of those polled.

There are lots of reasons why "Cafeteria Catholicism" has become so prevalent, of course, but one reason has to be that our leaders don't lead. In the five years I've been attending Mass on a regular basis, I can count on the fingers of one hand the number of homilies I've heard on these topics.

Dean v. Clinton

In January 1996, President Bill Clinton declared that "The era of big government is over," albeit while arguing that "we can't go back to a time when our citizens were just left to fend for themselves." In his clearest statement yet that he he is running against not only Bush but also the centrist DLC, Howard Dean today told the Washington Post that:

The former Vermont governor said he would reverse the trend toward deregulation pursued by recent presidents -- including, in some respects, Bill Clinton -- to help restore faith in scandal-plagued U.S. corporations and better protect U.S. workers.

In an interview around midnight Monday on his campaign plane with a small group of reporters, Dean listed likely targets for what he dubbed as his "re-regulation" campaign: utilities, large media companies and any business that offers stock options. Dean did not rule out "re-regulating" the telecommunications industry, too.

Since virtually all US corporations now use stock options, Dean is basically talking about "re-regulating" the entire economy. Predictably, the blogosphere is all over it. Notable posts include: Virginia Postrel (link via Pejman Yousefzadeh), Tyler Cowen, BusinessPundit, Steve at Deinonychus antirrhopus, and Sean Hackbarth at TAM. Joe Lieberman, who remains the Democrat who impresses me most, was prompt in condemnation:

"[Dean] would give us a treacherous trifecta of policies that turn back the economic clock: new trade barriers, a larger tax burden on our middle class and now bigger bureaucracy," Sen. Joseph I. Lieberman (Conn.) said in a statement. "Either he doesn't know how to turn the economy around, or this is another reckless mistake."

UPDATE: Robert Prather notes:

Dean is repudiating much of what we have learned economically over the last twenty-five years and, for those too young to remember, the 1970's sucked. High inflation and high unemployment were the defining characteristics of that decade and regulation of economic activity contributed mightily to the latter of the two. Even Clinton had more sense than that. As the article notes, if Dean follows this path he'll be repudiating the Clinton years and the prosperity that happened on his watch.

Well said, indeed. The GOP's economic policies are annoying the heck out of me right now (e.g., here and here), but Dean's scare the heck out of me. Stuart Buck has a fair and balanced take on the subject, which still manages to make Dean look bad:

Most of the criticism ... seems to focus on the mere fact that Dean appeared to favor "re-regulation." One can have a reasonable debate over how much regulation is needed, what its terms should be, whether complete regulation is better than deregulating half-way, and so forth.

But Dean's comment about telecommunications isn't even comprehensible. Telecommunications is overwhelmingly regulated right now, as much as or more than any other American industry. I can't even imagine how anyone could think that there is an undersupply of regulation in that particular field. (The Telecommunications Act of 1996 has sometimes been described as "deregulation," but nothing could be further from reality.) [Ed.: Emphasis in original.]

The Scholarly Bobby Jindal

So there I was peacefully reviewing what the editors had done to one of my law review articles, feeling quite content because they hadn't changed much and the changes they had made were generally improvements, when I suddenly realized that I had cited an article by recently defeated GOP Louisiana gubernatorial candidate Bobby Jindal (Relativism, Neutrality, and Transcendentalism: Beyond Autonomy, 57 Louisiana Law Review 1253, 1253 (1997)) for the proposition that: "Because all conceptions of the good necessarily invoke non-derivable moral assumptions, we cannot avoid an inquiry into the morality of an act we propose to regulate." Later in the article I also cited it for the proposition that: "Laws mala in se derive their legitimacy from ideals—justice, love, liberty—that have traction precisely because they are based in a common belief in the truth of some abstract principle." When I wrote this article 2 years ago I had no idea who Bobby Jindal was, of course, and the editorial process had taken so long I had forgotten all about those footnotes. But now, these citations are quite literally footnotes to history. Or something like that.

Substantive due care and the business judgment rule in corporate fiduciary duty law

Gordon Smith has a very thoughtful post at his Venturpreneur blog on the Disney/Ovitz executive compensation litigation and the emerging duty of good faith in Delaware corporate law. Gordon cogently argues that the duty of good faith presages a revival of the idea that courts will review director conduct to ensure compliance with the so-called duty of substantive due care:

Although the [Delaware Supreme] Court does not like the phrasing, "substantive due care," the idea underlying that notion remains intact. In the future, we are told, litigants and courts should call it "waste" or "bad faith."

To the extent a substantive due care-based standard of review contemplates judicial review of the merits of a board decision, I think that is a very bad idea. Explaining why I think so is a task beyond the scope of any mere blog posting, but if you want 50-odd pages on the subject, check out my article The Business Judgment Rule as Abstention Doctrine, which is forthcoming in the Vanderbilt Law Review. My more modest goal for this post is to suggest that the emerging duty of good faith can be squared with existing law (although I acknowledge the possibility that it might well turn into something entirely new).

As the abstract of my article explains:

Two conceptions of the business judgment rule compete in the case law. One views the business judgment rule as a standard of liability under which courts undertake some objective review of the merits of board decisions. This view is increasingly widely accepted, especially by some members of the Delaware supreme court. The other conception treats the rule not as a standard of review but as a doctrine of abstention, pursuant to which courts simply decline to review board decisions. The distinction between these conceptions matters a great deal. Under the former, for example, it is far more likely that claims against the board of directors will survive through the summary judgment phase of litigation, which at the very least raises the settlement value of shareholder litigation and even can have outcome-determinative effects.

Like many recent corporate law developments, the standard of review conception of the business judgment rule is based on a shareholder primacy-based theory of the corporation. This article extends the author's recent work on a competing theory of the firm, known as director primacy, pursuant to which the board of directors is viewed as the nexus of the set of contracts that makes up the firm. In this model, the defining tension of corporate law is that between authority and accountability. Because one cannot make directors more accountable without infringing on their exercise of authority, courts must be reluctant to review the director decisions absent evidence of the sort of self-dealing that raises very serious accountability concerns. In this article, the author argues that only the abstention version of the business judgment rule properly operationalizes this approach.

How do I square my abstention version of the business judgment rule with the Disney decision about which Gordon writes? I do so by acknowledging that an essential precondition for application of the business judgment rule long has been the absence of irrationality. I phrase the precondition as the absence of irrationality rather than as an affirmative requirement of a rational business decision for reasons made clear in this excerpt from my treatise Corporation Law and Economics (pages 274-75; footnotes shown in brackets):

In Sinclair Oil Corp. v. Levien, the Delaware supreme court held that so long as the board's decision could be attributed to any rational business purpose the business judgment rule precluded the court from substituting its judgment as to the merits of the decision for those of the board. [Sinclair Oil Corp. v. Levien, 280 A.2d 717, 720 (Del.1971).] Similarly, in Brehm v. Eisner, the court held that the business judgment rule does not apply when the board has "act[ed] in a manner that cannot be attributed to a rational business purpose." [Brehm v. Eisner, 746 A.2d 244, 264 n.66 (Del.2000).]

The reference to a "rational business purpose," properly understood, does not contemplate substantive review of the decision's merits. As Professor Michael Dooley observes, "Sinclair's use of [the word] rational is to be equated with conceivable or imaginable and means only that the court will not even look at the board's judgment if there is any possibility that it was actuated by a legitimate business reason. It clearly does not mean, and cannot legitimately be cited for the proposition, that individual directors must have, and be prepared to put forth, proof of rational reasons for their decisions." [Michael P. Dooley, Two Models of Corporate Governance, 47 Bus. Law. 461, 478-79 n.58 (1992).] Consequently, as Chancellor Allen has stated:

[W]hether a judge or jury considering the matter after the fact, believes a decision substantively wrong, or degrees of wrong extending through "stupid" to "egregious" or "irrational", provides no ground for director liability, so long as the court determines that the process employed was either rational or employed in a good faith effort to advance corporate interests. To employ a different rule--one that permitted an "objective" evaluation of the decision--would expose directors to substantive second guessing by ill equipped judges or juries, which would, in the long run, be injurious to investor interests. [In re Caremark International Inc. Derivative Litig., 698 A.2d 959, 967 (Del.Ch.1996).]

Instead, as Chancellor Allen observed elsewhere, "such limited substantive review as the rule contemplates (i.e., is the judgment under review 'egregious' or 'irrational' or 'so beyond reason,' etc.) really is a way of inferring bad faith." [In re RJR Nabisco, Inc. Shareholders Litig., 1989 WL 7036 at *13 n.13 (Del.Ch.1989).]

Put another way, inquiry into the rationality of a decision is a proxy for an inquiry into whether the decision was tainted by self interest. In Parnes v. Bally Entertainment Corp., for example, the Delaware supreme court stated that: "The presumptive validity of a business judgment is rebutted in those rare cases where the decision under attack is 'so far beyond the bounds of reasonable judgment that it seems essentially inexplicable on any ground other than bad faith.' " [722 A.2d 1243, 1246 (Del.1999) (quoting In re J.P. Stevens & Co., Inc., 542 A.2d 770, 780n81 (Del.Ch.1988)).] In that case, Bally's CEO allegedly demanded bribes from prospective takeover bidders and, moreover, allegedly received such a bribe from the successful bidder. In holding that the plaintiff shareholder had stated a cause of action, the court observed that "it is inexplicable that independent directors, acting in good faith, could approve the deal" when it was so tainted.

Litwin v. Allen[, 25 N.Y.S.2d 667 (Sup.Ct.1940),] is often cited as an exception to the foregoing proposition. Put another way, Litwin supposedly creates an "incredible stupidity" exception to the business judgment rule. Under this reading of the opinion, it stands as an example of a board decision so irrational as to not deserve the protection of the business judgment rule. One problem with this analysis is that Litwin involved the directors of a bank, who are typically held to a higher standard of accountability than directors of other corporations. Another is that Litwin is a sport -- a case that falls well outside the norm. It is cited so often, because it stands alone as plausible precedential support for the irrationality exception to the business judgment rule. Finally, consistent with our hypothesis that courts use rationality as a code word for self dealing, the Litwin court found the transaction in question to be "so improvident, so risky, so unusual, and unnecessary as to be contrary to fundamental conceptions of prudent banking practice." Although the court expressly declined to find a violation of the duty of loyalty, it seems fair to ask whether "we have reason to disbelieve the protestations of good faith by directors who reach 'irrational' conclusions?" [Michael P. Dooley, Fundamentals of Corporation Law 263 (1995).]

In sum, it may be that there are some board decisions that are so dumb that the business judgment rule will not insulate them from judicial review. [See Gagliardi v. TriFoods Int'l, Inc., 683 A.2d 1049, 1051n52 (Del.Ch.1996) ("There is a theoretical exception ... that holds that some decisions may be so 'egregious' that liability for losses they cause may follow even in the absence of proof of conflict of interest or improper motivation. The exception, however, has resulted in no awards of money judgments...."; emphasis supplied).] Even if the set of such decisions is not an empty one, however, the tail ought not wag the dog. Because a prerequisite of rationality easily can erode into a prerequisite of reasonableness, courts must tread warily here. If they want to persist in requiring that there be a rational business purpose, at least they can ensure that that requirement lacks teeth.

I think Disney fits into the class of cases I'm discussing here. Chancellor Chandler explained in Disney that:

[A]ll of the alleged facts, if true, imply that the defendant directors knew that they were making material decisions without adequate information and without adequate deliberation, and that they simply did not care if the decisions caused the corporation and its stockholders to suffer injury or loss. Viewed in this light, plaintiffs' new complaint sufficiently alleges a breach of the directors' obligation to act honestly and in good faith in the corporation's best interests for a Court to conclude, if the facts are true, that the defendant directors' conduct fell outside the protection of the business judgment rule.

There are two ways of interpreting this key passage, both of which can be squared with existing doctrine. First, we could be dealing with a case of egregiously flawed process due care. In this interpretation, Chandler is not concerned with the merits of the Disney board's decision, but rather is finding that the procedures by which the decision was made were so fundamentally flawed as to deny the board the protections of the business judgment rule. This requirement of process due care is a well-established principle of Delaware law, as explained at pages 276-83 of my treatise Corporation Law and Economics. This interpretation is what I think is going on in Disney.

Second, however, one could also interpret this passage as emphasizing a requirement of good faith. In this interpretation, the Disney board's decision was so egregiously unsound on the merits as to shock the court's conscience and, therefore, fall outside the protections of the business judgment rule. I gather this is how Gordon interprets it and it is a very plausible reading. Yet, even if this interpretation is correct, Disney still could be squared with existing law by fitting it into the absence of irrationality line of cases discussed herein.

The Disney board made a decision that, on its face, is almost impossible to defend. As the Delaware Suprme Court put it in Brehm v. Eisner, “the sheer size of the payout to Ovitz, as alleged, pushes the envelope of judicial respect for the business judgment of directors in making compensation decisions.” The board gave Ovitz cash payments of $39 million and stock options worth over $101 million for just 14 months work. The facts suggest that Eisner hired his buddy Ovitz, fell out with Ovitz and wanted him gone, cut very lucrative deals for his friend Ovitz both on the way in and on the way out, all the while railroading the deals past a complacent and compliant board. The story that emerges is one of cronyism and backroom deals in which preservation of face was put ahead of the corporation's best interests. As such, the case does not necessarily presage the emergence of what Allen called "'"objective' evaluation of the decision" made by a board. Instead, this looks like another case in which "we have reason to disbelieve the protestations of good faith by directors who reach 'irrational' conclusions?" Michael P. Dooley, Fundamentals of Corporation Law 263 (1995). Once again, a seeming inquiry into the rationality of the decision arguably masks an underlying search for conflicted interests and self-dealing.

The Relevance of Catholic Social Thought to Policy Issues

The recent discussion in this space of employee wages and, in particular, Mark Sargent's thoughtful contribution re the Catholic doctrine of just wages, prompted the following email from a reader:

Prof Bainbridge: Been a fan of yours ever since you coined the phrase "statist snakes in the communitarian grass" some time ago in a law article. [Ed.: My blushes. He is referring to Community and Statism: A Conservative Contractarian Critique of Progressive Corporate Law Scholarship.] And glad to hear you have received some sensible thoughts on living wages. One thing I did not see much discussed is to me the critical one. Where is the faith-based justification for wage LEGISLATION? I can see compelling appeals to individual consciences and beliefs, but it is a big jump to argue that one should harness the power of the state to this end. One of the things you jump would appear to be separation of church and state. If we don't address this issue, we look a lot more like those who would impose Sharia law, no?

It's a fair question, but it sure opens up a can of worms. There is a long and complex debate over the extent to which faith-based arguments are appropriate in what Fr. Neuhaus calls the Naked Public Square. There are a number of perfectly sensible people who argue that faith-based arguments should be excluded from discourse in a pluralistic liberal democracy. Others say that faith based arguments are perfectly appropriate. (There probably are even some lunatic fringe types who think only faith based arguments should be allowed.)

For what it's worth, and so regular readers know where I'm coming from, my own take is somewhere in the middle. I think it is perfectly appropriate for people to make faith-based arguments with respect to legislative issues. On the other hand, I don't think those arguments are trump cards. Instead, those who advance faith based arguments must do so in a way that can persuade those who do not share the faith in question. This can be done in one of two ways. First, it can be done by transcending narrow sectarian beliefs to call upon moral norms that are very widely shared amongst folks of differing beliefs. Not just Catholics, for example, think murder is wrong morally. (I discuss this option, which is the one I find most attractive in my article Social Propositions and Common Law Adjudication.) Second, it can be done by using faith based arguments to make a case for results that can also be reached through secular reasoning.

With respect to the living wage argument, I think it is perfectly appropriate to invoke just wage doctrine because (a) lots of non-Catholics also believe for religious or ethical reasons in what Catholicism calls the preferential option for the poor and (b) you can argue for living wage on other secular grounds. Hence, the just wage argument is part of the overall marketplace of ideas and, as such, may make a valuable contribution. As it happens, I am deeply skeptical of living wage legislation, but I found Dean Sargent's discussion of how the just wage doctrine fits into the debate quite informative (as was Paul Jaminet's reply).

Employees, Pay, and Risk (IV): Paul Jaminet on Just Wage Theory

Paul Jaminet (of the Brothers Judd Blog) sent in a very thoughtful email in reply to what Mark Sargent wrote in this space about Catholic social thought's just wage doctrine. Since I liked Paul's email a lot, but he said he wasn't going to post it over at Brothers Judd, I asked if I could reprint it here. He kindly consented:

Some years back I read a fascinating review of medieval just price theory by some leading economic historians of the 1930s. (Alas, I didn't take notes and can't cite sources.) Apparently, Aquinas and his successors were free marketers in the sense that they thought, as a general rule, that mutually agreed prices should not be interfered with by authorities, but they also felt a need to address the moral process of price determination. (Just price theory, like just war theory, also involves moral & prudential considerations, not just questions of right or legitimacy).

In the medieval economy, most merchants were monopolists, and there was routinely a wide range of mutually agreeable prices -- the buyer (or seller) would willingly pay (accept) a much higher (lower) price than the merchant could profitably sell (buy &dispose of the good). Just price theory was meant to provide some guidance for buyer/seller and merchant, helping them to reach agreement and avoid giving all the profit to the merchant.

It seems to me there's much less basis for a just price or just wage theory today, when most bargaining situations are competitive. Prices/wages are constrained on both sides -- the would-be employee by other job opportunities, the would-be employer by the need to remain competitive; so a just price theory for wages, even if both parties believe in it, can only slightly alter the bargain. Meanwhile, if just wages are mandated by law, they risk harming both parties by outlawing the mutually acceptable terms and destroying the possibility of a bargain. If the prices involved are wages, this leads to unemployment, as Professor Sargent notes. On the other side, advocates of mandates can point to some existing 'just price' regulation, e.g. for electrical utility rates and telephones, which are arguably beneficial.

If the goal of modern just wage theory is to give every household an income that 'enables a parent to stay home with the children,' then eliminating poverty is what we are after; and this is a very different goal than Aquinas's. If eliminating poverty is the goal, then other means beside price regulation (or price moralizing) are necessary. And this modern goal will only be accomplished by proving Jesus wrong!

Boy do I love having really smart readers. I don't have a dog in this fight (yet), as I am still sorting out for myself both the theological and prudential aspects, but I am enjoying providing a forum for the discussion and I'm learning a lot!

Employees, Pay, and Risk (III): Mark Sargent on Just Wage Theory

My good friend Mark Sargent, Dean of the Villanova law school, leading corporate law scholar, and general good guy, sent me an email earlier today following up on my living wage post. Mark brought Catholic social thought's just wage doctrine to bear on the problem. I liked Mark's comments so much that I asked him if I could post his email. He kindly consented; so with no further ado, herewith Dean Sargent on just wages:

The Sanders/Graham exchange on the Santa Monica Living Wage proposal raises questions that are very familiar in the debate in Catholic Social Thought over the concept of the “just wage.” While the concept has its origin in pre-modern notions, it was amplified in the industrial era both in papal encyclicals and the theoretical literature to give weight to the CST concept of the dignity of labor. It is often invoked by modern Catholic theorists and activists in debates over minimum wage policy, and thus may be relevant to the Santa Monica question.

1. At first blush, the CST just wage tradition would seem to support the Living Wage proposal. In fact, it would even seem to refute Prof. Sanders' argument that some consolation can be drawn from the fact that low wages are often paid to people not dependent exclusively on that wage. In the CST tradition, a just wage is one that enables a parent to stay home with the children, which is obviously something that reflects the centrality of the family in Catholic social teaching, particularly under the principle of subsidiarity. Wage policy that undermines family structures can't be a good thing, in the CST view.

2. Upon closer examination, however, the just wage concept is a statement of basic principle that would allow prudential judgment leading to a counterintuitive application of the CST principle. An example of this is my colleague Michele Pistone's argument that traditional CST opposition to "brain drain" emigration of educated elites from developing countries is misguided, because such emigration creates a very significant flowback of financial and human capital to the home country. With respect to the Living Wage question, the argument would be twofold: first, the imposition of such a minimum wage requirement on employers in a local market subject to significant competition from outside that jurisdiction is likely to result in fewer jobs, particularly with employers who are marginal competitors. The less needy also may derive unintended benefits (i.e., tipped employees). That hardly serves the goals of just wage theory. Second, the unworkability of a high minimum wage, however, does not eliminate the social responsibility to develop alternative mechanisms that would put low-income workers into something like the position they would have been in had a just wage have been paid. That alternative mechanism may be the EITC or some other tax change that benefits the poor. The key point is that we can't be simple-minded in arriving at the "just wage"; we need to recognize that the goal may be achieved through a means other than high minimum hourly rates. But we do need to do more about achieving that goal!

3. I draw less comfort than Professor Sanders from the observation that most minimum wage earners are not depending exclusively upon those wages for family support. Many of those families are depending upon two minimum or near-minimum salaries to live. That's not easy, as Barbara Ehrenreich showed so painfully in her well-known field study, Nickel and Dimed. I don't think Professor Sanders intends to dismiss that dilemma (and I am sure he is aware of it), but it's not like hotel maids are the wives of professionals looking for pin money. The problem of two-earner families that can’t make a decent living is a real one, and one of major concern from a CST perspective.

Thanks Mark. I knew I should work just wage theory into the discussion, but I also knew I would only be exposing my ignorance! I'm glad to have provided a forum for Mark's very thoughtful comments.

Employees, Pay, and Risk (II): A Living Wage

My post on employee pay and risk generated some very thoughtful emails. One of the more common points was the observation people can't live on what Wal-Mart pays them, which is almost certainly true. But what are we to do about it, as a matter of social policy? One option popular with the Left is living wage legislation. My UCLA colleague Richard Sander, however, has demonstrated that living wage laws don;t work and even prove counterproductive. His extensive research culminated in a report on a proposed living wage ordinance in Santa Monica, whch Sander summarized in an excellent op-ed, in which he explained:

Most people who have low-wage jobs do not live in low-income households -- they are usually secondary earners in their families. This was obviously true for the teenagers working the rides at Santa Monica Pier, but it is even true for hotel maids. In Los Angeles as a whole, less than 20% of maids (and fewer than 15% of low-wage workers generally) are the primary wage-earner for a family with children, and fewer than 5% are the sole wage earner for a family. The argument that minimum wages should be determined by what is enough money to lift a family out of poverty is, therefore, logically a non-starter. Overall, Prop JJ [Santa Monica's living wage ballot proposition] was so poorly targeted that 65% of the benefits went to households with incomes in the top half of the Los Angeles income distribution, and only 7% went to households that were poor or near-poor (that is, within 50% of the federal poverty line).

He goes on to explain how the proposition would have cost an enormous number of jobs to leave Santa Monica. Granted, one example is hardly enough to condemn the whole enterprise, but Sander's research does raise doubts about the merits of such legislation. (Also of interest is Sander's report on the Los Angeles living wage law, which supported a modified version of that law.)

Constructively, Rick did not simply shoot down the living wage law. Instead, he advocates a local version of the Earned Income Tax Credit (in effect, a local negative income tax). A very promising idea for really helping low-income workers. As they say, go read the whole thing. Update: Check out Chris St Pierre's rebuttal.

Employees, Pay, and Risk

I've been thinking a lot today about employee compensation. Yesterday's LA Times had a long article on Wal-Mart, the gist of which is that Wal-Mart's employees should be unionized and paid a lot more. One of the article's key points is that Wal-Mart's low pay has ripple effects, driving down the pay and benefits of unionized grocery store workers at Safeway and Albertson's. The subject came up again when I surfed over to CalPundit, where guest blogger Barbara Maynard, the chief spokesperson for UFCW Locals 770 and 1442, the grocery store unions on strike here in the Southland, asks:

Would you rather that these 70,000 middle class jobs become poverty level jobs filled by workers who have to turn to the taxpayer for healthcare and food stamps? That’s what the companies are proposing because that’s what Wal-Mart has. The CEOs of these three companies are just trying to keep up with the Waltons. Their combined operating profits have gone up 91% in the past five years...but Wal-Mart’s have gone up even more. Good lord — when is enough enough? At what price profits??? [Ed.: My emphasis]

I think unions serve important social and economic functions, as I've explained before, but when I hear actual union leaders talk I am reminded of an old Peanuts cartoon in which Linus says: "I love Mankind, its people I can't stand!" It's a lot easier to think positive thoughts about unions at the level of economic theory than when watching them work in practice.

Anyway, I was thinking about whether I wanted to write up Maynard's and CalPundit's comments, when I discovered a post by Rob at Business Pundit that provides a powerful answer to Maynard's question(to be clear, Rob's post didn't say anything about either the Times article or the CalPundit post):

What people don't accept is that some people make almost nothing while the company they work for makes a huge profit. The question seems to be that if a company is profitable, why should all the money go to the shareholders? Why not give some to the employees who are barely getting by? I think I have an answer to this, based on my own recent experience - the profits belong to those who take the risk, not those who do the work....

I am in the process of starting a company. ... I am the one who, by doing this, is on the hook for 300K if it fails. I am the one who may lose my house and file bankruptcy if it doesn't work. This could ruin my life. Why would I take such a risk? Because if things go well, I will have significantly more money than I do now. ... The people who will work for me aren't taking a risk. If we can't make it, they will simply move on to another job. They won't owe a bank huge sums of money, they won't have lost tens of thousands of dollars of their own hard-earned cash.

Gordon Smith at Venturpreneur followed up with a great post putting fleshing out Rob's framework with some economic theory:

Instead of asking who is entitled to the profits, let's ask who is most likely to maximize profits? (After all, from a societal standpoint, maximizing the residual claim maximizes value creation, and we generally like value creation.) On the one hand, anyone who has a claim to the profits will want to maximize them. On the other hand, the only person who has a chance of success is the person who controls the firm. Here is a kernel of insight: profits attach to residual control. ...

Well, maybe I failed to mention that people can exercise residual control only by "purchasing" the right (not necessarily from another person, but by exposing oneself to substantial personal loss). This is where the notion of risk comes into the picture. If control were cheap, everyone would want it (which, of course, would cause the price rise ... so that was a silly game, wasn't it?). Residual control is expensive relative to other forms of participation in the firm.

Requiring entrepreneurs to take this step of puchasing residual control acts as a defense against adverse selection: people who know that they have limited competence would not be willing to purchase residual control because the costs of failure are too high.

As I explained in my article, In Defense of the Shareholder Wealth Maximization Norm, maximizing the value of the residual claim is just as important for established public companies as it is for the startups Rob and Gordon are discussing. In sum, Ms. Maynard is asking the wrong question. It's not "at what price profit" but "at what price not making a profit?" Take away the profit motivation and Ms. Maynard's union members won't be dealing with higher health benefit costs, they'll be out of a job.

Update: I want to quibble with one point Rob made. Rob wrote:

The people who will work for me aren't taking a risk. If we can't make it, they will simply move on to another job. They won't owe a bank huge sums of money, they won't have lost tens of thousands of dollars of their own hard-earned cash.

Rob’s argument only works with respect to employees whose jobs do not require investments in firm specific human capital, because employees who do make such investments fairly can be said to be taking an entrepreneurial-like risk.

Consider an employee who invests considerable time and effort in learning how to do his job more effectively. Much of this knowledge will be specific to the firm for which he works. The effort and opportunity costs incurred in developing such knowledge constitute an investment in firm specific human capital upon which the employee can earn a return only so long as he remains with that firm.

A rational employee will invest in firm-specific human capital only if rewarded for doing so. An implicit contract thus comes into existence between the employee and the firm. On the one hand, employees promise to become more productive by investing in firm-specific human capital. They bond the performance of that promise by accepting long promotion ladders and compensation schemes that defer much of the return on their investment until the final years of their career. Accepting deferred compensation, in which salary or wages rises with seniority, provides such a bond because the employee will carry out his side of the bargain in order to avoid being terminated before compensation rates rise at the end of his career. In return, the firm promises to fulfill its part of the bargain by providing job security so that the employee will be able to collect that deferred compensation. This bargain exposes the employee to firm specific risk. If the firm fails, their investment will be lost. If the firm behaves opportunistically, such as by terminating older employees, again their investment will be lost. These employees thus are taking an entrepreneurial-like risk. They can't just "simply move on to another job," as their investment has created a bilateral monopoly. As for Rob's employees, however, I gather that Rob will be helping his employees develop their general human capital to a higher level, rather than requiring them to develop human capital that is specific to your firm, in which case he is quite right that they are not taking entrepreneurial-like risk.

As for employees who do invest in firm specific human capital, do such employees have a “right” to a share in firm profits? Of course not. As an economic matter, however, failing to provide such employees with credible prote ctions for their investments in firm specific human capital will significantly increase labor costs and/or reduce firm productivity. Firms that want to encourage such investments will find a variety of ways of providing the requisite assurances. Promotion ladders with ports of entry, profit-sharing, seniority systems, and the like are all options.

From a management perspective, an entrepreneur needs to figure out whether his new business will require employees with general or firm specific human capital. In many front-line industries, skills evolve so rapidly that the skills of even quite young employees become obsolete and are replaced by still younger workers. This has led to a situation in which the old implicit contract between workers and companies, in which workers traded loyalty for job security, is virtually dead. Instead, the labor relationship is increasingly viewed as temporary by both sides. Job mobility is increasingly more common than job security. In such an environment, workers need – and are more likely to develop – general human capital rather than firm specific human capital. Figuring out which type of employees you need is a key management decision for any entrepreneur.

Ribstein on mutual funds

My friend Univ. of Illinois law professor Larry Ribstein (who also put together the BusFilm web site on business movies) has an op-ed in draft on the mutual fund scandal, in which he argues:

Investors care mainly about fund returns. Market timing and late trading by large investors are significant only to the extent that they might affect expected returns, as by indicating mismanagement. But then it seems enough that investors know about the fund’s policies so they can decide whether to, for example, hire their own professional portfolio managers, invest in exchange traded funds whose prices are constantly updated, or buy low-fee index funds whose managers lack incentives to make deals with big investors.

Although at first glance Larry seems to be making the same "much ado about nothing" argument recently advanced by Alex Tabarrok, Larry does acknowledge the need for limited regulatory intervention; indeed, he seems to agree with my points that (a) no new laws are needed but (b) we do need to enforce the laws on the books:

There does seem to be a problem here. Special favors to large investors allow them to make discount purchases or premium sales of fund shares, siphoning $5 billion a year for “market timing” and $400 million for late trading from small investors, in addition to “liquidity” costs of portfolio rebalancing. ...

In short, [however,] the problems with mutual funds do not require a federal solution. Congress and the SEC have had their chance for 60 years. It’s time to give markets and state law a chance.

i agree with the thrust of Larry's case against new regulation, but disagree insofar as Larry seems unwilling to apply the federal laws that are already on the books. As I understand it, the mutual funds in trouble all had policies against late trading and market timing. The prospectuses by which they sold those funds described those policies (I pulled some of my fund prospectuses and they all have fairly detailed statements of such policies, although none of the fund companies in which I'm invested have been implicated -- yet). Hence, as I suggested in my original post, we not only have a problem of self dealing, we also have fraud. So while I'm all in favor of markets and state fiduciary duty law being used as constraints on the fund industry, I also think that the fraudsters can and should be punished under Securities Exchange Act Rule 10b-5 and the relevant Investment Company Act provisions. UPDATE: Larry emailed me:

To clarify [that] I don't suggest not enforcing current disclosure laws. My article asks whether disclosure alone is enough ("Beyond disclosure, the potential solutions become murky . . . "). Also, I'm curious what you think about my suggestion in my followup post that all we have in most of these cases is bad business judgment.

I don't know that I would call fraud bad business judgment. Anyway, as I understand the facts, at some of these funds the managers have had a financial stake in the entities allowed to do market timing, which would be self dealing.

Let's Take Calpundit Back to the Vault

Mr. Drum opines:

Least surprising headline of the day: "2 Bills Would Benefit Top Bush Fundraisers." Can you imagine?

Shocking. But let's go to the vault:

[Former President Bill] Clinton issued 140 pardons and 36 sentence commutations hours before he left office January 20.

Clinton has come under heavy fire for the pardons, particularly that of Marc Rich, a billionaire financier who had been listed as an international fugitive by the Justice Department, for various tax and fraud charges. ...

Former President Jimmy Carter criticized the Rich pardon in an appearance at Georgia Southwestern State University on Tuesday night. "I don't think there's any doubt that some of the factors in his pardon was [Ed.: sic] attributable to large gifts, some of which he gave to Israel, other benefactors and the influence of his former wife, so I think that was, in my opinion, disgraceful," Carter said, adding that Clifton [Ed.: sic] had "brought discredit to the White House because of it."

Can you imagine?

Slate's Coverage of the Martha Stewart Trial

Henry Blodget, a former securities analyst, is going to be covering the Martha Stewart trial for Slate (go here). The first entry bodes well, at least for the potential amusement value. Regular readers know I've been blogging in defense of Martha, even though I don't like her TV persona very much (okay, you got me, I don't like it at all).

Private Sector Unions: Catholic Social Thought and Economic Analysis

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

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

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

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

How not to Starve the Beast: Bush's Tax and Spending Policies

The argument made by some that tax cuts will "starve the beast" is looking dumber and dumber. As David Wessel observed in this morning's WSJ:

There are two competing visions of government. The tax-more and spend-more approach sees bigger government as popular and prudent. The cut-taxes and cut-spending approach sees smaller government as popular and prudent. Either adds up. A third doesn't: The current approach of cutting taxes and increasing commitments to spend into the future.

Bush continues to shovel money into Leviathan's gaping maw. Although Bush keeps talking about limiting growth in discretionary spending to 4% a year, discretionary appropriations actually increased by 12% percent from fiscal year 2002 to fiscal year 2003. Granted, part of that is attributable to the war on terror, as military and homeland security appropriations grew 17%, but non-defense discretionary appropriations grew by 8% - double what the President says he wants. (Data here.) Now we're going to throw more fuel on the fire with the biggest new entitlement program in decades in the Medicare bill, which will cost at least $400 billion over the next ten years (and such estimates always are too low). How can any serious person believe that this orgy of spending will ever lead to budget cuts down the road?

Hagiographic FDR Biographer under SEC Investigation

Lord Conrad Black, who is the largest shareholder and chairman of the board of directors of Hollinger International, has stepped down as CEO of Hollinger in the wake of charges that he and cronies received payments that had neither been approved by the board nor disclosed to the shareholders (see here). Black also is the author of a recent biography of Franklin Delano Roosevelt. Interestingly, one of the charges against Black is that he caused Hollinger to spend $8 million to buy FDR historical papers, which he presumably then used in writing his FDR biography. For a critique of Black's analysis of FDR's economic policies, see Jim Powell's review, which Alex Tabarrok of Marginal Revolution strongly endorsed.

On to the good stuff, however; i.e., the corporate governance aspects. The WSJ (sub. req'd) is reporting that:

Mr. Black's continued role as chairman has angered some minority shareholders. "It's a disgrace," said Laura Jereski, an analyst with Tweedy Browne Co., the New York investment firm that prompted the Hollinger board to investigate fees paid to Lord Black and his associates. "This board has left a guy in place who has no recognition at all of the inappropriateness of taking money out of a public company."

To the extent Ms. Jereski is mad at the board for not removing Black from his position as chairman of the board, she has a point. Under Delaware law, the board may remove its chairman from that office. And, under these circumstances, they probably should have done so. To the extent Ms. Jereski is mad at the board for not removing Black from the board of directors, however, she has no case. According to Hollinger's 10-K, it is incorporated in Delaware. There is no provision under Delaware law for the board of directors to remove one of its members. Indeed, there is case law specifically holding that the board lacks power to remove one of its own members. See, e.g., Dillon v. Berg, 326 F. Supp. 1214 (D. Del. 1971). Under Delaware General Corporation Law § 141(k) only shareholders are authorized to remove a board member. Unfortunately for Ms. Jereski, Lord Black still controls 73% of Hollinger's voting stock. As the risk factors section of Hollinger's 10-K explains:

Lord Black currently controls a majority of the voting power of the Company. Other shareholders will be unable to affect the outcome of stockholder voting as long as Lord Black retains his controlling interest. ... As a result of this controlling interest, Lord Black will be able to determine the outcome of all matters that require shareholder approval, including the election of directors, amendment of the Company’s charter and approval of significant corporate transactions. Lord Black will also have a significant influence over decisions affecting our capital structure, including the incurrence of additional indebtedness and the declaration of dividends.

What then is to be done about Lord Black? The minority shareholders could try to remove him, but they’ll lose if he opposes it. (They'll probably also have a lot of trouble calling a special meeting and getting removal on the agenda, but set that aside). If they manage to hold a vote, and Black votes against his removal, they could try suing him for breach of the fiduciary duties owed by controlling shareholders, but that's a tough cause of action to win. (Unlike the Model Business Corporation Act, Delaware law has no provision for judicial removal of directors.) Under Securities Exchange Act § 21(d)(3), the SEC may seek to have Black barred from serving as a director or officer but only if Black is found to have violated Exchange Act § 10(b) (i.e., to have committed securities fraud). So the minority may well be stuck with Lord Black for quite a while.