ProfessorBainbridge.com

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.

Why do Restaurant IPOs Perform So Badly?

According to yesterday's WSJ (sub. req'd), there have been 75 restaurant chain IPOs in the last ten years. Overall, the sector has gained only 2% from their initial offering price, which is staggering given the evidence that IPOs generally are way underpriced. The sector's results become even more surprising, however, when you strip out the two success stories -- PF Chang China Bistro and Krispy Kreme Doughnuts. If you remove them from the data set, the sector as a whole lost 20%. On top of this data, moreover, one might note the anecdotal results from such high-profile flame-outs as Boston Chicken and Planet Hollywood. Granted, the restaurant game is a perilous one, as most restaurants fail in their first year. Restaurant IPOs, however, involve chains that are reasonably well-established and geographically diversified. The failure of any one location (or even several) should not take down the whole chain. Also, of course, the restaurant business was particularly hard hit by the combination of the recession and 9/11. Yet, it seems that restaurant IPOs were not doing all that well even before the stock market bubble burst. So I don't have a good theory for why this sector underperforms. (Ideas, anyone?) All I know for sure is that it's a sector I would avoid.

UPDATE: Jeremy Wright of Ensight offers some thoughtful comments, especially with regard to the role franchising plays in the restaurant sector.

Alex Tabarrok on the mutual fund scandal

Few blogs are consistently as thought-provoking as Marginal Revolution. I am an unabashed fan. Every once in a great while, however, the thoughts they provoke are those of utter astonishment. So it was with Alex Tabarrok's post The Mutual Fund Scandal - much ado about nothing. In the following table, the text of Alex's post is in the left-hand column, my comments are on the right.

Alex Tabarrok	Steve Bainbridge
Let's take it for granted that insiders have used the peculiar pricing practices of the mutual fund industry to transfer some profits from buyers. According to some accounts, hundreds of millions of dollars have been transferred in this way ....	1. It's important to make clear that the scandal is not just self dealing by insiders. A big part of the scandal relates to mutual fund companies allowing certain investors to engage in market timing trades and late trading. These mutual fund companies all had policies against such trading, which were stated in their prospectuses. As such, we not only have self dealing, we also have discrimination among investors and securities fraud. 2. The gist of what is to come is signaled by the dismissal of siphoning of hundreds of millions of dollars as the transfer of "some profits."
But remember mutual fund buyers get quarterly statements showing their returns net of all chicanery. Is it so hard to believe that buyers make their decisions based upon their actual returns? A mutual fund that performs poorly is a mutual fund that performs poorly regardless of whether this was due to bad investment decisions, high expense ratios, or a slick transferring of funds. A few investors might buy and then accept any return as a matter of luck but the marginal investor can and does move funds around easily (what market is more contestable?) - not to mention the institutional investors.	Alex seems to be assuming zero transaction costs. In fact, the transaction costs of switching mutual funds can be significant. Many funds charge back-end load fees (a.k.a. exit fees or deferred sales charges) of 3-7% when investors pull their money out. Many more fund charge front-end load fees that reportedly run "5.75% for equity funds, [albeit] less for bond funds, and [which] are simply deducted from the amount being invested." In addition, many investors hold their mutual funds through brokerage accounts, which is another potential source of fees. As such, the transaction costs of switching may well be significant. (Alex's co-blogger Tyler Cowen likewise has suggested that mutual fund investments are sticky. I doubt whether mutual funds are quite as sticky as Tyler seemed to think, for reasons explained here, but that doesn't mean I think the mutual fund market is a zero transaction cost environment.) Because there are non-trivial transaction costs to switching funds, investors should care why a fund is under-performing. A fund that has a bad quarter because they got unlucky with a couple of big positions presents a very different problem than a fund that has a bad quarter because insiders have been self dealing and letting favored investors violate stated policies. The latter fund is much more of a long-term threat to investor wealth than the former. If you don't know why the fund is underperforming, however, you can't distinguish between the two. The last observation suggests that self dealing by insiders at a few funds could have negative externalities for the industry as a whole. If investors cannot distinguish between underperformance caused by a run of bad luck and self dealing, they may begin to perceive the whole industry as a lemons market. Assume there are two classes of investors. One class believes the magnitude of the harm posed by insider self dealing justifies restricting such self dealing. Accordingly, this class is willing to pay higher fees to funds who promise not to allow self dealing. The other class is willing to allow self dealing by managers of its funds, so long as those funds charge lower legal fees. An unscrupulous fund will try to maximize its income by attracting investors in the first class while secretly self dealing. Investors in the first class will be aware of this phenomenon, but the high detection and enforcement costs associated with self dealing make it almost impossible for them to distinguish between honest and dishonest funds. A prohibition of self dealing enforced by public law enforcement agencies makes these investors better off, but makes the second class worse off. If one believes that most investors fall into the first class, however, a prohibition of insider trading would be efficient (so long as one is willing to use the Kaldor-Hicks definition of efficiency.) Hence, a prohibition of self dealing may have advantages for the industry as a whole, by giving credibility to their promises not to allow self dealing and thus reducing agency costs. UPDATE: As Leaderlog observes, "non-transparency is usually synonymous with rent-seeking."
As a result, it makes little difference whether the managers get their return through the above-board expense ratio or the under-handed exploitation of stale pricing. Sure, there may be some exploitation at the margin but this is akin to banks that charge fees for "free checking" or restaurants that include a gratuity in their bill. It's annoying and the occasional consumer may be dunned but once consumer and competitor responses are taken into account the net transfer is small.	This is the part that really surprised me. If Alex is right, then generations of corporate lawyers have wasted their time worrying about the duty of loyalty and generations of economists have wasted their time worrying about agency costs. So long as markets are liquid, we apparently don't need either prohibitions of self dealing or institutional constraints on agency costs such as hostile takeovers. Investors can fully protect themselves by switching out of underperforming funds. Of course, if I'm right about the transaction cost and transparency points above, maybe that isn't true. (I also think Alex is too glib about the "net transfer" from self dealing.) In any event, I think it is instructive that corporate law long has drawn a distinction between bad management and self dealing. At first blush, you might think that the agency costs associated with bad management and self dealing differ in degree but not in kind. Both reduce shareholder wealth. Both are forms of shirking, at least in the broad sense that term is used by agency cost economists. On closer examination, however, self dealing in fact differs in kind, not just in degree, from bad management. Managerial decisions typically are collective actions of the board or top management team as a whole. In making such decisions, the board and/or management is constrained to exercise reasonable care by a combination of external market forces and internal team governance structures. In contrast, self dealing transactions rarely implicate the entire board or management team. To the contrary, they often involve misconduct by a single director or even a mid-level employee. Those who intentionally self deal, moreover, likely also actively seek to conceal their defalcations. Given the potential gains of self dealing in an organization characterized by a separation of ownership and control, legal liability thus is a necessary deterrent against such misconduct.
If you doubt the above, assume that we eliminate all under-handed practices. Do you think that consumers will now earn higher returns? Or, do you think, that other fees will rise to make up the difference? I predict the latter.	Here is where we come back to the point that the problem is not just self dealing but also securities fraud. Even if Alex is right that investors would (should?) view self dealing and disclosed fees as interchangeable, it is not clear that they would view fraud and fees as interchangeable. (Anyway, another aspect of Alex's argument puzzles me. Because fees benefit the fund management firm, while self dealing benefits individual managers, even if investors don't care about self dealing, fund management firms should.) We also come back to the points about the transaction costs of switching funds and the risk that a lemons market will emerge. If investors care whether their funds lie about things like market timing and late trading by favored investors, honest firms could attract investors by promising to prevent such trading. In order to work, however, such promises must have credibility. Investors will demand that fund management provide a credible promise—a bond—that guarantees that the fund will abide by its stated policies. Law can facilitate private ordering by providing such a bond. Candidly, I am somewhat skeptical that one needs the full panoply of disclosure and procedural rules imposed by U.S. securities law in order to provide such a bond (see here). At the very least, however, facilitating the making of credible commitments requires an antifraud rule (like present Rule 10b-5) and enforcement regime.
The only danger is that in their haste to make political hay the politicians will end up passing some dumb law that makes everyone worse off.	Here we are in complete agreement. Regular readers know I am a skeptic of much recent corporate governance reform legislation and regulation. At the same time, however, I think that current laws against self dealing and fraud ought to be enforced with vigor. I would have thought Alex would too.

But, as they say, decide for yourself.

Securities Lawyers as Gate-Keepers and the Economic Incentives of Modern Legal Practice

Securities Litigation Watch blogged on a talk by Columbia University law professor John Coffee at which Coffee advanced his argument that outside legal counsel should take on an auditor-like role in certifying the accuracy of the client's financial disclosures. Mike O'Sullivan at Corp Law Blog picked up on that post, linking the report about Coffee's talk to Coffee's recent law review article The Attorney as Gatekeeper: An Agenda for the SEC, 103 Columbia Law Review 1293 (2003). Mike does a typically excellent job of explaining why Coffee's proposal should "die a quick death and be quietly buried in the academic legal writing cemetery." Ouch.

I don't disagree with anything Mike said, but my take on the problem would start by thinking about incentives. Some might say I am too cynical about my fellow lawyers, but I can't help thinking that people respond to incentives (and cognitive biases). And, as I see it, the incentives of lawyers are such that they would not do a very good job at the task Coffee wants to assign them. The remainder of this post is derived from my article, The Tournament at the Intersection of Business and Legal Ethics. (You might also be interested in Managerialism, Legal Ethics, and Sarbanes-Oxley Section 307.)

In the first place, all partners have an incentive to keep key clients happy. Enron was Vinson & Elkins’ largest client, generating about 7% of the law firm’s revenues. About 20 former Vinson and Elkins lawyers took jobs in Enron. Vinson & Elkins therefore had strong incentives to remain on good terms with Enron’s managers. Can the Enron example be generalized? Coffee argues that attorneys are likely to have a more varied client base than do auditors, which reduces the conflicts of interest that apparently contributed to the auditing failures at the base of the most recent corporate scandals. Coffee cites no empirical data for this proposition, although I suspect he may well be correct with respect to large national law firms. At the smaller regional firms—like Vinson & Elkins—that were involved in many of the recent scandals, however, I suspect it is far more common that a firm will be dependent on billings to a single client.

In the second, modern legal practice winning the tournament that leads to partnership does not put an end to survival of the fittest competition. In recent years, law firms have shifted away from the old rules of partnership in which promotion to partner carried with it job tenure and seniority-based compensation to new models in which compensation is variable and partners lack job security.

Compensation based on business generation means that partners are more vulnerable to shifting market conditions. ... A partner subject to an “eat-what-you-kill” system may be anxious about where her next meal is coming from. Milton C. Regan Jr., Corporate Norms and Contemporary Law Firm Practice, 70 GEO. WASH. L. REV. 931, 937 (2002).

Because an individual partner is even more likely than a firm to be dependent on billings to a single major client, the eat what you kill phenomenon makes it highly unlikely that such a partner will risk antagonizing key clients absent the proverbial smoking gun (and maybe not even then).

In the third, behavioral economic analysis suggests certain basic cognitive biases likely to discourage lawyers from detecting or acting upon management misconduct. Behavioral economists have identified a number of the well-documented cognitive errors relevant to the problem in hand. One is the overconfidence bias, which has been defined as “the belief that good things are more likely than average to happen to us and bad things are less likely than average to happen to us.” Russell B. Korobkin and Thomas S. Ulen, Law and Behavioral Science: Removing the Rationality Assumption from Law and Economics, 88 Cal. L. Rev. 1051, 1091 (2000). If a lawyer is subject to this bias, his judgment will be skewed against believing that his clients are bad people committing fraud. A closely related bias is the confirmatory bias, which is defined as the tendency for actors to “interpret information in ways that serve their interests or preconceived notions.” Id. at 1093. As former Delaware Chancellor Allen aptly noted, albeit in a rather different context, “human nature may incline even one acting in subjective good faith to rationalize as right that which is merely personally beneficial.” City Capital Associates Ltd. Partnership v. Interco Inc., 551 A.2d 787, 796 (Del. Ch. 1988). Lawyers who made the decision to associate with a particular client therefore are less likely to recognize client misconduct, because evidence thereof would be inconsistent both with the lawyer’s self-interest in maintaining a relationship with the client and the lawyer’s self-image as someone who identifies and associates with honest people. In view of the uncertainties created by some of the Part 205 Regulations, it is particularly significant that self-serving biases typically “arise when there is a reasonably high level of ambiguity surrounding a situation.” Donald C. Langevoort, When Lawyers and Law Firms Invest in Their Corporate Clients’ Stock , 80 Wash. U.L.Q. 569, 574 (2002). Taken together, these systematic decisionmaking biases generate a type of “cognitive conservatism” that makes a lawyer “likely to dismiss as unimportant or aberrational the first few negative bits of information that she receives regarding the client or situation.” Donald C. Langevoort, Where Were the Lawyers? A Behavioral Inquiry Into Lawyers’ Responsibility for Clients’ Frauds, 46 Vand. L. Rev. 75 (1993). Given the incentives created by the promotion-to-partner tournament, winners of that tournament are likely to be particularly vulnerable to these biases.

The best evidence for my thesis is the behavior of auditors. Despite reams of rules for conducting audits, training, professional standards, liability threats, and so on, the last few years have demonstrated that the economic incentives of auditors skewed their performance. Why should lawyers be any different?

Statistics on the Judicial Nomination Impasse

The Economist reports:

The Republicans insist that the Democrat's routine resort to the filibuster is unprecedented. ... The Democrats retort that the Senate has been confirming Bush nominees at a record-breaking rate: 168 have been confirmed. Mr Bush has got more judges confirmed in his first three years in office than Ronald Reagan got in his first four. The Senate blocked far more judicial candidates during Bill Clinton's presidency than it has during Mr Bush's.

There is some truth in the Democrats' claim .... But the Republicans stress that, if you narrow it down to the US appeals courts, which decide on tricky judicial issues and provide a pool of candidates for the Supreme Court, the picture changes: only 29 of Mr Bush's 46 nominations to the appeals courts have been confirmed, a lower confirmation rate than Mr Clinton faced in his first three years in office.

So the question you have to decide is this one: Is the relevant statistic 168 to 6 or 29 out of 46? It's the appeals court numbers that bother me the most, but that didn't come as a surprise did it? See my posts The Politicization of the Bench and the Legalization of Politics and Game Theory and the Judicial Nominations Impasse.

UPDATE: Pejman Yousefzadeh is worried about the same set of numbers as I am:

[T]he metrics the Democrats use are misleading, and the Democrats themselves are being disingenuous. Everyone knows that the nominees the Democrats are concentrating on blocking are appellate court nominees. No one is filibustering nominations to a district court, or the United States Court of Federal Claims, or to the various bankruptcy courts. Only appellate nominees are being targeted. And for that reason, when measuring the level of obstruction, one should look at the confirmation rate for appellate court nominees.

Precisely.

Why I'm Opposing the SEC Proposal to Let Shareholders Nominate Directors (II)

My friend and fellow law professor/blawgger Gordon Smith responded to my post Why I'm Opposing the SEC Proposal to Let Shareholders Nominate Directors by arguing that:

Steve is right to oppose the proposed rule, but he has the wrong reason. This is not a problem of the SEC going too far, but rather not going far enough. I hope to share a more complete explanation of my position in a letter to the SEC, but here it is in a nutshell: shareholder voting on board composition is the most important thing that shareholders can do; while we should not allow the shareholder proposal rule to become a vehicle for hostile takeovers, we should enable meaningful ballot access without triggers that evidence managerial dysfunction.

Steve is rightly worried about the costs associated with corporate reform, but this is not the place to draw the line. The SEC should reduce other regulatory burdens, but not stop short of the most important potential corporate governance reform since the adoption of the federal securities laws.

The problem here, of course, is that Gordon and I are coming from very different places with respect to the proper role of shareholders in corporate governance. I start with the premise that the corporation is not a thing capable of being owned. Hence, it is error to view the corporation as being owned by the shareholders. Once you recognize that private property concepts are not relevant, it becomes much harder to see a case for privileging shareholders within the corporate governance structure. Instead, as I see it, the shareholders properly are viewed as just one of many factors of production. Put another way, the corporation is a vehicle by which the board of directors hire, inter alia, equity capital. Of course, in return for their investment of equity capital, the shareholders are entitled to the residual claim on corporate assets and the concomitant shareholder wealth maximization norm. If I'm right about that, then the legitimacy of the corporate governance structure does not depend on shareholder voting. Rather, shareholder voting rights are just one of a myriad of systems by which directors are held accountable for how they exercise their authority. I call this model "director primacy." From a director primacy-based perspective, expanding shareholder voting rights as proposed by the SEC make no sense -- none. Bear with me -- the explanation is pretty long (it also pulls together a number of earlier posts, so it will look familiar to regular readers).

The Costs and Benefits of Promoting Shareholder Democracy

A chief claimed benefit of Rule 14a-11 is its contribution to shareholder democracy. U.S. corporate law, however, is far more accurately described as a system of director primacy than one of shareholder primacy. As Berle and Means famously demonstrated, 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.

Some commentators have argued for reducing the extent to which ownership and control are separated through promoting shareholder democracy, a goal the SEC has advanced to justify Rule 14a-11. Most of these scholars acknowledge that the rational apathy of small individual shareholders precludes such investors from playing an active role in corporate governance, even setting aside the various legal impediments to shareholder activism. Instead, these scholars focus on institutional investors, such as pension and mutual funds.

As the theory goes, institutional investors will behave quite differently than dispersed individual investors. Because they own large blocks, and have an incentive to develop specialized expertise in making and monitoring investments, they could play a far more active role in corporate governance than dispersed shareholders. Institutional investors holding large blocks thus have more power to hold management accountable for actions that do not promote shareholder welfare. Their greater access to firm information, coupled with their concentrated voting power, might enable them to more actively monitor the firm’s performance and to make changes in the board’s composition when performance lagged.

There is relatively little evidence that institutional investor activism has mattered, however. Large blocks held by a single institution remain rare, as few U.S. corporations have any institutional shareholders who own more than 5-10% of their stock. Even the most active institutional investors spend only trifling amounts on corporate governance activism. Institutions devote little effort to monitoring management; to the contrary, they typically disclaim the ability or desire to decide company-specific policy questions. They rarely conduct proxy solicitations or put forward shareholder proposals. Not surprisingly, empirical studies of U.S. institutional investor activism have found “no strong evidence of a correlation between firm performance and percentage of shares owned by institutions.” Bernard S. Black, Shareholder Activism and Corporate Governance in the United States, in The New Palgrave Dictionary of Economics and the Law 459(1998).

Some former advocates of institutional investor activism have therefore retreated to the more modest claim that “it’s hard to be against institutional investor activism.” Yet, even this last revisionist redoubt fails to adequately acknowledge that the purported benefits of institutional control, if any, may come at too high a cost. For example, the interests of large and small investors often differ. If the board becomes more beholden to the interests of large shareholders, it may become less concerned with the welfare of smaller investors.

Let us assume, however, that interests of individual and institutional investors are congruent. As I have argued elsewhere in detail, institutional investor activism still is undesirable because the separation of ownership and control mandated by U.S. law has substantial efficiency benefits. The separation of ownership and control is a highly efficient solution to the decisionmaking problems faced by large corporations. Stephen M. Bainbridge, Director v. Shareholder Primacy in the Convergence Debate, 16 Transnat’l Law. 45 (2002).

Kenneth Arrow’s work on organizational decisionmaking identified two basic decisionmaking mechanisms: “consensus” and “authority.” Consensus is utilized where each member of the organization has identical information and interests, which facilitates collective decisionmaking. In contrast, authority-based decisionmaking structures arise where team members have different interests and amounts of information. Because collective decisionmaking is impracticable in such settings, authority-based structures are characterized by the existence of a central agency to which all relevant information is transmitted and which is empowered to make decisions binding on the whole.

The modern public corporation precisely fits Arrow’s model of an authority-based decisionmaking structure. Shareholders have neither the information nor the incentives necessary to make sound decisions on either operational or policy questions. Overcoming the collective action problems that prevent meaningful shareholder involvement would be difficult and costly. Rather, shareholders will prefer to irrevocably delegate decisionmaking authority to some smaller group. Separating ownership and control by vesting decisionmaking authority in a centralized entity distinct from the shareholders thus is what makes the large public corporation feasible.

To be sure, this separation results in the well-known agency cost problem. Agency costs, however, are the inevitable consequence of vesting discretion in someone other than the shareholders. 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, however, they also are antithetical—at some point, one cannot have more of one without also having less of the other. This is so because the power to hold to account is ultimately the power to decide. As Kenneth Arrow explained:

[Accountability mechanisms] must be capable of correcting errors but should not be such as to destroy the genuine values of authority. Clearly, a sufficiently strict and continuous organ of [accountability] can easily amount to a denial of authority. If every decision of A is to be reviewed by B, then all we have really is a shift in the locus of authority from A to B and hence no solution to the original problem. Kenneth J. Arrow, The Limits of Organization 78 (1974).

Hence, directors cannot be held accountable without undermining their discretionary authority. Establishing the proper mix of discretion and accountability thus emerges as the central corporate governance question.

The root economic argument against shareholder activism thus becomes apparent. Large-scale investor involvement in corporate decisionmaking seems likely to disrupt the very mechanism that makes the public corporation practicable; namely, the centralization of essentially non-reviewable decisionmaking authority in the board of directors. The chief economic virtue of the public corporation is not that it permits the aggregation of large capital pools, as some have suggested, but rather that it provides a hierarchical decisionmaking structure well-suited to the problem of operating a large business enterprise with numerous employees, managers, shareholders, creditors, and other inputs. In such a firm, someone must be in charge. As Arrow put it: “Under conditions of widely dispersed information and the need for speed in decisions, authoritative control at the tactical level is essential for success.”

Shareholder activism necessarily contemplates that institutions will review management decisions, step in when management performance falters, and exercise voting control to effect a change in policy or personnel. For the reasons identified above, giving institutions this power of review differs little from giving them the power to make management decisions in the first place. Even though institutional investors probably would not micromanage portfolio corporations, vesting them with the power to review major decisions inevitably shifts some portion of the board’s authority to them.

Given the significant virtues of discretion, one ought not lightly interfere with management or the board’s decisionmaking authority in the name of accountability. Preservation of managerial discretion should always be the null hypothesis. The separation of ownership and control mandated by U.S. corporate law has precisely that effect. To the extent Rule 14a-11 empowers shareholders to review board decisions, it weakens the very foundation of U.S. corporate law—namely the principle of director primacy.

The Effect on Board Governance

A proponent of Rule 14a-11 likely would respond that the rule does not give shareholders the power to reverse board decisions, but only a power to replace one board member. Fair enough, but there are sound reasons to believe that Rule 14a-11 would lead to worse rather than better corporate governance. The problem is that introduction of a shareholder representative is likely to trigger a reduction in board effectiveness.

The impact of a shareholder right to elect board members on the effectiveness of the board’s decisionmaking processes will be analogous to that of cumulative voting. Granted, some firms might benefit from the presence of skeptical outsider viewpoints. It is well-accepted, however, that cumulative voting tends to promote adversarial relations between the majority and the minority representative. The likelihood that cumulative voting will results in affectional conflict rather than cognitive conflict thus leaves one doubtful as to whether firms actually benefit from minority representations.

The likelihood of disruption in effective board processes is confirmed by the experience of German firms with codetermination. German managers sometimes deprive the supervisory board of information, because they do not want the supervisory board’s employee members to learn it. Alternatively, the board’s real work is done in committees or de facto rump caucuses from which employee representatives are excluded. As a result, while codetermination raises the costs of decisionmaking, it seemingly does not have a positive effect on substantive decisionmaking.

The likely effects of electing a shareholder representative therefore will not be better governance. It will be an increase in affectional conflict (as opposed to the more useful cognitive conflict). It will be a reduction in the trust-based relationships that causes horizontal monitoring within the board to provide effective constraints on agency costs. It will be the use of pre-meeting caucuses and a reduction in information flows to the board. A chief indirect cost of Rule 14a-11 therefore will be less effective governance.

It's not global warming but better winemaking

A little while ago, Alex Tabarrok of Marginal Revolution did some armchair debunking of a recent "study" that concluded wine quality is improving due to global warming. Tabarrok objected:

Armchair economics makes me suspicious. The "top wine-producing regions" should be located in places where the weather is optimal fo grape growing. If higher temperatures are better, why weren't the top wine regions located further to the South to begin with? Higher temperatures could make previously inhospitable areas good for wine-making and even raise wine quality on net but the best regions ought to be made worse by climate change. I suspect the authors did not control well for other factors that are improving wine.

I suspected Alex was right, which this article from the Wine Spectator confirms:

Improvements in wine quality in the past half-century have had as much to do with global warming as with advances in winemaking and grapegrowing, according to research presented at the Geological Society of America's conference in Seattle last week. But if temperatures continue to rise, it could make some established wine regions less suitable for grapegrowing and force others to plant different grape varieties. ...

"I would say a warming trend, which is what the research is suggesting, would improve wine quality, since ripeness is critical to top-quality wines," said Doug Shafer, winemaker for Shafer Vineyards in Napa Valley. "However, I think progress in the areas of grapegrowing and winemaking has, and will continue to have, the greatest effect on the increase in wine quality."

Indeed, these improvements have been credited with turning the 2000 Bordeaux vintage from a potential disaster into one of the great vintages of the last century. So kudos to Alex.

Why I'm Opposing the SEC Proposal to Let Shareholders Nominate Directors

The Securities and Exchange Commission is now considering proposed regulations designed to allow shareholders to nominate directors and, moreover, to require the incumbent directors to place the shareholder’s nominee on the company’s own proxy statement and ballot, albeit under relatively limited circumstances. At first blush, the regulation strike many people as perfectly reasonable. After all, directors are elected by shareholders, so why shouldn’t the shareholders be allowed to nominate directors?

This argument, however, fails to put the SEC proposal in context. The SEC’s proposed regulations are just the latest in a continuing string of new corporate governance rules. Taken together, these new rules have significantly increased the regulatory burden on Corporate America. So let’s step back and look at the SEC proposal in its proper context: the recent corporate scandals and the government’s response.

History teaches that market bubbles are fertile ground for fraud. Cheats abounded during the Dutch tulip bulb mania of the 1630s. The South Sea Company, which was at the center of the English stock market bubble in the early 1700s, itself was a pyramid scheme. No one should have been surprised that fraudsters and cheats were to be found when we started turning over the rocks in the rubble left behind when the stock market bubble burst in 2000.

We all know the litany, of course: accounting scandals at Enron and WorldCom, to cite but two; insider trading at ImClone; alleged looting at Adelphia and Tyco; and so on. NY’s attorney general, Elliott Spitzer has brought to light high profile problems calling into question the integrity of both stock market analysts mutual fund managers.

Corporate scandals are always good news for big government types. After every bubble bursts, going all the way back to the South Sea Bubble, a slew of new laws have been enacted. Why? There is nothing a politician or regulator wants more than to persuade angry investors that he or she is “doing something” and being “aggressive” in rooting out corporate fraud. Look, for example, at how vigorously the SEC is trying to keep up with attorney general Spitzer.

Hence, it was entirely predictable that the shenanigans at Enron, WorldCom et al., coming after several years of steady decline in the stock market, would lead to regulation. Yet, how quickly we forget. Remember what Ronald Reagan said: “The nine most terrifying words in the English language are: ‘I’m from the government and I’m here to help.’”

Like a cook who throws spaghetti at the wall to see if it’s done, legislators and regulators have been throwing a lot of new rules at corporations to see what sticks: Sarbanes-Oxley, numerous SEC regulations, California’s onerous corporate disclosure act, Spitzer’s settlement with the analyst community, and countless law suits and indictments. Unlike the cook, who stops when the spaghetti is done, the lawmakers just keep throwing stuff at corporations without stopping to ask whether enough is enough.

The costs of all this regulatory activity are beginning to mount up. Some companies, for example, will incur 20,000 staff hours to comply with just one SEC new rule – a rule the SEC estimated would require only 383 staff hours per firm. According to a study by Foley Lardner, “Senior management of public middle market companies expect costs directly associated with being public to increase by almost 100% as a result of corporate governance compliance and increased disclosure as a result of the Sarbanes-Oxley Act of 2002 (SOX), new SEC regulations and changes to [stock] exchange listing requirements.”

If adopted, the SEC’s shareholder access proposal would significantly add to that regulatory burden. A review of contests in the late 1980s survey found that insurgents spent an average of $1.8 million and incumbents an average of $4.4 million. Those costs are almost certainly much higher today, but let's use them as a baseline. Assume that a company faces a shareholder nominee every three years. Assume further that a shareholder nomination contest costs one-third what a full proxy contest costs. On those assumptions, each public corporation would face annualized costs of about $500,000. Using the 10,000 actively traded U.S. companies in the Compustat data base as a proxy for the number of companies potentially subject to the rule, we can estimate an aggregate annual cost of $5 billion. Of course, I may be overestimating the number of contests and the cost of each contest. Remember two things, however: (1) I'm using 1980s era cost estimates and (2) the SEC grossly underestimated the cost of complying with Sarbanes-Oxley.

A more conservative estimate might use data about shareholder proposals under current SEC regulations. According to the SEC's own figures, the cost per company of including a shareholder proposal in the proxy statement $87,000. ISS tracked 1,042 shareholder proposals at public corporations during the 2003 proxy season, which gives us total corporate expenditures on shareholder proposals of $90,654,000.

Either way, there can be no doubt that giving shareholders access to the proxy statement to nominate directors is going to be expensive. Plus there are all the indirect costs. Companies are already having a hard time attracting independent directors. The shareholder access proposal likely will make that search even harder. Why would somebody be willing to serve on the board if he or she might be the one singled out to be ousted?

The election of a shareholder representative also will disrupt the delicate internal dynamics that make boards successful. Its effect will be analogous to that of cumulative voting, which allows minority shareholders representation on the board. Experience with cumulative voting suggests that it often leads to pre-meeting caucuses by the majority and a reduction in information flows to the board as a whole. In turn, this results in adversarial relations between the majority and minority board members, which interferes with effective board governance.

Is it clear that the benefits of shareholder access will exceed these costs? Why, for example, should you and I have to subsidize some activist or gadfly who wants some free publicity?

If the SEC could figure out a way to limit the proposal to situations in which the board is clearly dysfunctional, these concerns might less important. The problem is that the SEC rules apply to all public corporations, whether their internal governance is good, bad, or just indifferent. As currently drafted, a shareholder would be allowed to put its nominee on the corporation’s proxy if one of two triggering events occurred:

1. A shareholder puts forward a proposal to authorize shareholder nominations, which is then approved by the holders of a majority of the outstanding shares; or
2. Shareholders representing at least 35% of the votes withhold authority on their proxy cards for their shares to be voted in favor of any director nominated by the incumbent board of directors.

Nothing in either trigger limits the rule to the Enrons of the world. If enough shareholders are disgruntled, for whatever reason, they can force a vote. This makes no sense. The point of all these reforms, supposedly, is to restore investor confidence by ensuring good corporate governance. But if firms are well-managed why put them to the expense and bother of a shareholder nomination contest?

Just as a good cook eventually stops throwing spaghetti at the wall, it is time for the regulators to stop, take a deep breath, and stop throwing new reforms at Corporate America. Let’s wait and see how the first couple of rounds of reform play out before imposing yet more burdens on corporations in our still precarious economic environment.

Anglo-Saxon Capitalism in Germany

A key tenet of Anglo-American corporate governance is the legal obligation of a corporation's directors and officers to maximize shareholder wealth (within the bounds of law).^* According to most commentators, corporate governance in continental Europe is oriented towards a broader model of stakeholder capitalism. In my article, Community and Statism: A Conservative Contractarian Critique of Progressive Corporate Law Scholarship, 82 Cornell Law Review 856 (1997), I criticized that claim:

Although admirers of the German and Japanese systems claim they promote long-term commitments to the firm and investments in firm-specific assets by workers, this claim is not supported by the evidence. American enterprise long prevailed in world economic competition. Moreover, despite the conventional wisdom about German and Japanese competitive success, American enterprise in many respects is still winning the competitiveness war. Over the last decade, in fact, the U.S. economy has performed as well or better than those of Japan or Germany. As a result, Japanese and German growth rates no longer exceed the U.S. rate, for example, as they did during the post-war recovery period. ...

Interestingly, stakeholderism is under attack in both Germany and Japan. In Germany, the combined pressure of high production costs and international competition have encouraged large German firms to shift production abroad to less regulatory states. There is also growing political pressure to deregulate German labor laws.

Striking evidence of the German shift towards the Anglo-American model is provided by today's WSJ (sub. req'd), which reports on a dramatic corporate restructuring at Bayer. Bayer wants to spinoff a number of assets, so as to downsize and focus on a smaller set of core competencies. And why are they doing this?

"We are convinced this will generate the greatest value for our shareholders," said Werner Wenning, Bayer's chief executive officer. [Ed.: Emphasis supllied.]

Granted, Bayer has not abandoned the stakeholder model. The article reports, for example, that Bayer employees have entered into a "solidarity pact" pursuant to which they are all taking pay cuts so as to minimize job losses. Even so, it is quite striking to see a European firm restructuring for the avowed purpose of maximizing shareholder wealth. How very Anglo-Saxon of them.

^*My most recent defense of this proposition against the contrary claims of some legal scholars, with references to both my prior defenses of, and the main attacks on, the shareholder wealth maximization norm, is The Bishops and the Corporate Stakeholder Debate.

The insider trading charge against Martha Stewart

With Martha Stewart about to sit down with Barbara Walters, I thought it might be an opportune moment to revisit the question of whether Martha Stewart actually committed insider trading (given the facts as we know them thus far).

As I'm sure you know by now, the SEC has charged Martha Stewart with illegal insider trading in ImClone, a biotech company run by her buddy Samuel Waksal. According to the SEC, in December 2001, Waksal learned that the FDA was going to hold up ImClone’s key Erbitux cancer drug. Waksal and a family member then dumped ImClone shares from their Merrill Lynch accounts. In violation of Merill Lynch policy, Stewart’s Merill Lynch broker told her the Waksals were selling. Stewart dumped her ImClone stock before the FDA announced its Erbitux decision, avoiding a 16% a drop.

The SEC thus is asking us to believe that Martha Stewart, TV show host, corporate president and directors, and multi-millionaire risked her reputation, livelihood, and fame to avoid losing the whopping sum of $45,673.

The SEC’s charges actually have very little to do with insider trading. Suppose Jane is the CEO of a big mining corporation. Jane learns the company has struck gold. Before the discovery is announced, Jane buys some more stock. That is classic insider trading. Now suppose Jane tells her friend Don the good news. Don buys stock, also pre-announcement. That is known as tipping. According to the U.S. Supreme Court, the tip will be illegal if Jane got a personal benefit from making the tip and Don knew (or should have known) that Jane’s tip violated her fiduciary duty to the company. A third kind of insider trading is called misappropriation. Suppose Jane’s company plans a hostile takeover of a second company. She tells her attorney Anne about the plan. Anne then buys stock in the target company. Anne has committed illegal insider trading based on misappropriated information. If Anne tips her friend Dave, that would be illegal too. The charges against Stewart don’t look anything like these examples. It is as though Jane’s broker thought her trade was unusual and told another client about it.

Martha Stewart pretty clearly didn’t know about the FDA’s Erbitux action. In fact, according to the SEC itself, after selling her ImClone stock, Stewart called Waksal and left the following message: “Martha Stewart—something is going on with ImClone and she wants to know what….” Although the SEC’s complaint makes much of the Stewart-Waksal friendship, the SEC nowhere alleges that Stewart had any advance knowledge of the problem with Erbitux.

In other words, Martha Stewart got a hot tip and she acted on it. So what? As a society, we care about insider trading because it is a form of theft. Information about the gold discovery belonged to Jane’s company, not to Jane. Information about the takeover bid belonged to the company, not to Anna. They stole that information from its owner and used it for personal gain. If the information leaked as a result, the company would be injured. But what information did Stewart steal and from whom? The SEC tells us she stole it not from ImClone but from Merrill Lynch, but does this look like theft as you know it? To be sure, the SEC may be able to make out the requisite theft in some hyper-technical sense but Stewart’s misconduct has very little to do with the historic reasons for policing insider trading.

Tellingly, the Justice Department’s criminal indictment does not charge Stewart with insider trading. Only the SEC’s civil complaint did so. Instead, the Justice Department went after Stewart for conspiring to obstruct justice by the great American pastime of lying to the cops. According to published reports, the U.S. Attorney decided going after Stewart would be an “unprecedented” expansion of insider trading law.

I don’t particularly like Martha Stewart’s public persona. Like a lot of people, I get a vicarious little thrill out of seeing the high and mighty brought low. But charging her with insider trading stretches that crime beyond where it was ever meant to go.

The Faithless Servant Doctrine and Partner (or Agent) Compensation

Always disclose. Disclose even if your bosses/partners/fellow shareholders/whatever keep telling you to shut up. When a fiduciary benefits himself at the expense of his fellow partners or the corporation for which he works or whatever, the fiduciary often will have an elaborate justification for his conduct. Yet, that justification will almost always unravel if you ask a simple question: "why didn't you tell us about it?"

Today's NY Times offers a great object lesson illustrating this principle The NY Times reported today on a recent Second Circuit decision applying New York's faithless servant doctrine. Phansalkar v. Andersen Weinroth & Co., L.P., 344 F.3d 184 (2d Cir. 2003). Rohit Phansalkar was an investment banker working for AW, a merchant banking organized as a limited partnership. Phansalkar was a nominal partner -- he had the title of partner but no equity stake (which is one more reason this case would make a great exam question -- it would let you throw in a partnership by estoppel issue). Even if we treat Phansalkar as a mere agent rather than a partner of the firm, however, he would still be a fiduciary. AW allowed (encouraged? required?) AW partners and employees to serve on boards of directors of companies with which AW did business. AW required that this "Directors' Compensation" be passed on to the firm. Phansalkar served on the boards of a number of AW clients. From several he received, inter alia, stock options. Although Phansalkar apparently did not attempt to actively conceal his receipt of the stock options from AW's partners, he did not affirmatively disclose the options to those partners. This failure would come back to haunt him. When he had a falling out with AW and left the firm, litigation ensued. Finding that Phansalkar breached his fiduciary duties to AW, the court turned to the issue of remedy. Applying the so-called faithless servant doctrine in its full glory, the court held that:

Pursuant to the principles articulated above, Phansalkar is required to forfeit all compensation awarded to him after October 15, 1999, the date upon which he received but did not report his ... Options, and thus the date upon which his disloyalty began.

Phansalkar's forfeiture should include ... (1) the portion of Phansalkar's $250,000 salary paid from October 15, 1999 to the end of 1999, (2) his interest in Treasure Master received in December 1999 as part of his share of the 1999 Partner Allocations, and (3) his interests in, and any benefits received from, his MCEL and Headway investments, which he made in 2000.

In other words, he forfeits not just the profit he earned on the concealed options but also his salary and bonuses for the entire period in question, even though they were untainted by the specific misconduct in which Phansalkar engaged. Where an agent or partner violates the duty of loyalty, the firm typically will get a constructive trust over the agent's ill-gotten gains. The constructive trust extends not only to the ill-gotten gains themselves but also to any other fruits of that poisonous tree. Suppose the corporation for which you work had an opportunity to buy a new business. But you swoop in and usurp that opportunity for yourself. You appoint yourself CEO and pay yourself a lavish salary. Not only is the corporation entitled to a constructive trust on the business itself, but also to capture the salary you paid yourself while you were CEO. This sanction clearly seems rather harsh. The recovery seems wholly disproportionate to any injury the firm suffered. Why such a harsh sanction? First, damages are hard to quantify in these cases. The constructive trust sanction becomes, in effect, a liquidated damages provision. Second, it is hard to detect these sorts of breaches. They inherently are done by stealth. hence, you need a strong sanction to deter. The faithless servant doctrine takes the harshness of the constructive trust remedy and extends it. The faithless servant must forfeit not only his ill-gotten gains but also any compensation the principal paid him during the period of the disloyal conduct. This doctrine seems especially draconian. As the Times reported, one lawyer they quoted is appalled:

The ruling has the potential to make "indentured servants out of employees,'' said Hillary Richard, an employment lawyer in New York. "Imagine if you applied this interpretation to a blue-collar worker who took a couple of pads of paper," she said. "Should she or he forfeit their yearly salary?"

Ms. Richard, the employment lawyer, says she has concerns. "The ruling gives an employer another tool, an iron fist if you will, to get out of their obligations to employees for work they've already performed," she said. "There's a huge threat now hanging over the head of employees."

Counselor Richard has clearly mastered the soundbite. In my view, however, her analysis is overly apocalyptic. First, Phansalkar violated a clearly stated policy of the firm. Second, the court informs us that "Directors' Compensation was a very important source of revenue for AW, because it was the only source of revenue upon which the firm could rely from year to year." There's a big difference between an employee who swipes a couple of legal pads and one who is cheating you on your principal source of revenue. Third, the court also informs us that "Phansalkar's disloyalty was not limited to a single, isolated incident, but rather occurred repeatedly, in nearly every transaction on which he worked. ... Phansalkar's disloyalties lasted for many months, and persisted boldly through an opportunity to correct them in June 2000, when Phansalkar and Andersen discussed the various interests accumulated during Phansalkar's tenure." Fourth, and most important (IMHO), Phansalkar could have avoided all of this fuss by doing one simple thing: by telling his employer what he was doing! You want to avoid the iron fist about Richards complains? Then disclose. And after you disclose write a CYA memo in which you set forth the details of the disclosure you made. Copy the partners on that memo if need be. But first and foremost disclose.

Kaizen as human resources tool

Business Week offers up an interesting article on Toyota's Kaizen (continuous improvement) process. (Link via Business Pundit.)

[Toyota] executives created the doctrine of kaizen, or continuous improvement. "They find a hole, and they plug it," says auto-industry consultant Maryann Keller. "They methodically study problems, and they solve them."

While kaizening works well as an engineering process, it's less clear that it makes an effective human resources tool, at least in the US. I wrote about kaizening, TQM, and other types of employee involvement in in my article Privately Ordered Participatory Management: An Organizational Failures Analysis, in which I quoted a worker at NUMMI (the Toyota-GM joint venture), who said:“Kaizening is supposed to be creative, but I mean how many times can you sit there and Kaizen a job after you’ve done it for four and one-half years? ... [J]ust keep me in a job and I’ll do it the way you want me to do it.” This worker seemingly would prefer a more structured environment.

Studies of formalization—the creation of written rules, procedures, and instructions—suggest that it reduces role conflicts and ambiguity, which increases work satisfaction and reduces feelings of alienation and stress. Kaizening and other forms of employee involvement can trigger role stress because many employees lack the quasi-management skills—agenda building, conflict management, and problem solving—required for successful employee involvement. Alienation can result from the greater workload and negative changes in peer group relationships experienced by some participants in employee involvement. Not all employees respond well to formalization, of course. Many prefer a less structured and less hierarchical workplace.

A good manager manages to his/her people, not to the latest management fad. Understanding your workers' tastes is the essential first step in making decisions about how workplaces are structured. All too many managers, however, manage to the latest fad rather than managing to the preferences of their people.

Implications of the expectations effect for behavioral economics

The WSJ (sub. req'd) reports today on research into the so-called expectations effect:

British philosopher Bertrand Russell was only half joking when he described the powerful effect that the nationality of a scientist can have on lab rats. "Animals studied by Americans rush about frantically, with an incredible display of hustle and pep, and at last achieve the desired result by chance," he wrote in 1927. "Animals observed by Germans sit still and think, and at last evolve the solution out of their inner consciousness."

Seventy-six years on, scientists have documented the power of expectations, not only of lab researchers but also of teachers, athletic coaches, judges and work supervisors.

"Expectation becomes a self-fulfilling prophecy," says Robert Rosenthal, professor of psychology at the University of California, Riverside. "When teachers have been led to expect better intellectual performance from their students, they tend to get it. When coaches are led to expect better athletic performance from their athletes, they tend to get it. When behavioral researchers are led to expect a certain response from their research subjects, they tend to get it." [Ed.: Emphasis supplied.]

Expectation effects, also known as the Pygmalion effect, have been documented time and again (479 studies have found that teachers' expectations affect how students do, for instance).

The highlighted sentence is what caught my eye. Much recent legal scholarship has relied on the burgeoning school of behavioral economics. In turn, much behavioral economics research is based on psychology experiments using university students.

A longstanding critique of behavioral economics claims that many of these experimental situations are highly artificial, which raises doubts as to whether the results can generalized from the lab setting to real markets. The behavior of undergraduates swapping coffee mugs, for example, probably doesn’t tell us very much about the behavior of institutional investors buying IPO stocks in the primary capital market.

In contrast, the expectation effect suggests an even more powerful -- and fundamental -- critique of behavioral economics. If the experimental model is not well-designed to eliminate covert communication by the researcher, it seems, the researcher's expectations may be what is driving the result rather than any real cognitive bias on the part of the subjects. Consider the Journal's description of one experiment involving lab rats:

In one set of studies, 12 experimenters were each given five rats. Six experimenters were told that their rats were of a genetic strain that learned like long-tailed geniuses; the other six were told that their rats were dolts. The experimenters then spent five days training their rats to run a maze. From the first day, the rats identified as bright ran the maze better -- and kept getting better.

You can guess the punch line: all the rats belonged to the same strain. They differed only in the experimenters' expectations for them. In this case, the covert communication probably came from the way experimenters with "smart" rats acted: They felt more relaxed and enthusiastic as they worked with the rats, talked to them less (fewer outbursts of "you stupid rat!") and handled them more.

The effect is a very significant one:

The size of the expectation effect varies, but is always statistically significant, and sometimes big. For teachers, high expectations can raise student performance 30%. For rats, they can improve maze learning 65%.

What are we to make of all this? I don't think we should throw the baby out with the bath water. Behavioral economics is an important development every law and economics scholar should be prepared to grapple with. On the other hand, it is another reminder that behavioral economics cannot be used glibly. In the legal literature, one increasingly sees advocates of government intervention using behavioral economics to tell a variety of market failure stories. They jump glibly from positing the status quo bias, citing the coffee mug experiments, for example, to the conclusion that the government needs to shake up the status quo, without demonstrating that the bias is truly valid in the specific setting at hand. The expectation effect teaches that such a demonstration may prove even harder than I suspected. Interestingly, the Journal reports that a recognition of the power of the expectations effect is the reason studies of new therapies are done on a "double-blind" basis, so that not even the investigators know which patients received the active compound and which a dummy pill. Perhaps we should only trust those behavioral economic studies that mimic the double blind methodology.

Why institutional investors are not the saviors of corporate governance

At the CorporateCounsel.Net Blog, Broc writes:

As Pat McGurn of ISS noted in our recent "Wildest Proxy Season" webcast, mutual funds often are the "swing" vote in a close vote. In addition, the SEC's recent proposal on shareholder access will undoubtably make the votes cast by mutual funds even more important. That's one reason why the governance failures at funds are so scary. The reforms that companies have undergone over the past two years pale next to the ones necessary to fix governance in the mutual fund industry.

If I may be allowed to toot my own horn, I saw this one coming. In my article, The Politics of Corporate Governance, 18 Harvard Journal of Law & Public Policy 671 (1995), I wrote:

Dr. Seuss tells a marvelous tale about the town of Hawtch-Hawtch, whose principal industry is a bee. The Bee-Watcher’s job is to watch the bee, because “[a] bee that is watched will work harder, you see.” Unfortunately, the bee didn’t work very hard. The townspeople concluded that this was the fault of the Bee Watcher, so they decided to hire a Bee-Watcher-Watcher. But the latter also failed. So a Watch-Watcher-Watcher was hired. Things progressed as one might expect, with the upshot being that soon all of Hawtch-Hawtch was out in the field watching one another. ...

[The] problem with reforms designed to enhance institutional investor monitoring of public corporation management should now be readily apparent: it amounts to hiring a Bee-Watcher-Watcher. The vast majority of large institutional investors manage the pooled savings of small individual investors. From a governance perspective, there is little to distinguish such institutions from corporations. The holders of investment company shares, for example, have no more control over the election of company trustees than they do over the election of corporate directors. Nor do the holders of such shares have any greater access to information about their holdings, or ability to monitor those who manage their holdings, than do corporate shareholders. Indeed, until quite recently, most investment companies would not even disclose the name and background of the individual who managed the fund. Worse yet, although an individual investor can always abide by the Wall Street Rule with respect to corporate stock, he cannot do so with respect to such investments as an involuntary, contributory pension plan. In sum, if separation of ownership and control is a problem in search of a solution, encouraging large financial intermediaries to evolve and to take an active corporate governance role simply moves the problem back a step: it does not solve it.

Fun Funds

Since I've been thinking about further diverisfying my investments, I've been doing some mutual fund research. In the course of that research, I have stumbled upon two very interesting, albeit diametrically opposed funds:

1. The Ave Maria Mutual Fund Family, whose website states:

   The Ave Maria Mutual Funds are designed specifically for morally responsible investors who are looking for financially sound investments in companies that do not violate the core teachings of the Catholic Church.

   Their latest shareholder report states:

   For the quarter ended June 30, 2003, the Fund was up 19.6% vs. 15.4% for the S&P 500. For the first six months of 2003, Ave Maria Catholic Values Fund was up 12.1% vs. 11.7% for the S&P 500.

2. The Vice Fund, whose prospectus unabashedly proclaims:

   We select securities of companies using a two-part test: (1) First, we look for companies that derive a significant portion of their revenues from products often considered socially irresponsible, and (2) Then we select companies from this group based on their financial soundness and potential for growth. For the first part of the test, we select companies that have significant involvement in, or derive a substantial portion of their revenues from, industries such as tobacco, gambling, defense/weapons and liquor. By “significant” or “substantial portion,” we mean a minimum of approximately 25% of the company’s revenues. It is our philosophy that although often considered politically incorrect, these and similar industries and products will always be supported and/or consumed and that companies in these industries, if managed correctly, will continue to experience significant capital appreciation during good and bad markets. We consider these industries to be nearly “recession-proof.”

   Their fund is up almost 32% in the last year (returns here).

Being the Republican Party Reptile Catholic that I am, I'm thinking about investing in both.