ProfessorBainbridge.com

Group Decision Making

The cubicle culture column in today's WSJ($) has a great take on group decision making:

Some Ideas Are So Bad That Only Team Efforts Can Account for Them Years ago, when a civilian worker at one of the nation's largest Air Force bases was working for a general, she watched as a team was formed to come up with a better system to handle the mail.

Mail to the base included letters from multi-starred generals and directives that had deadlines. The "process improvement team," also known as a PIT, had a roster of middle managers, mostly civilians, who spent the better part of a month coming up with a plan.

But instead of streamlining the process, they complicated it. "I was horrified," says the woman. "There used to be eight steps; now there were 19." Each piece of official mail was viewed by a greater number of managers before getting to its intended recipient, she says, enabling the mail to be lost at home or in the bathroom, or covered with spills from someone's breakfast. And ponies could have delivered it faster. The lag between the first manager who saw a piece of mail and the person who had to act on it was two weeks, she says.

Questioning the team would have amounted to heresy, so she kept quiet until a year later, when her general emerged from his office and bellowed, "What the hell is happening to my mail?" Once enlightened, he changed everything on the spot.

The columnist's mostly negative view of team production is a salutary reminder that teams are not the panacea many managers believe them to be. Yet, I think it overstates the disadvantages of team production.

I spent a tremendous amount of time working through the literature on team decision making for my article Why a Board? Group Decisionmaking in Corporate Governance:

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

In brief, the old joke about the camel being a horse designed by a committee captures the valid empirical observation that individuals are often superior to groups when it comes to matters requiring creativity. In addition, teams are subject to unique cognitive biases, such as groupthink, and unique sources of agency costs, such as social loafing. Even so, however, the empirical evidence I review in my article shows that groups are better at tasks requiring the exercise of critical evaluative judgment. Not only do groups clearly outperform average individuals at such tasks, there is considerable (albeit contested) evidence that the process of group interaction has synergistic effects allowing groups to outperform even the best decision makers in the given sample.

Hence, I would never ask a committee to design a new mail system. I would, however, ask a committee to evaluate whether the new mail system is working properly.

Group Decision Making

The cubicle culture column in today's WSJ($) has a great take on group decision making:

Some Ideas Are So Bad That Only Team Efforts Can Account for Them Years ago, when a civilian worker at one of the nation's largest Air Force bases was working for a general, she watched as a team was formed to come up with a better system to handle the mail.

Mail to the base included letters from multi-starred generals and directives that had deadlines. The "process improvement team," also known as a PIT, had a roster of middle managers, mostly civilians, who spent the better part of a month coming up with a plan.

But instead of streamlining the process, they complicated it. "I was horrified," says the woman. "There used to be eight steps; now there were 19." Each piece of official mail was viewed by a greater number of managers before getting to its intended recipient, she says, enabling the mail to be lost at home or in the bathroom, or covered with spills from someone's breakfast. And ponies could have delivered it faster. The lag between the first manager who saw a piece of mail and the person who had to act on it was two weeks, she says.

Questioning the team would have amounted to heresy, so she kept quiet until a year later, when her general emerged from his office and bellowed, "What the hell is happening to my mail?" Once enlightened, he changed everything on the spot.

The columnist's mostly negative view of team production is a salutary reminder that teams are not the panacea many managers believe them to be. Yet, I think it overstates the disadvantages of team production.

I spent a tremendous amount of time working through the literature on team decision making for my article Why a Board? Group Decisionmaking in Corporate Governance:

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

In brief, the old joke about the camel being a horse designed by a committee captures the valid empirical observation that individuals are often superior to groups when it comes to matters requiring creativity. In addition, teams are subject to unique cognitive biases, such as groupthink, and unique sources of agency costs, such as social loafing. Even so, however, the empirical evidence I review in my article shows that groups are better at tasks requiring the exercise of critical evaluative judgment. Not only do groups clearly outperform average individuals at such tasks, there is considerable (albeit contested) evidence that the process of group interaction has synergistic effects allowing groups to outperform even the best decision makers in the given sample.

Hence, I would never ask a committee to design a new mail system. I would, however, ask a committee to evaluate whether the new mail system is working properly.

The Nose versus The Algorithm

Over at the Cyberlibris blog, Eric has a very nice post comparing economist Orley Ashenfelter's econometric approach to evaluating wine and the gustatory approach of former lawyer Robert Parker.

Ashenfelter decries what he perceives to be a sense of elitism in the wine industry: "Writers whose palates we respect act as if they were able to pick out the qualities in young wines that will emerge a decade or more from now,". Parker Jr., an influential wine critic, calls the professor's methods "Neanderthal," not to mention "ludicrous and absurd". ...

According to [University of Maryland Law Professor Garret Power], the conflict between the two men is obviously tense. However, he thinks that the disagreement between the two men is in fact a profound professional disagreement between a judge (Parker was a law student at the University of Maryland) and an economist. For Power, Robert Parker is a wine judge: "He employs the method of the common law. He sniffs, sops, and spits his way through a number of cases each week." New evidence will make him change his mind. Ashenfelter is undoubtedly a wine economist. To put it again in Power's words, "he simplifies the world of wine and gauges the quality of a vintage on the basis of variables that are subject to objective measurement."

I used to subscribe to both Ashenfelter and Parker's newsletter; I still subscribe to Parker's pay web site. As between the two, I found Parker's tasting notes far more useful; if I were collecting wine for investment purposes, however, Ashenfelter's price data and econometric analysis would be very useful. In any event, my all time tasting triumph came in a seminar given by Ashenfelter: I correctly identified the vintage and appellation of a wine that turned out to be a 1973 Latour.

Disney, Ovitz's Compensation, and the Business Judgment Rule

In my Business Associations class today, I'm teaching Brehm v. Eisner, the principal shareholder suit challenging the comepnsation Michael Ovitz received from Disney (one of the key moments in Michael Eisner's fall from investor grace). Almost a year ago, I posted Substantive due care and the business judgment rule in corporate fiduciary duty law, which explores the relevant legal doctrines in some depth. It concludes that the Disney litigation can be squared with existing doctrine:

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

Mark Noll on the Evangelical Mind

Mark Noll's book The Scandal of the Evangelical Mind thoughfully critiqued Protestant evangelicals for having abandoned the life of the mind. Over at Mirror of Justice, Rob Vischer reports on Noll's current thinking, which is much more optomistic. Interestingly, Noll credits the ecumenical bridges being built between evangelicals and Catholics with having revived interest in intellectual rigor among the former:

"Because evangelicals tend to disregard tradition," Noll explains, "we are liable to miss the rich contributions that other strands of faithful believers have made to interpreting and applying the multitudinous biblical words that are so potent for the life of the mind. But this can change." The first "source of hope" Noll points to in this regard is "the increasing engagement between evangelicals and Roman Catholics," which has "contributed dramatically to improved evangelical use of the mind."

Mark Noll on the Evangelical Mind

Mark Noll's book The Scandal of the Evangelical Mind thoughfully critiqued Protestant evangelicals for having abandoned the life of the mind. Over at Mirror of Justice, Rob Vischer reports on Noll's current thinking, which is much more optomistic. Interestingly, Noll credits the ecumenical bridges being built between evangelicals and Catholics with having revived interest in intellectual rigor among the former:

"Because evangelicals tend to disregard tradition," Noll explains, "we are liable to miss the rich contributions that other strands of faithful believers have made to interpreting and applying the multitudinous biblical words that are so potent for the life of the mind. But this can change." The first "source of hope" Noll points to in this regard is "the increasing engagement between evangelicals and Roman Catholics," which has "contributed dramatically to improved evangelical use of the mind."

Is More Always Better?

My latest TCS Daily column

John Kerry recently told the AFL-CIO that, if elected, he intends to do something about executive compensation:

"I am very concerned about runaway executive compensation. Today, the average CEO makes more than 500 times what the average worker makes, and I think that's wrong. While I don't believe our government should place dollar limits on compensation, I do think there are steps we can take to make the system fair. We must curb abuses where they occur, especially such practices as funneling money to offshore accounts or tax shelters that allow executives to avoid paying their fair share of taxes."

I commend Kerry for recognizing that the government should not get in the business of setting executive compensation. As I've observed before on this blog, how much you get paid depends in large part on the thickness of the market for your services. In a thick market, wages tend to be low because there are many potential employees -- all more or less fungible -- competing for jobs. In a thin market, however, wages tend to be high because many employers are competing to hire a small number of eligible workers. The market for burger flippers is very thick. The market for CEOs of Fortune 500 companies is thin. Very thin. I'd guess the number of people who have what it takes to run a Fortune 500 company isn't much larger than the number of people who can run a NBA fast break. Its just supply and demand, folks.

Unfortunately, Kerry was not content to leave the problem to the markets. Instead, he proposes to get at executive compensation by imposing new disclosure obligations on firms:

"I believe that the SEC should consider requiring companies to provide greater transparency in the reporting of their executive retirement stock purchase and investment plans in order to determine whether executives receive significantly better compensation and retirement benefit packages than other workers in the same company."

Just how much more disclosure Kerry wants is unclear. As it is, executive compensation disclosures already constitute the bulk of most annual shareholder meeting proxy statements.

Indeed, the chief problem with Kerry's proposal is that the existing disclosure rules already provide shareholders with too much information. The assumption behind both the existing rules and Kerry's proposal is that enhanced disclosure will enable shareholders to participate more actively in compensation decisionmaking. Shareholders will complain to the board about excessively high compensation, challenge excessive compensation in derivative litigation, reject excessive compensation plans put to a shareholder vote, and vote out of office directors who approve excessive compensation.

This assumption is dead wrong. Basic financial economics tells us that most shareholders prefer to be passive investors. A rational shareholder will expend the effort to make an informed decision only if the expected benefits of doing so outweigh its costs. Given the length and complexity of SEC disclosure documents, the opportunity cost entailed in becoming informed before voting is quite high and very apparent. Moreover, most shareholders' holdings are too small to have any significant effect on the vote's outcome. Accordingly, shareholders assign a relatively low value to the expected benefits of careful consideration.

As a result, making disclosures more transparent won't help, while requiring greater volumes of information will make the situation worse. For most shareholders, the investment of time and effort necessary to make informed voting decisions remains a game that is not worth playing. Accordingly, they will do what they always do with corporate disclosure: ignore it and simply vote for management's director slate and management compensation proposals.

Some believe that this shareholder passivity model no longer holds true in light of the growing importance of institutional investors. To be sure, institutional investors are an increasingly important force in the stock markets and, moreover, some institutions are playing a more active role in corporate governance. At the same time, however, the passivity model remains applicable even to most institutional investors. Participating in corporate governance is not a cost-less endeavor. Just as with other shareholders, institutional investors must expend resources to make informed decisions. Other than a handful of public pension funds, most institutions have therefore opted for passivity.

In sum, adopting Kerry's proposal will increase the cost to companies of complying with their disclosure obligations, but will not lead to more informed shareholder decisionmaking. As such, it's lousy securities regulation policy.

On the predictive power of markets

I just noted a Larry Ribstein post that relies on the predictive power of markets; a sentiment seemingly shared by Steve Verdon:

Check out the Iowa market's graph. Remember these markets tend to have somewhat better predictive power than standard political polls. These people are looking at the polls plus additional information that we are seeing in the news. Further, this information in aggregated over a large number of individuals so it is likely the "aggregate information set" is larger than your typical person taking a poll.

You can see the same thing over at TradeSports.com as well. Bush is now around 0.69 and Kerry is continuing his long slow decline to 0.20. Right now the momentum is with Bush and it shows no sign of changing.

But then there's this post by Michael Stastny at Marginal Revolution:

On TradeSports a contract of George Bush in the winner-take-all market is currently selling for around $7. But what does this actually mean? Most traders and researchers would argue that 0.7 is the current "market probability" that the event "George Bush wins the 2004 presidential election" occurs. But this answer drives Charles Manski, an economist who recently also published an article in the September issue of Econometrica, crazy.

He says that under not-so-far-fetched assumptions, the price of a contract reveals nothing about the dispersion of traders' beliefs and partially identifies the central tendency of beliefs. A President.GWBush2004 contract trading at 70 reveals that 70 percent of traders believe the probability of the event "George Bush wins the 2004 presidential election" to be larger than 0.7. The mean subjective probability of this event lies somewhere in the open interval (0.49, 0.91) (price/mean belief region).

Candid admission time. I tried reading Manski's paper, but he's dealing in a level of statistical analysis that's way above my pay grade. And, frankly, I'm having a hard time even parsing Stastny's explanation. (Hey, I went into law precisely because I stunk at numbers. You're looking at a guy who got a C in Calculus and a D+ in Differential Equations.) So can somebody please explain, in simple English, exactly what prediction markets tell us? Try emulating what economic historian Deirdre McCloskey (who is herself an interesting story) calls "the lawyerly rhetoric" of Nobel economics laureate Ronald Coase.

SOX Costs

In a useful post linking to several sources on the costs of complying with Sarbanes-Oxley, Larry Ribstein concludes:

This is all part of two broad stories. First, ... we must recognize that there is an international securities markets that puts competitive pressure on US law. Second, we should recognize the heavy of costs of federal regulation of corporate governance, toward which Sarbox was a significant and misguided step.

Yep. For my take on one part of the problem, see my articles The Creeping Federalization of Corporate Law. Manage rialism, Legal Ethics, and Sarbanes-Oxley Section 307, and/or A Critique of the NYSE's Director Independence Listing Standards. Alternatively, just type Sarbanes in the search box in the left sidebar for a plethora of posts on SOX.

Corrected and Updated: Sumner Redstone's Stock Trades During

My friend Thomas Lifson (blogger and winemaker) note s some curious trading by Sumner Redstone, Viacom's CEO (and major contributor to the Dems), during the Rathergate episode:

A copy of the SEC?s Form 4 ?Statement of Changes in Beneficial Ownership? posted on [Voacom's] website indicates that the billionaire exercised 341,500 options, and sold the stock on the same day, September 14, 2004. ... It is frankly mind-boggling to contemplate that Redstone would take such a step. There must be some compelling reason for him to have exercised the options and sold the shares, a reason which would immediately cause the SEC to accept it as valid. But we don?t know what it is. ... At the end of trading Friday, Viacom stock closed at $34.73. By selling at $35, Redstone made an extra $92,205 on his shares, compared to what they were worth at the end of the week. His profit on the deal totaled $6,744,625 before brokerage fees.

I agree with Thomas that the timing of the sale is a bit curious, but I suspect there is an innocent explanation. One possibility, for example, is that Redstone has a Rule 10b5-1 plan pursuant to which he routinely liquidates the shares covered by such options. If so, he would have had to effect the transaction so as to maintain the plan's viability, the whole point of such plans being that you always trade according to a pre-set pattern regardless of what's going on at your firm. For an overview of the insider trading rules, including 10b5-1, relevant to the recent trading by Viacom insiders, see this post.

Update: I stand corrected. Dinocrat has persuasive evidence that Redstone's sales were not effected within a 10b5-1 plan. Hence, my speculation was erroneous. Having said that, however, I still doubt whether his conduct would qualify as insider trading. There's still going to be problems of materiality and causation that will be difficulty to overcome.

On the Nature of the Common Law

I recently had occasion to reread Professor Melvin Eisenberg's ambitiously titled book, The Nature of the Common Law, which I highly recommend as a short and very accessible introduction to some very complex ideas.

Eisenberg's stated goal "is to develop the institutional principles that govern the way in which the common law is established in our society." In doing so, Eisenberg addresses the functions of courts in American society, modes of legal reasoning and the process of overturning prior precedents. Yet Eisenberg never loses sight of his central thesis, namely that "all common law cases are decided under a unified methodology, and under this methodology social propositions always figure in determining the rules the courts establish and the way in which those rules are extended, restricted, and applied." To say that courts should and do rely on social propositions (such as moral norms and public policy) in deciding common law cases is hardly new. Eisenberg's contribution comes in mapping a coherent course between the Scylla and Charybdis of modern jurisprudence. He explicitly rejects theories claiming that some cases can be decided without reference to social propositions. On the other hand, Eisenberg also rejects theories claiming that legal reasoning is nothing more than a mask for the social and political values of the decisionmaker. Any complex society needs an institution before which claims based on existing societal standards can be heard. In our society, that institution is the courts. "If the courts resolved disputes by reasoning from those moral norms and policies they think best, there would be no institution to which a member of the society could go to vindicate a claim of right based on existing standards." Second, since the judicial system is a peculiarly undemocratic institution, the legitimacy of the adjudicative process requires courts to look to "existing legal and social standards rather than those standards the court thinks best." Finally, prohibiting the courts from employing their personal standards makes legal reasoning fairer and more easily replicable by the profession.
Common law adjudication thus is not merely the ad hoc application of whatever social propositions a particular judge is taken by; rather, he lays out institutional principles that constrain and guide the adjudicative use of social propositions. According to Eisenberg, adjudicators may only employ those norms or policies that "can fairly be said to have substantial support in the community, can be derived from norms [or policies] that have such support, or appear as if they would have such support." Two critical assumptions underlie this claim: (1) that social morality is a meaningful concept; and (2) that judges are capable of discerning and effectively applying social morality. As space does not permit one to do full justice to Eisenberg's defense of those assumptions, suffice it to say that the argument is well-crafted and even-handed.

Eisenberg's second claim is that courts have a duty to utilize only those social propositions that have the requisite degree of social support. "By accepting and retaining office the judge undertakes an ongoing commitment to carry out the rules of the office," one of which is "a moral obligation to faithfully employ the norms of social morality ... whether or not he privately agrees with those norms." One may be skeptical about the force of an oath of office in constraining judicial discretion, but this is not the only arrow in Eisenberg's quiver. A variety of corrective forces come into play when a judge strays from those social propositions having the requisite degree of support. From the aggrieved litigant's perspective, the best outcome will be a reversal on appeal. Even if the decision stands, however, it may nevertheless soon be consigned to the dust bin of legal history. Lawyers will make a decent living arguing that the rule should be overturned or distinguished in future cases. Commentators and other courts may point out the decision's flawed reasoning. In extreme cases, the legislature may step in. In sum, common law decisions do not live in a vacuum. The wider arena of legal discourse acts a significant check on judicial error, whether the "error" is deliberate or accidental.

At first glance, Eisenberg's thesis appears to create substantial problems of doctrinal stability. He is unwilling, however, to make doctrinal propositions entirely defeasible in the face of changing social propositions. Accordingly, he constrains the use of social propositions by giving some counter-balancing weight to the value of doctrinal stability. In areas where parties are unlikely to plan their behavior based on existing doctrines, doctrinal stability may be relatively unimportant and a court should be fairly liberal in bringing out of whack doctrines back into line. But in areas such as property and estates, where planning is common and reliance on doctrinal stability is likely, courts should be more reticent. In these latter areas, techniques such as signaling (in which the court suggests that it will revisit the issue later) or prospective overturning may be more appropriate than an immediate reversal of existing doctrine.

For readers persuaded by Eisenberg, or at least interested in seeing his ideas play out, the book's only major flaw is likely to be its length: It is too short. For example, I would have been interested in Eisenberg's view of the claim that efficiency is the sole acceptable and/or the prevailing norm in common law adjudication. Perhaps the most glaring omission, however, is Eisenberg's failure to discuss in more detail the relationship of statutory interpretation to common law adjudication. Nonetheless, it belongs in every common lawyer's library.

Peter Ackroyd, The Life of Thomas More

As a lawyer and Catholic convert, Thomas More is my patron saint and one of my heroes. As anyone who has read or seen "A Man for All Seasons" knows, More was martyred by Henry VIII for refusing to support the English Reformation. More's critics delight in the supposed irony that More was executed for his beliefs in the same way as certain Protestants were executed on More's orders when he was Chancellor of England. In the modern age, when toleration is regarded as the chief virtue, More's stance is easy to dismiss as illiberal and medieval. Yet, to his credit, in this important biography of More, Peter Ackroyd does not fall into the modernist trap. Historical figures must be judged by reference to the standards of their day and the "permanent things," but not by modern sensibilities. Ackroyd therefore presents More as a man of his times. It was a complex time amd More was a complex man.

I honestly wish I liked this biography better. I find Ackroyd's prose to be dense and heavy going. Especially annoying is his frequent use of quotations that he fails to render in modern English. Fifteenth century English is almost a different language than 21st century English and many of the quotations arealmost unintelligible. Granted, a scholarly work of history should not take liberties with translation. But this is a narrative history for a generalist audience, which appropriately has laxer standards.Having said that, I still recommend Ackroyd's biography and am very glad I finally finished it. One comes away impressed with More's humanity, and inspired by his example. More had flaws beyond his supposed intolerance...as Ackroyd demonstrates, for example, More loved bawdy humor. Yet, when push came to shove, More demonstrated great moral courage. It is an inspiring story. I just wish it were told better.

Wealth effects of takeovers

It has long been known that while shareholders of corporations that are targets of a successful takeover gain substantially?on the order of hundreds of billions of dollars. In contrast, studies during the 1980s and early 1990s of acquiring company stock performance reported results ranging from no statistically significant stock price effect to statistically significant losses. By some estimates, up to half of acquiring companies lost money on takeovers during that period. A more recent study, covering the period 1998-2001, finds spectacular losses for acquiring shareholders but those results are skewed because a few acquirers may particularly bad investment decisions:

ABSTRACT: Acquiring-firm shareholders lost 12 cents around acquisition announcements per dollar spent on acquisitions for a total loss of $240 billion from 1998 through 2001, whereas they lost $7 billion in all of the 1980s, or 1.6 cents per dollar spent. The 1998 to 2001 aggregate dollar loss of acquiring-firm shareholders is so large because of a small number of acquisitions with negative synergy gains by firms with extremely high valuations. Without these acquisitions, the wealth of acquiring-firm shareholders would have increased. Firms that make these acquisitions with large dollar losses perform poorly afterwards.

Why do some acquirers make such spectacularly bad decisions? In my book Mergers and Acquisitions, I advance three explanations for why bidders might make negative synergy acquisitions:

1. The Winner's Curse: An auction of corporate control is the most likely situation in which such an outcome might result. Bidder One makes an offer for Target. Bidder Two then makes a competing, slightly higher bid. Several rounds of competitive bidding follow. In the end, the bidder with the highest reservation price should prevail. Yet, that bidder is the one most likely to overpay. In behavioral economics, this phenomenon is known as the "winner's curse." Suppose Target's stock was trading at $10 before the bidding began. Due to the familiar problems of uncertainty and complexity, nobody knows for sure what Target is really worth. Bidder One's reservation price is $20, Bidder Two's reservation price is $22. All else being equal, Bidder Two should win the auction. Suppose Bidder Two ends up paying its reservation price of $22, but later discovers that Target really was worth no more than $20. Bidder Two has experienced the winner's curse: it won the auction, but lost the war. It overpaid. Target shareholders are better off by $12, but Bidder Two's shareholders are worse off by $2. Net, this is still a value creating acquisition, of course, but that fact may not assuage Bidder Two's shareholders.
2. Acquisitions made for the sake of empire building: Bigger is typically better from management's perspective. Just like putting oriental rugs down on the floor, bigger organizational charts on the wall are a management perk. If size reduces the chances of firm failure, management even has a financial incentive to pursue such acquisitions. As with acquisitions motivated by a desire for intra firm diversification, empire building acquisitions doubtless reduce shareholder wealth. Free markets are self correcting, however. Empirical studies confirm that bidders motivated by considerations other than shareholder wealth maximization themselves tend to become targets.
3. Acquisitions made for the sake of diversification: Around the middle of the 20th Century, the idea grew up that good managers could manage anything. This view was operationalized via conglomerate mergers, in which companies intentionally sought to diversify their product lines and business activities horizontally across a wide array of unrelated businesses. The theory was that a cyclical manufacturer could buy a noncyclical business, making the combined company stronger because some division would always be doing well. Diversification necessarily reduces the maximum gains a conglomerate can produce. When one segment is doing well, it is being pulled down by a segment that is doing less well. To be sure, diversification reduced the conglomerate's exposure to unsystematic risk. But so what? Investors can diversify their portfolios more cheaply than can a company, not least because the investor need not pay a control premium. Management of a conglomerate may be better off, because their employer is subject to less risk, but the empirical evidence is compelling that intra firm diversification reduces shareholder wealth. The self correcting nature of free markets is demonstrated by what happened next: during the 1980s there was a wave of so called "bust up" takeovers in which conglomerates were acquired and broken up into their constituent pieces, which were then sold off. The process resulted in a sort of reverse synergy: the whole was worth less than the sum of its parts.

Does the prospect that some acquirers lose money for their shareholders - and some lose a whole lot of money for them - have any policy implications? Should we do anything from a legal perspective to make it harder for one company to acquire another? No. As we just discussed, markets tend to be self-correcting. Firms that make bad acquisition decisions tend themselves to become targets. The market for corporate control is far more likely to make sound judgments in this area than some bureaucrat in Washington.

How many spaces after a full stop?

A colleague sent around the following email, which prompted some thoughts about writing style that segued into the hot topic du jour:

I was taught as a young dude that there should be *two* spaces following a period that concludes a sentence (prior to beginning a new sentence in the same paragraph). For some reason, the advent of word processors (and perhaps a mania for saving space on the page) has led some people to advocate the reduction of this number to *one* space. I find this unsightly (if not unseemly) and cannot bring myself to break the habit of following the period with two spaces. Is there a consensus on which is the proper style?

The Chicago Manual of Style's website relates:

The view at CMS is that there is no reason for two spaces after a period in published work. Some people, however—my colleagues included—prefer it, relegating this preference to their personal correspondence and notes. I’ve noticed in old American books printed in the few decades before and after the turn of the last century (ca. 1870–1930 at least) that there seemed to be a trend in publishing to use extra space (sometimes quite a bit of it) after periods. And many people were taught to use that extra space in typing class (I was). But introducing two spaces after the period causes problems: (1) it is inefficient, requiring an extra keystroke for every sentence; (2) even if a program is set to automatically put an extra space after a period, such automation is never foolproof; (3) there is no proof that an extra space actually improves readability—as your comment suggests, it’s probably just a matter of familiarity (Who knows? perhaps it’s actually more efficient to read with less regard for sentences as individual units of thought—many centuries ago, for example in ancient Greece, there were no spaces even between words, and no punctuation); (4) two spaces are harder to control for than one in electronic documents (I find that the earmark of a document that imposes a two-space rule is a smattering of instances of both three spaces and one space after a period, and two spaces in the middle of sentences); and (5) two spaces can cause problems with line breaks in certain programs.

As both my colleague's email and the CMS commentary suggests, there was a convention back in the manual typewriter days of using two spaces after a full stop, but the advent of wordprocessing seems to have undermined, if not wholly eliminated, that convention. (I note, however, that the rise of hte internet and concomitant HTML style conventions may have been an even more important factor.) John Rhodes reports:

In late September 1998 I asked several people what I thought was a simple typographic question. I was thinking about doing a quick eye tracking study with a colleague and I wondered if there was any empirical research available that showed that a single space after a period was "better" than two spaces, or vice versa.

While this was originally a question about web usability, I realized that the spacing issue is basically irrelevant! Steve Outing of Planetary News correctly pointed out that almost all browsers will only render one space after the period, regardless of how many spaces you put into the HTML code. Note however, that spaces can be hard-coded into the HTML using " ". ...

One of the next things I realized is that, in general, the spacing after a period will be irrelevant since most fonts used today are proportional. That is, each character is not the same size. Amy Gahran of Contentious kindly indicated that very few monospaced (i.e., non-proportional) fonts are used today on the Internet, except for perhaps Courier. This is generally the case offline as well. Proportional fonts are used much more often. For your information, I did not get any good feedback about the various fonts that are used for other Internet applications and activities, such as chat rooms and email. My guess is that they are mostly monospaced, but it is just a guess.

Like Amy Gahran, Kathy Gill told me that the current typographic standard for a single space after the period is a reflection of the power of proportionally spaced fonts.

"The only reason that two spaces were used after a period during the 'typewriter' age was because original typewriters had monospaced fonts -- the extra space was needed for the eye to pick up on the beginning of a new sentence. That need is negated w/proportional space type, hence [it is] the typographic standard."

While I'm on the topic, here's what one of the folks at The Design & Publishing Center had to say about the history of typographic spacing: "In the days of typewriter manuscripts the extra space was necessary to separate the ends and beginnings of sentences. The space character never changed. With the advent of electronic typesetting, the software attempts to 'fit' the type to specific line lengths, it both expands or contracts the available space to make the type fit. Word spacing is where most of this space 'play' takes place."

The relevance to Ra^thergate is self-evident. In all the reporting on the Killian memos, however, I have yet to see any reportage on the number of spaces following the full stops. Has anybody tried to figure out whether there are one or two? If so, email me and I'll post a link. Update: Steve Minor says there are two spaces!

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.)