ProfessorBainbridge.com

The essential foundation for an ownership society

President Bush has been talking a lot lately about creating and fostering an "Ownership Society." George Melloan recently wrote an excellent WSJ ($) column on the political advantages of this policy program for the Republicans. In the course of doing so, Melloan makes a very important point about the essential foundation without which such a society would founder:

The promise by politicians to protect the sanctity of private property is not exactly a new idea in American politics. It just got lost somewhere back there when environmental radicals started dictating how private land could be used, municipal authorities started using their eminent domain powers recklessly and lawyers became birds of prey, hunting for deep pockets to pick. That has been a dangerous trend, because the protection of private property has been fundamental to American economic and political development.

Alexis de Tocqueville in "Democracy in America" (published in 1835 and 1840) discovered the social value of property rights: "Why is it that in America, the land par excellence of democracy, no one makes that outcry against property in general that echoes through Europe?" His answer: "It is because there are no proletarians in America. Everyone, having some possession to defend, recognizes the right to property in principle."

Indeed, the Founding Fathers planned it that way. James Madison, perhaps the most influential politician in the design of the American Constitution, wrote: "That alone is a just government which impartially secures to every man whatever he owns."

In The Conservative Mind, Russell Kirk put it somewhat more succinctly: "freedom and property are closely linked: separate property from private possession, and the Leviathan becomes master of all."

The freedom to accumulate property and use it as you wish does more than merely protect economic interests. Economic liberty, of which the rights of private property are the foundation, is a necessary concomitant of personal liberty—the two have almost always marched hand in hand. The pursuit of property has been a major factor in destroying arbitrary class distinctions, moreover, by enhancing personal and social mobility. At the same time, the manifest failure of socialist systems to deliver reasonable standards of living has undermined their viability as an alternative to democratic capitalist societies in which accumulation of property is a paramount societal goal. Accordingly, it seems fair to argue that the economic liberty to pursue and use property is an effective means for achieving a variety of moral ends.

Unfortunately, we live in a society in which neither party is fully committed to protecting private property rights. Both parties routinely infringe on property rights through taxation and regulation. At least since the Reagan Revolution, of course, the GOP has been the lesser of two evils on this score. If Bush is serious about creating an ownership society, however, he must convert the GOP into an affirmative friend of private property-promoting and protecting ownership by all (not just corporate elites).

Hollinger Report

The NY Times has the key section of the special committee report on how Hollinger's executives (including Lord Conrad Black) allegedly looted the company over a period of several years. Eleven separate sets of transactions are called into question. For corporate law professors, this report will be a gold mine. I can already see a slew of exam questions. A key item that immediately draws one's attention is the section dealing with the audit committee. The report notes that the audit committee was deliberately misled by management, but nevertheless blasts the audit committee for being "inert and ineffective." (Ouch.) As to a number of related party transactions, which require close scrutiny due to the potential for conflicts of interest, the committee "failed to make any meaningful inquiry or to obtain independent advice regarding, or to meaningfully and independently negotiate." The special committee thus is lining up its ducks to go after the audit committee members for breach of fiduciary duty. All of which will significantly ratchet up the pressure on audit committees, which have taken the brunt of post-Enron reforms. As a result, trying to find qualified persons to serve on audit committees is probably going to get even harder after this report.

The SEC's Futile and Misguided Efforts to Clamp Down on Inside Information

A front page article in today's WSJ ($) reports on the SEC's continuing efforts to clamp down on the flow of inside information in the stock markets:

Merrill Lynch & Co. retail analyst Peter Caruso unexpectedly learned one July day two years ago that Home Depot Inc. sales had been weak in the prior two months. He quickly crafted a research report that reversed his bullish projection for the home-improvement chain.

But first, according to a New York Stock Exchange disciplinary proceeding, Mr. Caruso leaked the bad news at a lunch with a few big clients. A Merrill institutional saleswoman attended the lunch and told several people afterward she believed the stock would be downgraded, the document says.

Mr. Caruso also allegedly let his new information about Home Depot slip to more investors in a conference call. By day's end, investors had dumped 3.7 million shares of Home Depot and the stock was down 5.6%, according to the proceeding, which Merrill, Mr. Caruso and the saleswoman recently settled.

The next morning, Billy Williams, a retired highway engineer in Atlanta, woke up more than $2,000 poorer. His original $60,000 investment in Home Depot reached its lowest level in four years, shrinking a nest egg for his retirement and his grandchildren's college. The 66-year-old recalls thinking: "Someone must know something we don't."

Mr. Caruso was censured, fired, and fined.

But so what? They caught one guy and made his life miserable. Big deal. It's just a drop in the bucket.

The SEC's efforts to limit the flow of inside information in the capital markets is both futile and misguised. As to its futility, if money is the mother's milk of politics, information is the mnothers milk of investment markets:

Tips about stocks have always been a hot currency on Wall Street. In the 1980s, financier Ivan Boesky pleaded guilty to insider trading after paying bankers to tell him about pending mergers. But unlike that egregious case, much of the continuing Wall Street information flow to the well-connected either is legal or falls into a gray area. In a regulatory environment that limits what companies can disclose selectively, the supply of corporate insights is more coveted than ever, driving some investors to seek ever-more-creative ways to get them.

The SEC thus is playing whack-a-mole. As soon as they crack down on one channel of inside information, another one pops up:

One venue that has risen in importance: Meetings that corporate executives often hold with small groups of investors -- where useful nonpublic information sometimes slips out, inadvertently or otherwise. Brokerage firms give special treatment to big investors who pay the most commissions, and that includes inviting them to those meetings with corporate executives.

Big clients who pay big commissions are always going to have an informational advantage, just like political candidates will always find a way to get ahold of the money no matter how many campaign finance laws we pass (see, e.g., McCain-Feingold and the 527s). Get over it.

As for being misguided, the SEC seems to assume that people like Billy Williams ought to be investing in individual stocks. With all due deference, however, most folks like Mr. Williams ought to be investing in mutual funds rather than individual stocks (preferably passively managed index funds).

The case against individual investors directly investing in stocks rests on the efficient capital markets hypothesis. First, after you correct for risk, the survivorship bias, and the large number effect, nobody systematically and predictably beats the market. The empirical evidence clearly indicates, for example, that the vast majority of mutual funds that outperform the market in a given year falter in future years. Once adjustment is made for risks, it seems reasonably certain that most mutual funds do not systematically outperform the market over long periods.

Second, the mechanisms by which the market prices stock systematically favor professionalinvestors rather than individuals. The ECMH’s semi-strong form posits that current prices incorporate not only all historical information but also all current public information. This form predicts that investors can not expect to profit from studying publicly available information about particular firms because the market almost instantaneously incorporates information into the price of the firm’s stock.

When new information is released, investors with high estimates of the firm’s new net present value will buy, while those with lower estimates will sell. An equilibrium price quickly results. This process necessarily assumes that investors are engaging in precisely the behavior the ECMH predicts they should eschew, namely searching out new information and seeking to capitalize on the information’s value through stock trading. Accordingly, some suggest that there is a paradox behind the ECMH: markets may be efficient only if large numbers of investors do not believe in market efficiency. If everyone believed the ECMH, no one would engage in securities analysis to find “undervalued” or “overvalued” stocks. Only because a large number of investors engage in precisely this activity are the markets efficient.

More sophisticated analysis eliminates the apparent paradox behind the ECMH. The first analyst to correctly interpret new information can profit by being the first to buy or sell. Full-time professional investors capture enough of the value of new information to make the game one worth playing. It is trading by these investors that moves a stock’s price to a new equilibrium in response to changed information. These investors thus set the price at which other investors trade.

Individual investors almost never get the requisite information before price-setting investors. Hence, the game is simply not worth playing for them. They'd be much better off holding a diversified mutual fund.

The empirical literature supporting this argument is summarized in Chapter 3 of my Corporation Law and Economics text. You might also want to check out Burton Malkiel's classic book A Random Walk Down Wall Street. Finally, Larry Ribstein has some very good posts both on the futility of the SEC's efforts to crack down on the use of inside information and on why the SEC should not be encouraging individual investors to invest directly in stocks.

Idle Hands Are Not Always the Devil's Workshop

Or so opines Chris:

Out of about 7000 petitions for cert, the Court only hears argument for about 100 each term. By no account is that a substantial (hell, it?s barely a minimal) number. Part of me wants to say this is a terrible thing because what else do we have a Supreme Court for but to hear cases? If the Supreme Court?s JOB is to hear and decide cases, shouldn?t it be doing it by hearing and deciding as many cases as possible? There?s certainly an attractiveness to this line of thought?but I ultimately come down on the side that a Court that hears so few cases a year is less likely to be an ?activist? court and therefore, a more conservative one.

A court that doesn?t do much, almost tautologically, doesn?t have much to do. For those of us that like our whiskey and women warm, this is a great thing to see in a court. In much the same way that gridlock results in less gov?t regulation, a highly selective court simply has less opportunity to impose itself onto a (sometimes unwilling) populace. Rather than kill you with a thousand pinpricks by establishing its authority in as many places as possible, a Court is at its most conservative when it refuses to exercise its authority. ...

To conclude, I?ll draw a baseball analogy. The best umpires are the ones that, after the game, you barely knew they were there. The same holds true for courts.

It's a good point, and I especially like the baseball analogy, but don't forget that a certain amount of activity beating up on the 9th Circuit comes in handy.

Liberty Law School

So Jerry Falwell's Liberty University has opened a law school, promising: "We'll be as far to the right as Harvard is to the left." Not surprisingly, that comment got a lot of (negative) attention. Over at Mirror of Justice, however, Rob Vischer has a post quoting a friend of his defending the school:

Liberty Law School's mission is less to train an army of warriors who will, upon graduation, immediately try to mount a battle against (fill in a social issue, newly minted fundamental right of your choice here). Rather, it is to train law students in the fullness of the Anglo-American common law tradition. In our climate, that means giving students confidence that there is such a thing as objective truth, and that these truths are publicly accessible, not private religious commitments.

Bruce is a deacon in the continuing Anglican Church. He is very much an Anglo-Catholic and is not a Baptist. Bruce has and will, I believe, continue to leave his mark on the law school. I'd encourage you to try to look past Falwell and look at the law school itself, as things unfold in Lynchburg in the weeks, months, and years to come.

I'm willing to try, provided I first get an answer to the following. On the one hand, the new dean is an Anglo-Catholic. He also has a blog (does everybody have a blog now?), in which he reports :

Bernard Dobranski, Dean and Professor of Law at Ave Maria School of Law, has agreed to serve as an ABA Consultant to the LU School of Law.

Dean Dobranski was responsible for selecting the core faculty, establishing educational guidelines, and overseeing the general operation of Ave Maria from inception through the acquisition of provisional approval by the American Bar Association. Ave Maria is now in the process of seeking full approval by the ABA. Dean Dobranski has served on the Accreditation Committee of the American Bar Association Section on Legal Education. He will provide counsel to our law school to ensure compliance with the American Bar Association standards for legal education. ...

The assistance already provided Liberty University School of Law and me by administration and faculty at Ave Maria School of Law exceeds normal bounds of collegiality. We are particularly encouraged that Dean Dobranski will be providing formal counsel on the process of seeking approval of our program by the American Bar Association.

Ave Maria, of course, is a very seriously Catholic law school.

On the other hand, Liberty University's Theological Q&A says:

While some think all Catholics will miss Heaven, neither I nor Dr. Falwell feel that way. We believe that there will be some Roman Catholics that go to Heaven in spite of the Roman Catholic Church. If a person has simple faith in Jesus Christ they will go to Heaven, “Believe in the Lord Jesus Christ and thou shall be saved” (Acts 16:31). Obviously we are not Roman Catholics, and there are many things that Roman Catholicism has added to the Gospel. If a person follows everything that the Roman Catholics teach, we do not believe that they will be saved. However, many Roman Catholics just believe in Jesus Christ; we believe they will go to Heaven because of their faith in Christ, not their Roman Catholic alliance.

Frankly, I can't help wondering what's going on here. Has there been a sudden outbreak of Christian unity in southeast southwest Virginia? Anyway, I'm glad us Papists can be of help "in spite of the Roman Catholic Church."

Classroom eChatter

With specific reference to yours truly and Tung Yin, Scheherazade asks:

Professors, what do you think about the fact that your students are chatting to one another via wi-fi during your lecture, and how do you structure your presentation so that the presence of the backchannel is acknowledged and will add value?

As someone who got kicked out of Corporate Tax for doing a crossword puzzle in class, I lack the moral high ground on which to condemn students who do this! Anyway, I touched on this subject quite a while back in a post called Why instant messaging might kill the socratic method, which oddly enough linked to one of Sherry's posts. As I more or less admitted in that post, I have no idea how to use the backchannel to add value. In very small classes, I have occasionally asked a student to Google something for me and report back. In large classes, however, my style is mostly lecture, so my main concern with the eChatter is to keep students sufficiently engaged that they aren't spending the entire class IMing and emailing and so on. Sorry, Sherry!

Kinsley on Shareholder Democracy

Michael Kinsley notes that Google thumbed "its nose at one of the major pieties of our day: shareholder democracy."

No one is forced to buy Google shares. People do it voluntarily, even downright eagerly. This is so even though what they are buying are so-called Class A shares, which might more accurately be labeled second-class shares. First-class shares, mischievously called Class B, are held by the company's two founders and other executives. In terms of dividends and so on, the two classes are identical. But Class B shares get 10 votes each while Class A shares get only one. This means in effect that the company can raise money, and the founders can get fabulously rich by selling stock to the public, but even with a tiny minority of the shares the founders will control the company. And the public shareholders can't do anything about it.

Kinsley approves, staking out a surprisingly libertarian position:

Democracy is actually a second-best solution. If we're going to McDonald's, and we all have to get the same thing, it should be decided by majority vote. But it's even better if we each can get what we want. And you can be fairly confident that a majority of McDonald's customers prefer hamburgers, while a majority at KFC prefer chicken. You don't have to require a vote.

Advocates of shareholder democracy believe it will lead to companies that care more for the environment, treat their workers better and so on. Well, maybe, maybe not. In a world of perfect corporate democracy, in which large public companies are required to pursue only those goals that can be agreed upon by the owners of a majority of the publicly traded shares at any moment, the most likely result would be companies focused exclusively on maximizing profits.

Requiring shareholder democracy actually stifles it. Why shouldn't shareholder democracy include the right to decide whether or not you want shares in a company that practices shareholder democracy?

And then he slaps paternalistic corporate governance regulation: "unlike Google, you can't free yourself of the SEC by simply calling your broker." Wow. Rarely does one see such common sense in the LA Times. Yet, while I applaud Kinsley, I can't resist pointing out that there is still a subtext of shareholder primacy in his analysis. Why, for example, should shareholders be able to vote on corporate goals? As my director primacy model of corporate governance explains, the corporation is a vehicle by which directors hire equity capital. Shareholders are entitled to use the vote to ensure that directors use their capital to pursue wealth maximization rather than personal self-interest, but shareholders have no right to set corporate policy or otherwise exercise the rights of ownership. As I explained in my article Director v. Shareholder Primacy in the Convergence Debate:

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 nonreviewable 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: “Under conditions of widely dispersed information and the need for speed in decisions, authoritative control at the tactical level is essential for success.” While Roe argues that shareholder activism “differs, at least in form, from completely shifting authority from managers to” institutions, it is in fact a difference in form only. Shareholder activism necessarily contemplates that institutions will review management decisions, step in when management performance falters, and exercise voting control to effect a change in policy or personnel. For the reasons identified above, giving 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.

As the paper further explains, corporate law therefore provides a whole host of devices that insulate directors from shareholder influence. The drive for shareholder democracy thus not only interferes with choice (Kinsley's position), it also threatens to undermine the very structures that make corporations work.

This doesn't surprise me

My ad hoc eyeballing of M&A activity and regulation in the European Union long has suggested that politics trumps economics. If the French want one of their national champions (e.g., Alstom) to do a deal, they find a way to make it so - and EU competition rules be damned. Empirical support for this view is provided by this working paper, which finds:

Why do regulatory authorities scrutinize mergers and acquisitions? The authorities themselves claim to be combating monopoly power and protecting consumers, but the last two decades of empirical research has found little supporting evidence for such laudatory motives. An alternative is that M&A regulation is actually designed to protect privileged firms. In this paper, we provide a test of protectionism by studying whether European regulatory intervention is more likely when European firms are harmed by increased competition. Our findings are unambiguous: European regulation is protectionist. The results are robust to a variety of statistical difficulties, including endogeneity between investor valuations and regulatory actions.

Socrates Volokh

My friend and colleague Eugene Volokh opines: "I do think that students' speaking in class tends to help them understand the material better, and get more interested in it. It also helps the professor and the other students, precisely because then class discussions aren't just the usual five or ten talkers." I don't believe it, at least insofar as upperclass law school courses are concerned. And I would very much like somebody to explain to me - with empirical support - how the so-called Socratic method enhances the classroom learning experience (outside of small group seminars, where I think you can get a valuable discussion going). [Of course, I should note that Eugene seems mainly focused on voluntary class participation rather than the traditional Socratic method, but I'm not even sure about the former. In particular, while the student who speaks may benefit from voluntary class participation, I'm not at all sure that the professor and other students derive much benefit.]

Bubbles as Morality Tales?

I just finished reading a very interesting paper by Syracuse law professor Chris Day, which tells a contrarian story of some famous bubbles:

Markets are sometimes accused of "irrational exuberance." Some distrust stock markets because of "predatory" behavior by speculators. Three fantastic bubbles - Tulip mania, the Mississippi Company and the South Sea Company are held out as horrid examples of market excess and malfunction by the public and sophisticated commentators alike.

Tulip mania never occurred and was, instead, a rational attempt to organize markets for rare commodities in a primitive futures market. The Mississippi Company collapse and the loss of liquidity in France are linked to the South Sea Bubble. Both the Mississippi Company and South Sea Company were spectacular investments with major structural flaws. But they were not morality tales.

This paper delves into the economics, finance, psychology, legality and morality of these bubbles. It demonstrates that the markets often worked rationally and efficiently, that the investments were not wildly unsound, and that exogenous factors (the Plague in Holland) and politics and illegality in France may have played major roles in these "disasters." The paper concludes that markets got it right and that popular wisdom has failed to appreciate the market's wisdom.

Fascinating stuff and highly persuasive.

One more reason to buy index funds

It is well-established that you're better off, over the long haul, investing in passively-managed index funds rather than actively-managed mutual or pension funds. Over time, as numerous studies have shown, nobody meets the market once you adjust for risk and the survivor bias. Why? In part, at least, because the managers of active funds are subject to a whole slew of cognitive biases and errors that tend to adversely affect their decisionmaking. The latest example is the split between US and global money managers with respect to the pending election:

As in most current election polls, the race came out close. By 41 percent to 37 percent the nearly 300 respondents, who together manage around $940 billion in investments, said Kerry, the Democrat, would beat Bush, the Republican. The rest did not know.

But there was a difference in view depending on where the fund manager was based. "This is very much an international perspective of the election," said David Bowers, Merrill's chief global investment strategist. Bush won among the 36 North American-based respondents by a margin of 44 percent to 33 percent, among the 68 British-based managers by 37 percent to 34 percent, and among the 43 Japan-based respondents by 49 percent to 37 percent.

Kerry, however, was favoured by the 96 continental Europeans by 46 percent to 33 percent, by 28 Asian Pacific- based respondents by 43 percent to 29 percent, and by 16 South African managers by 50 percent to 31 percent.

The Europeans et al. may end up being right (I'm still in a rather pessimistic mood about Bush's chances), but the split also suggests the possibility that they're letting anti-American sentiment color their judgment. So once again, I'd put my money in passively-managed funds where the political dispositions of the manager cannot affect my returns.

Coase in Action

T odd Zywicki defends the do-not-call registry from attacks by libertarians and small-government conservatives:

I believe the criticism is misplaced--the DNC registry is simply law & economics in action. It took an ambiguously defined property right (when can telemarketers call you), defined it clearly (telemarketers can call you whenever they want to), and provided a low-cost way of reallocating the property right (register on the DNC). Thus, it is nothing more than the Coase Theorem in action.

But even more, the DNC is actually the first example I can think of that illustrates a Contracts principle of an efficient minoritarian default rule. Usually contract default rules are allocated so as to create a majoritarian default rule (i.e., what the majority of people would want). Based on the registration numbers, a majority of Americans want to be free from telemarketing calls. So why not make the default rule "no calls" and make the telemarketers get your permission? Leaving aside the logistical problems (Would calling you to ask you if you want to be called count as a telemarketing call?), the minoritarian default rule is efficient because the transaction costs of reallocating are so munch lower for consumers than for telemarketers, especially because the FTC made registration so easy.

If you're wondering what the Coase theorem is, go here.

The SEC: From Bad to Worse?

My latest TCS Daily column

In October of last year, the SEC proposed a new rule that would permit shareholders to directly nominate directors of the corporations in which they have invested. As I detailed in my TCS column, Does the SEC Know When Enough Is Enough?, the proposal was seriously flawed. It was likely to impose significant indirect costs on corporations, without much in the way of countervailing benefits. (For more details, see my blog's archive of posts on the rule.)

As bad as the original proposal was, however, things may be about to take a turn for the worse.

The WSJ ($) reports that a "compromise" is in the works, under which:

"While details of the proposal are still being worked out, it would essentially allow shareholders to sit down with a company and agree on a person to replace a director who has been targeted by investors for removal. If an agreement couldn't be reached, shareholders would likely gain the right to nominate their own director the following year. The proposal may allow companies to bypass negotiating with investors if they agree to include shareholder-backed nominees on the ballot the following year."

Problems:

(1) Which shareholders get to sit down with management? All of them, which can be in the millions, or just a select few? If a select few, how do we ensure that the interests of the few coincide with those of the many? How, for example, do we ensure that unions don't use the shareholder access rule for leverage in collective bargaining (as they often use the current shareholder proposal rule)? Or that social activists don't use it to promote a social agenda at odds with the profit-maximization interests of most shareholders?

(2) If adopted, the proposal may deter qualified individuals from being willing to serve as a member of the board. There will be a significant risk that activist investors will use the rule frequently and at numerous companies. Unlike the current system, under the rule, the activists will be targeting individual investors. Who would want to serve as a director if there is a significant risk one might be singled out for a smear campaign by unhappy investors? (Granted, the effect may only be at the margins, but many companies report that in light of the director liabilities created by Sarbanes-Oxley they are already having a hard time attracting independent directors.)

(3) The presence on the board of a single shareholder-approved director likely will have a highly disruptive effect on the board's decisionmaking processes. Granted, some firms might benefit from the presence of skeptical outsider viewpoints. The analogy to cumulative voting, however, suggests that such benefits will be rare. It is well-accepted that cumulative voting tends to promote adversarial relations between the majority and the minority representative. On such boards, the majority tends to resort to pre-meeting caucuses at which decisions are worked out. In addition, management tends to restrict the flow of information to such boards, out of concern that the minority will use confidential firm information for improper purposes. A chief indirect cost of the proposed compromise therefore will be less effective governance.

(4) Finally, and perhaps most disturbingly, there is still nothing in the reported compromise that would limit the rule to situations in which the targeted board is clearly dysfunctional. Instead, it apparently still applies to all public corporations, whether their internal governance is good, bad, or just indifferent. Hence, if enough shareholders are disgruntled, for whatever reason, they can force a vote. This makes no sense. The point of the rule, 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?

Several recent major SEC rules were adopted by a 3-2 vote, with SEC Chairman Donaldson (a Republican) siding with the Commission's two Democrats against his two fellow Republicans. It's been reported that Chairman Donaldson doesn't want to see that happen to this particularly controversial rule. Potential dissenters Glassman and Atkins thus may have significant leverage. If they can't use it to kill the proposal, they should use at the very least use it to emasculate the rule so that it does as little damage to corporate governance as possible.

Shareholder Democracy

My colleagues Lynn Stout and Iman Anabtawi have an op-ed in today's WSJ (subcriber link; nonsubscriber link) on shareholder democracy and the SEC's pending shareholder access rule:

American corporate law gives entrepreneurs seeking to sell stock in the companies they create the freedom to draft their corporate charters almost any way they like. This includes freedom to draft charters that either enhance shareholder voting power, or dilute it. If investors valued strong voting rights, you'd think they would pay more for the shares of companies that granted them. Corporate entrepreneurs would respond by supplying charters that give shareholders greater clout.

Yet in the real world, companies almost never "go public" with enhanced shareholder power. Instead, most IPO charters weaken shareholders' rights. Google is a case in point. Its charter gives its founders shares with multiple votes while the public gets shares with only a single vote. Such "dual class" stock is unusual, but milder forms of shareholder disenfranchisement abound. Most IPO charters these days include "staggered board" provisions making it harder for shareholders to replace incumbent directors. Far from avoiding these IPOs, investors, including sophisticated institutions, snap them up like hotcakes.

... Why, if greater power is such a boon to investors, haven't they already demanded it? Maybe because greater shareholder power isn't so wonderful for investors after all. This argument is being advanced by Google's founders, and it enjoys support from many corporate scholars as well. ...

First, even finance economists increasingly acknowledge what businesspeople have always known: stock prices don't always accurately measure value. (Remember the Internet bubble?) As a result boards can often do a far better job of picking the business strategy best for the firm in the long run than unorganized, uninvolved, and price-obsessed stockholders can.

Second, investors don't always share common interests. The SEC's proposed rule would allow only shareholders with large holdings to push their own board candidates. This invites intra-shareholder conflict, allowing large investors-including financial intermediaries, union-sponsored pension plans, and politically-motivated groups-to nominate directors who will represent only their own special interests.

Third, strong boards can mediate not only conflicts among shareholders, but also conflicts between shareholders and other important corporate constituencies. The "team production" theory of corporate governance teaches that a principal function of board governance is to encourage executives, customers, rank-and-file employees, and others to make long-term commitments to a company by assuring these groups corporate policy will not be set by an anonymous, myopic, return-hungry pack of shareholders. Shareholders go along because, by ceding control to boards, they get greater loyalty and commitment from others. Google's investors may well believe the firm's founders and employees will work harder and better with a dual-class structure that protects them against hostile takeovers or shareholder pressures to raise profits by outsourcing jobs and cutting employee benefits.

Personally, I find only their second argument persuasive. (See my TCS column Does the SEC Know When Enough Is Enough?.) As for reason # 1, I agree that boards have better information than shareholders. But the existence of such an information asymmetry is independent of whether markets accurately price stock. As to the latter question, I still believe in the efficient capital markets hypothesis as the best available theory of how markets behave. As for reason # 3, I remain unpersuaded by my friend and colleague Lynn Stout's team production model of corporation law. Unfortunately, my critique of that model is way too long for a blog post, but you can download the law review article in which I rejected the team production model.

Director independence

I just ran across a very interesting paper by a couple of Swedish economists, Board Independence and Product Market Competition in Swedish Firms, in which they conclude:

This study suggests that firms in highly competitive industries should have fewer outside board members, whereas companies operating in less competitive industries should have more outside directors. Specifically, we argue that board independence is less relevant or even redundant in highly competitive industries, where the firm is already monitored by a competitive product market. Using publicly traded Swedish firms for empirical testing, this study finds that board independence reduces firm performance in industries with highly competitive product markets. On the other hand, board independence enhances firm performance among companies facing less competitive product markets.

I don't know enough about the Swedish economy to predict with complete confidence that the same result would hold in the US, but it wouldn't surprise me a bit. Independent directors are not the sole mechanism by which management?s performance is monitored. Rather, a variety of forces work together to constrain management?s incentive to shirk: the capital and product markets within which the firm functions; the internal and external markets for managerial services; the market for corporate control; incentive compensation systems; auditing by outside accountants; and many others. The importance of the independent directors? monitoring role in a given firm depends in large measure on the extent to which these other forces are allowed to function. For example, managers of a firm with strong takeover defenses are less subject to the constraining influence of the market for corporate control than are those of a firm with no takeover defenses. The former needs a strong independent board more than the latter does. Hence, I'm inclined to file this one away as another data point supporting my view that government-mandated one-size-fits-all rules requiring firms to have specific numbers of independent directors and to put them in specific roles are bad public policy. (See, e.g., A Critique of the NYSE's Director Independence Listing Standards.)