ProfessorBainbridge.com

On Delaware

Marcel Kahan and Ed Rock have published a fascinating paper, Our Corporate Federalism and the Shape of Corporate Law, which will be of interest to anyone who studies corporate law and/or questions of federalism. I don't agree with every jot-and-tittle of their analysis, but I think it is a wonderful stab at sorting out some very interesting problems:

ABSTRACT: In the public debate sparked by the corporate scandals of the last years, Delaware has been strikingly absent. In contrast to the high profile activity of Congress, the Securities and Exchange Commission, the stock exchanges, federal prosecutors, and even state law enforcement officials, Delaware has been largely mute: no legislation; no rule-making; no criminal investigations; few headlines. In this Article, we use Delaware's relative passivity during this latest episode of corporate law-making as a starting point in the analysis of the shape of American corporate federalism and Delaware's place within it.

We argue that Delaware long ago opted for what we will call a "classical" or "19th-century" common law model of corporate law-making. In Delaware, corporate law is largely judge-made; judicial opinions are filled with quasi-deterministic reasoning; statutory law is comparatively narrow and rarely subject of partisan disputes; the judiciary as well is relatively non-partisan and has claim to technical expertise; and the law is enforced through litigation brought by private parties. We view these traits through the lens of the institutional and political landscape in which Delaware must operate. This landscape is characterized by a federalist system in which Delaware's regulatory powers co-exist with, and can be constrained by, the powers of the federal government. In this system, Delaware is faced with the threat that populist pressures will lead to a federal preemption of Delaware corporate law and thus eradicate the huge profits Delaware derives from being the domicile of choice for public- traded U.S. corporations. By creating and enhancing an apolitical gloss over Delaware's corporate law, the various traits we identify help shield Delaware against this threat. At the same time, the scope of Delaware's corporate law is designed to minimize conflicts by assuring that Delaware has the requisite personal jurisdiction over defendants to enforce its law effectively and that the prevailing conflict rules point to substantive Delaware law as applicable to a corporate law dispute.

But this classical model of law making carries with it intrinsic limitations. Specifically, legal change is slow, standard-based and incremental. Faced with the recent corporate scandals, calls for action, and Sturm und Drang, Delaware reacted accordingly: Basically, it does nothing until cases are brought. Any more pro-active response by Delaware actors would have threatened to undermine the political legitimacy achieved by Delaware's commitment to the classical common law model. But because the classical common law style, together with jurisdictional and conflict rules, constrain Delaware, federal law is needed to complement Delaware's. In that respect, the relation between federal law and Delaware law is symbiotic, rather than antagonistic: Delaware is happy to have federal law pick up the slack and thereby reduce the likelihood that ineffective regulation produces a populist backlash.

The corporation as lobster trap

The lobster trap is a useful metaphor for many legal regimes. A real lobster trap is easy to get into, but very difficult to exit. There is an emerging consensus amongst corporate governance theorists that the lobster trap aptly describes an important aspects of the corporation; namely, the ease with which investors can out equity into the firm but the difficulty with which they can get it out. My friend and UCLA colleague Lynn Stout has just posted to SSRN an accessible and fairly short essay exploring these ideas:

ABSTRACT: Legal experts traditionally distinguish corporations from unincorporated business forms by focusing on such corporate characteristics as limited shareholder liability, centralized management, perpetual life, and freely transferred shares. While this approach has value, this essay argues that the nature of the corporation can be better understood by focusing on a fifth, often-overlooked, characteristic of corporations: their capacity to lock in equity investors' initial capital contributions by making it far more difficult for those investors to subsequently withdraw assets from the firm. Like a tar pit, a corporation is much easier for equity investors to get into, than to get out of.

An emerging school of theorists has begun to explore the implications of this idea for corporate law and practice. The idea is still novel enough to lack a uniformly-accepted label - in addition to the phrase capital lock-in, scholars have described this aspect of incorporation as affirmative asset partitioning, the absence of a repurchase condition, and asset separation from shareholders. Whatever label one chooses, the idea shows great promise for illuminating a variety of thorny problems that have long troubled corporate scholars and practitioners.

In illustration, this essay considers how the idea of capital lock-in sheds light on three corporate mysteries: the sui generis nature of corporate directors' fiduciary duties; the rise of the large modern service partnership; and lawmakers' enthusiasm for meddling with corporate governance rules.

Conference Board on Global Warming

One of President Bush’s first acts upon taking office was taking the US out of the controversial Kyoto Protocol on global warming. In the face of significant outrage from environmental groups and our European allies, the President announced in June 2001 that the U.S. would “work within the United Nations framework and elsewhere to develop with our friends and allies and nations throughout the world an effective and science-based response to the issue of global warming.” In doing so, he also recognized “the responsibility to reduce our emissions.” Yet, even its friends must admit that the administration has moved slowly on the global warming issue. It took until August 2004, for example, for the administration to formally acknowledge the role human activity plays in causing global warming.

I am not an expert on the climate. I don’t claim to know whether human activity causes global warming or not. Instead, my expertise lies at the intersection of business and law. And I believe a watershed event has just occurred at that intersection; namely, the Conference Board’s report on global warming:

Concludes the report: “The Earth – for whatever the exact reasons – is on a trajectory toward an ever warmer climate. This cannot be avoided at this point, but the trajectory can be jiggled and potential risks associated with the warming can be mitigated. Ultimately the trajectory could be reversed.”

The report finds that “governments and markets are likely to act” on expanding scientific evidence and perceptions that climate change has become “an urgent priority that must be addressed through a variety of measures.” Participating scientists in the report strongly believe that “a reduction in human-caused emissions is an essential step in any overall strategy for dealing with climate change.” ...

Corporate boards will be increasingly expected to evaluate potential risks associated with climate change, says the report. It adds: “The frequently cited ‘Enron effect’ will likely result in increased pressure on boards to evaluate potential costs and risks associated with mitigation either of carbon emissions or the effects of actual climate changes.”

Unfortunately, the entire report is locked away behind a firewall and available only to Conference Board members. Yet, a couple of observations can be made on the basis of what we do know. First, the report was prepared by "11 noted climate scientists who met this June under the auspices of the American Association for the Advancement of Science." As such, it's likely to reflect conventional wisdom. Indeed, it appears that none of the participants are known global warming skeptics. Second, it is not at all clear what the "Enron effect" has to do with the issue. Enron involved failure to disclose financial accounting fraud. We're not yet at the point at which failing to disclose emissions data is considered securities fraud. The securities laws, moreover, do not require boards to evaluate potential costs of anything; that is a question of state law duty of care.

Having said all that, however, I believe we will one day look back on this report as a pivotal moment in the regulation of greenhouse gases. The Conference Board is a highly regarded and generally nonpartisan association of over 2000 large international companies. Their economic and corporate governance recommendations have frequently been highly influential on company policy. In addition, the Conference Board's participation in this project was facilitated by Environmental Defense, which most analysts regard as relatively centrist by the environmentalist community's standards. (But see a critical report by Capital Research.) The combination of a centrist business group and a center-left environmental group will make a potent lobbying team both on Capitol Hill and in the boardroom.

On global warming, the business community thus has taken a double whammy in the last month. First came the Bush administration report on global warming asserting that “the approximate 0.5°C rise over the second half of the century, most pronounced in the last 30 years, can only be explained when factors related to human activity, such as carbon dioxide and other greenhouse gas emissions, are taken into account.” Now comes the elite Conference Board endorsing a report reaching the same conclusion and calling on business to respond.

How then will business respond? As Benjamin Hunt recently demonstrated in The Timid Corporation, business today is terrified of taking risk. In our highly litigious society, business men and women naturally are afraid of getting sued or, worse yet, indicted. Hunt argues, however, that they are just as afraid of appearing to be unethical or even insensitive to politically correct elite opinion. As a result, business self-regulates in the name of risk management. In addition, business becomes reluctant to oppose government regulation on sensitive issues like the environment. (Some observers even think that business men and women are influenced by their children, who come home from schools that teach the evils of capitalism and the blessings of environmentalism.)

What should those of us who believe in free markets do now? We could continue to stick our heads in the sand, hoping the problem would go away or that some major paradigm shift in the scientific community would prove it was all nonsense. Or we could adopt the anarcho-libertarian view that any regulation is inherently evil, putting us on a slippery slope to fascism. Either way, we would lose. We would be fighting not just the environmentalists, but also the business community and, perhaps, even the Bush administration (or, at least, segments thereof).

If we are not to let the perfect become the enemy of the good, we therefore must become proactive. We must work with responsible business leaders to come up with pro-market (or, at least, market friendly) solutions. Emissions trading programs spring to mind as but one example. In addition, since basic research has many of the characteristics of a public good, the government can and should fund research into technological solutions, such as carbon sinks and scrubbing technologies.

Regulation designed to prevent global warming is inevitable. Both the Bush administration and the business community have now caved on the basic question of whether human activity contributes to the problem. But while regulation is inevitable, Big Brother Kyoto-style command and control is not. There is still time for market-based approaches, but only if those of us who support free markets will pull our heads out of the sands of denial.

Why Regulate Insider Trading?

My latest TCS Daily column

The Washington Post recently reported on the considerable attention the SEC and Justice Department are devoting to enforcement of the insider trading laws. Who can forget the recent high profile case against Martha Stewart, which is only the very tip of a large iceberg? Is this a useful expenditure of government resources?

Henry Manne's 1966 book Insider Trading and the Stock Market stunned the SEC and corporate law academy by daring to propose the deregulation of insider trading. Manne argued that insider trading benefits both society and the firm in whose stock the insider traded. First, he argued, insider trading causes the market price of the affected security to move toward the price that the security would command if the inside information were publicly available. If so, both society and the firm benefit through increased price accuracy. Second, he posited insider trading as an efficient way of compensating managers for having produced information. If so, the firm benefits directly (and society indirectly) because managers have a greater incentive to produce additional information of value to the firm.

Although I have tremendous respect for Manne's daring in proposing such provocative arguments, I'm afraid I don't buy either one. As to the first, Manne argued (correctly) that both firms and society benefit from accurate pricing of securities. The "correct" price of a security is that which would be set by the market if all information relating to the security had been publicly disclosed. But while U.S. securities laws purportedly encourage accurate pricing by requiring disclosure of corporate information, they in fact do not require the disclosure of all material information. Where disclosure would interfere with legitimate business transactions, disclosure by the corporation is usually not required unless the firm is dealing in its own securities at the time.

Manne argued insider trading is an effective compromise between the need for preserving incentives to produce information and the need for maintaining accurate securities prices. Suppose, for example, that a firm's stock currently sells at fifty dollars per share. The firm has discovered new information that, if publicly disclosed, would cause the stock to sell at sixty dollars. If insiders trade on this information, the price of the stock will gradually rise toward but will not reach the "correct" price. Absent insider trading or leaks, the stock's price will remain at fifty dollars until the information is publicly disclosed and then rapidly rise to the correct price of sixty dollars. Thus, insider trading acts as a replacement for public disclosure of the information, preserving market gains of correct pricing while permitting the corporation to retain the benefits of nondisclosure.

The problem with this argument is that insider trading affects stock market prices through what is known as "derivatively informed trading." First, those individuals possessing material nonpublic information begin trading. Their trading has only a small effect on price. Some uninformed traders become aware of the insider trading through leakage or tipping of information or through observation of insider trades. Other traders gain insight by following the price fluctuations of the securities. Finally, the market reacts to the insiders' trades and gradually moves toward the correct price. But while derivatively informed trading can affect price, it functions slowly and sporadically. Given the inefficiency of derivatively informed trading, the market efficiency justification for insider trading loses much of its force.

As for Manne's second argument, insider trading in fact appears to be a very inefficient scheme for compensating corporate managers. Even assuming a change in stock price that accurately measures the value of the innovation, the insider's "compensation" from insider trading is limited by the number of shares he can purchase. This, in turn, is limited by his wealth. As such, the insider's trading returns are based, not on the value of his contribution to the corporation, but on his wealth.

Another objection to the compensation argument is the difficulty of restricting trading to those who produced the information. Where information is concerned, production costs normally exceed distribution costs. As such, many firm agents may trade on the information without having contributed to its production.

A related objection is the difficulty of limiting trading to instances in which the insider actually produced valuable information. In particular, why should insiders be permitted to trade on bad news? Allowing managers to profit from inside trading reduces the penalties associated with a project's failure because trading managers can profit whether the project succeeds or fails. If the project fails, the manager can sell his shares before that information becomes public and thus avoid an otherwise certain loss. The manager can go beyond mere loss avoidance into actual profit making by short selling the firm's stock.

In sum, the arguments for deregulating insider trading are not very persuasive. But that doesn't answer the question, why do we regulate insider trading? Efficiency-based arguments for regulating insider trading (as opposed to those grounded on legislative intent, equity, or fairness) fall into three main categories: (1) insider trading harms investors and thus undermines investor confidence in the securities markets; (2) insider trading harms the issuer of the affected securities; and (3) insider trading amounts to theft of property belonging to the corporation and therefore should be prohibited even in the absence of harm to investors or the firm. Only the latter proves very persuasive.

There are essentially two ways of creating property rights in information: allow the owner to enter into transactions without disclosing the information or prohibit others from using the information. In effect, the federal insider trading prohibition vests a property right of the latter type in the party to whom the insider trader owes a fiduciary duty to refrain from self-dealing in confidential information. To be sure, at first blush, the insider trading prohibition admittedly does not look very much like most property rights. Enforcement of the insider trading prohibition admittedly differs rather dramatically from enforcement of, say, trespassing laws. The existence of property rights in a variety of intangibles, including information, however, is well-established. Trademarks, copyrights, and patents are but a few of the better known examples of this phenomenon. There are striking doctrinal parallels, moreover, between insider trading and these other types of property rights in information. Using another's trade secret, for example, is actionable only if taking the trade secret involved a breach of fiduciary duty, misrepresentation, or theft. Likewise, insider trading is only unlawful if the use of the information involves a breach of fiduciary duty by the insider.

The rationale for prohibiting insider trading is precisely the same as that for prohibiting patent infringement or theft of trade secrets: protecting the economic incentive to produce socially valuable information. As the theory goes, the readily appropriable nature of information makes it difficult for the developer of a new idea to recoup the sunk costs incurred to develop it. If an inventor develops a better mousetrap, for example, he cannot profit on that invention without selling mousetraps and thereby making the new design available to potential competitors. Assuming both the inventor and his competitors incur roughly equivalent marginal costs to produce and market the trap, the competitors will be able to set a market price at which the inventor likely will be unable to earn a return on his sunk costs. Ex post, the rational inventor should ignore his sunk costs and go on producing the improved mousetrap. Ex ante, however, the inventor will anticipate that he will be unable to generate positive returns on his up-front costs and therefore will be deterred from developing socially valuable information. Accordingly, society provides incentives for inventive activity by using the patent system to give inventors a property right in new ideas. By preventing competitors from appropriating the idea, the patent allows the inventor to charge monopolistic prices for the improved mousetrap, thereby recouping his sunk costs. Trademark, copyright, and trade secret law all are justified on similar grounds.

This argument does not provide as compelling a justification for the insider trading prohibition as it does for the patent system. A property right in information should be created when necessary to prevent conduct by which someone other than the developer of socially valuable information appropriates its value before the developer can recoup his sunk costs. Insider trading, however, often does not affect an idea's value to the corporation and probably never entirely eliminates its value. Legalizing insider trading thus would have a much smaller impact on the corporation's incentive to develop new information than would, say, legalizing patent infringement.

The property rights approach nevertheless has considerable justificatory power. Consider the prototypical insider trading transaction, in which an insider trades in his employer's stock on the basis of information learned solely because of his position with the firm. There is no avoiding the necessity of assigning the property right to either the corporation or the inside trader. A rule allowing insider trading assigns the property right to the insider, while a rule prohibiting insider trading assigns it to the corporation.

From the corporation's perspective, legalizing insider trading likely would have a relatively small effect on the firm's incentives to develop new information. In some cases, however, insider trading will harm the corporation's interests and thus adversely affect its incentives in this regard. This argues for assigning the property right to the corporation, rather than the insider.

Those who rely on a property rights-based justification for regulating insider trading also observe that creation of a property right with respect to a particular asset typically is not dependent upon there being a measurable loss of value resulting from the asset's use by someone else. Indeed, creation of a property right is appropriate even if any loss in value is entirely subjective, both because subjective valuations are difficult to measure for purposes of awarding damages and because the possible loss of subjective values presumably would affect the corporation's incentives to cause its agents to develop new information. As with other property rights, the law therefore should simply assume (although the assumption will sometimes be wrong) that assigning the property right to agent-produced information to the firm maximizes the social incentives for the production of valuable new information.

Because the relative rarity of cases in which harm occurs to the corporation weakens the argument for assigning it the property right, however, the critical issue may be whether one can justify assigning the property right to the insider. On close examination, the argument for assigning the property right to the insider is considerably weaker than the argument for assigning it to the corporation. As we have seen, Manne argued that legalized insider trading would be an appropriate compensation scheme. In other words, society might allow insiders to inside trade in order to give them greater incentives to develop new information. As we have also seen, however, this argument founders because insider trading in fact is an inefficient compensation scheme.

The economic theory of property rights in information thus cannot justify assigning the property right to insiders rather than to the corporation. Because there is no avoiding the necessity of assigning the property right to the information in question to one of the relevant parties, the argument for assigning it to the corporation therefore should prevail.

None of this is to say that the precise set of rules the SEC has adopted is ideal. To the contrary, as I detailed in my book on insider trading, there are serious problems with a number of features of the current enforcement regime. As to the basic question of whether we ought to regulate insider trading, however, economic efficiency commands an affirmative answer.

The Ownership Society

Lew Rockwell thinks (I use the term very loosely) President Bush's ownership society is disguised tyrrany:

Under a certain kind of government structure--let's just call it fascism for short--ownership can be in private hands only in the most formal sense, but its control and use is subject to central command.

Along the way, he misrepresents the thrust of my recent TCS column on the ownership society. This is why I find it impossible to take the anarcho-libertarian fringe remotely seriously. Not only do the allow the perfect to become the enemy of the good, they misrepresent and distort the good.

Meanwhile, the Washington Post quotes my column in a piece on Bush's RNC speech:

The most prominent recommendation of Bush's Social Security Commission in late 2001 would ultimately put the nation's largest entitlement program on a path to solvency, according to a recent analysis by the nonpartisan Congressional Budget Office. It would also make stock ownership almost universal, "which surely would be the ultimate expression of the American dream," argues Stephen Bainbridge, a law professor at the University of California at Los Angeles.

Corporations Really do Rule the World

Proof from the NYC anti-GOP protests via Daniel Henninger:

At midweek, another march up to Madison Square Garden began at Ground Zero downtown. Amid the marchers, you could see shoes by Nike and Timberland, bike helmets by Bell, backpacks by Kelty, Caribee and Mizuno. They knew how to assemble this stuff.

So it seemed a paradox that at the other end of the demonstration, outside Madison Square Garden, the protesters were wearing pig masks, yelling "oink, oink" and making fun of Dick Cheney, calling Halliburton "Halli-bacon" and denouncing the Republicans as slaves to corporate America, even while they themselves were draped in corporate design logos.

No paradox. Part selective outrage, part stupidity, and part the dominance of economic life by corporations.