ProfessorBainbridge.com

Howard Stern Blasts Radio

Radio shock jock Howard Stern currently has a contract with Infinity Broadcasting, a division of Viacom, which expires in 2006. Stern recently announced he had signed a deal with to join Sirius satellite radio after his Infinity contract expires.

What’s the corporate law problem? According to the LA Times:

“Stern has already begun promoting Sirius on his website, and many people speculate that he will do the same on Infinity's airwaves.”

If so, Stern appears to have violated his fiduciary duties to Viacom (he may also be in breach of contract).

Analytically, the initial issue is whether Stern is an agent of Infinity. According to the Restatement (Second) of Agency:

An agency relationship exists if you have a manifestation of consent by one person (the principal) that another person (the agent) act (a) on the principal’s behalf; and (b) subject to the principal’s control; and (2) the agent’s consent to so act.

The employment contract between Stern and Infinity for him would suffice to demonstrate the requisite consents.

As an agent, Stern is entitled to begin preparing to compete with Infinity. Comment e of section 393 of the Restatement (Second) of Agency provides that an agent can make arrangements to compete with his principal even before the termination of the agency, but that he cannot properly use confidential information peculiar to his employer’s business and acquired therein.

“Thus, before the end of his employment, he can properly purchase a rival business and upon termination of employment immediately compete. He is not, however, entitled to solicit customers for such rival business before the end of his employment nor can he properly do other similar acts in direct competition with the employer’s business.”

Because promoting Sirius on the air and at his website almost certainly would be deemed an effort to solicit customers, Stern is in a clear breach of fiduciary duty.

In addition, Stern’s show includes a number of side-kicks, whom he has solicited to follow him to the new show on Sirius. Again, comment e to Restatement (Second) of Agency is relevant:

“The limits of proper conduct with reference to securing the services of fellow employees are not well marked. An employee is subject to liability if, before or after leaving the employment, he causes fellow employees to break their contracts with the employer. On the other hand, it is normally permissible for employees of a firm, or for some of its partners, to agree among themselves while still employed, that they will engage in competition with the firm at the end of the period specified in their employment contracts. However, a court may find that it is a breach of duty for a number of the key officers or employees to agree to leave their employment simultaneously and without giving the employer an opportunity to hire and train replacements.”

To the extent Stern induces the sidekicks to break their own employment contracts, there clearly would be a problem. In addition, courts are much less forgiving of employee solicitation when the solicitor has a supervisory role vis-à-vis those who are solicited. On the whole, however, this strikes me as a much less clear cut case than the problem of soliciting customers of terrestrial radio to shift to satellite.

The Ovitz Lawsuit and Corporate Governance

Today's WSJ($) quotes self-appointed shareholder activist Nell Minow on the impact of the lawsuit against Walt Disney's directors over their handling of former Disney President Michael Ovitz's compensation package:

Because cases like this rarely go to trial, the Ovitz dispute "has every director quaking in his boots," says veteran shareholder activist Nell Minow, editor and chairman of the Corporate Library, a research group in Portland, Maine, that covers corporate governance.

Nonsense. This is a relatively unique case involving a rare confluence of several factors. First, you have a company with a long history of crony capitalism:

The case will animate, in great detail, the bad old days of Disney's corporate governance, when Mr. Eisner ruled a board that was widely seen as stacked with cronies too passive and unwilling to challenge him.

Second, you have an unusually large compensation package who structure created fewer incentives for Ovitz to work hard than it did for him to find a way of being terminated without cause. Finally, you had a board full of Eisner cronies and/or ceremonial directors who allowed the decisionmaking process to be usurped by Eisner and, indeed, allowed it to poractically disintegrate. If the directors are held liable for the breakdown in the decisionmaking process, that will hardly break much new legal ground. As I explain in the chapter on directors' duty of care in my Corporation Law and Economics treatise:

It is frequently said that the exercise of “reasonable diligence and care” is a precondition for the business judgment rule’s application. This phraseology is most unfortunate. It implies the necessity to inquire into the care exercised by the board .... The problem reduces to one of mere semantics, however, if we understand the requirement of “reasonable diligence and care” as being limited to the process by which the decision was made. Numerous Delaware decisions confirm that judicial references to a requirement of due care really go to the adequacy of the decisionmaking process—what the court has begun calling “process due care.” It would be better to follow the lead of those decisions and simply stop talking about whether the board exercised “reasonable diligence and care.” Instead, the requisite precondition [to application of the business judgment rule] would be better stated as a rational and good faith decisionmaking process. ...

[The leading case of Smith v.] Van Gorkom rests not on failure to comply with some judicially imposed decisionmaking model but on the absence of a sufficient record of any deliberative process. Put differently, if the decisionmaking process is adequate, the court will continue to defer to the decision that emerges from that process. The basic thrust of the opinion then is that the board must provide some credible, contemporary evidence that it knew what it was doing. If such evidence exists, the court will not impose liability—even if the decision proves to have been the wrong one.

By so focusing its opinion, the Van Gorkom court arguably created a set of incentives consistent with the teaching of the literature on group decisionmaking. The decision disfavors agenda control by senior management. The decision penalizes boards that simply go through the motions. The decision encourages inquiry, deliberation, care, and process. The decision strongly encourages boards to seek outside counsel and financial advice, which is consistent with evidence groupthink can be prevented by outside expert advice and evaluations. Even the court’s criticism of the board’s willingness to take action after a single meeting is consistent with suggestions that a “second-chance meeting” also helps prevent groupthink.

My discussion of this issue closes, however, with a warning that will become especially pertinent if Delaware Chancellor Chandler holds the Disney directors liable:

Van Gorkom probably has resulted in many board decisions being over-processed. In many cases, even relatively minor board decisions are subjected to exhaustive review, with detailed presentations by experts. Why? The answer lies in the incentive structures of the relevant players. Who pays the bill if the director is found liable for breaching the duty of care? The director. Who pays the bill for hiring lawyers and investment bankers to advise the board? The corporation and, ultimately, the shareholders. Suppose you were faced with potentially catastrophic losses, for which somebody offered to sell you an insurance policy. Better still, you don’t have to pay the premiums, someone else will do so. Buying the policy therefore doesn’t cost you anything. Would not you buy it?

It’s also important to consider the incentives of the lawyers who advise corporations. Deciding how much time and effort to spend on making decisions is itself a business decision. Because that decision is driven by liability concerns, however, legal advice is usually critical to the making of the decision. Why might lawyers have an incentive to encourage boards to over-invest in the decisionmaking process? The cynical answer is that a more complicated decisionmaking process, which is driven by liability concerns, is likely to result in higher fees. A less cynical explanation is that the law is full of sports, mutants, and mistakes. Clients often lack the information or willingness to recognize that their situation was one of the exceptions that proves the rule. Instead, clients tend to blame the lawyer for an adverse outcome even if the lawyer did nothing wrong. Because the lawyers will be blamed even if losing the case was an act of god equivalent to a 100-year flood, lawyers are often conservative in giving advice. (The term conservative here is not used in its political sense, but rather in the sense of being cautious.) In economic terms, lawyers are risk averse. In a risky situation, the best thing for the lawyer to do is to point the client towards strategies whose outcome is certain.

In sum, the incentives of both sellers and buyers of legal advice are congruent. Lawyers have strong incentives to encourage clients to expend a lot of time, energy, and money on the decisionmaking process, while corporate boards of directors have strong incentives to take that advice. All of which goes to show that otherwise puzzling things become readily explicable if one understands the economic incentives at play.

Amicus Briefs in the Interstate Wine Shipping Case

As the Supreme Court gets ready to hear the case on the constiutionality of state bars on interstate shipment of wine, numerous amicus briefs have been filed with the court opposing such bans, including:

Seven respected economists, including three Nobel laureates -- two from UC Berkeley -- argued that barriers to direct-to-consumer wine shipping distort free-market activity by giving wholesalers a near-monopoly in liquor transportation.

A bipartisan group of U.S. legislators from New York, California and Oregon, including California Democratic Sens. Dianne Feinstein and Barbara Boxer, asserted that Congress never intended to let state laws discriminate against products from other states.

Small wineries told of the importance of direct-to-consumer shipping for their businesses.

Trucking companies like UPS argued that state laws preventing direct wine shipping put a "substantial burden" on them.

A coalition of consumer groups and Internet concerns including EBay complained that "discriminatory state barriers are restraining the growth of e- commerce."

You can access the briefs from the Coalition for Free Trade's website. The economists' brief makes especially interesting reading. (My ULCA colleague Stuart Banner authored the brief on behalf of the seven top economists. Great job!) As the summary of their argument explains:

Direct shipping restrictions, and especially bans on direct interstate shipments, are measures of a type that quite likely would inflict welfare losses on consumers and on many wine producers, especially smaller market participants. If existing state restrictions on direct interstate shipments were removed, there would be more competition, which would have a positive impact on consumer and social welfare (that is, the total surplus of consumers and producers).

... [Proponents of state restrictions] contend that the existing restrictions are justified by other state interests, such as the promotion of temperance, the protection of minors, tax collection considerations, and the maintenance of orderly market conditions. These concerns, however, cannot justify the discriminatory laws at issue in these cases. More broadly, the history and the contours of state restrictions on direct shipments, as well as the empirical evidence from state markets that lack those restrictions, indicate that the proffered public interest justifications are not persuasive. The available evidence supports the economists’ expectation that restrictions on market entry often serve to protect highly organized and entrenched interest groups, to the detriment of consumer welfare.

For what it's worth, I completely agree, as I explained in an op-ed arguing that the Court should strike down these antiquated laws.

Kaplow and Shavell, Microeconomics

I've just finished reading Louis Kaplow and Steven Shavell's short (and I do mean short - its only 82 pages of text!) introduction to microeconomics. It's very readable and highly accessible; the educated layperson will have no problem with it. So if you skipped Econ 101 and always wondered what it was about (or if you slept through it or what-have-you), pick up a copy. This is undoubtedly the best short overview of microeconomcis I've seen.

You are what you drive

For those of us who live in car crazy Southern California, where you are what you drive, this comes as no surprise:

According to the new study by Kelley Blue Book, you're more likely to vote for President George W. Bush if you drive a Mercury, Ford, GMC or Chevy. If you drive a Hyundai, Toyota or a Subaru, you'll likely go for Sen. John Kerry.

This is particularly interesting:

Overall, the survey showed Bush winning the election among drivers by 20 points.

I'm guessing this reflects Kerry's advantage in urban centers (like, say NYC or SF), where lots of folks don't bother driving. Anyway, as this was based on an on-line poll, I wouldn't put too much faith in these numbers.

Why Wineries Need Currency Hedging

D. Vino has a great post on the role currency hedging ought to play in winemaking (as if winemakers don't have enough to worry about):

Hedging provides a firm the opportunity to manage risk, often at a reasonable price (and there are even some "zero cost" options). In the wine industry, if American importers anticipate a decline in the dollar, which would raise their costs of buying wine overseas, they can buy the foreign currency at today's prices in what is called the spot market. But that would tie up a lot of capital to simply buy, say, one million euros today. A lower cost strategy is to buy cheap options on one million euros at today's prices. This provides the importer insurance against a decline of the dollar. And a similar strategy can even be set up to protect against a rise in the dollar too.

Wine needs currency hedging more than other consumer products. Car producers can hedge their currency risk by moving production into the consuming countries as BMW did by opening a plant in South Carolina. But wine producers cannot shift production. Wine from Burgundy cannot be produced in Bangalore. That makes wine extremely vulnerable to currency fluctuations. ...

Passing the cost of currency fluctuations on to the consumer is but one strategy for an importer. One importer told me that his sales had doubled recently while his profits remained flat because he refused to raise prices to the consumer. Instead of simply buying the currency in the spot market, just think how much profit he could have made with a hedging program! He could even have lowered prices while his competitors raised them.

I've added the Doctor to the blogroll.

Update: A reader who teaches management at a major business school writes:

Hedging is virtually costless, after fairly small transactions costs. The reason is that you and your counter-party are simply taking opposite sides of a fair bet. Hedging is costless just as a bet on a sports team is costless, net of vigorish, which in the FX markets is very small.

If the importer wants to hedge against the Euro, an easy way to do it, at least conceptually, is to buy wine futures on European wines. (The importer will have to put up margin and meet margin calls.) Still, if the Euro strengthens, the futures will be worth more. If the Euro weakens, they will be worth less. Either he will have the profits on the contracts, which will enable him to pay more for the wine, or he will lose on the contracts but the wine will cost him less.

Zero cost options aren't really; they just fold the premium in. On average options are costless. When you win, you win enough that it pays for all the premia you gave up when you didn't win. A life insurance company pays out in claims about what it takes in in premia (actually frequently a little more); if it isn't winning, who is losing?

Conventional wisdom on oustide directors' liability exposure rebutted

Conventional wisdom is that both inside and outside directors of corporations face significant liability exposure, especially in the wake of Sarbanes-Oxley. In a provocative paper, Bernie Black, Brian Cheffins, and Mike Klausner argue that "the liability concern is overdone. Although there are good reasons for outside directors to fulfill their duties diligently, fear of liability should not be one of them. Outside directors face only a tiny risk of paying damages or legal fees out of their own pockets." I'm not convinced the theoretical risk is as miniscule as Black et al. suggest, although I think they're right that the risk in practice is very low. Their paper thus is a useful corrective.

Will it change attitudes. however? We know from behavioral economics that people are significantly risk averse. People tend to evaluate the utility of a decision by comparison to some neutral reference point. Changes framed in a way that makes things worse (losses) loom larger in the decisionmaking process than changes framed as making things better (gains) - even if the expected value of the two decisions is the same. Hence, a loss averse person (as are most people) is more perturbed by the prospect of losing $100 than pleased by that of gaining $100. A bias against risk-taking is a natural result of loss aversion, because decisionmakers give the potential disadvantages greater weight than any potential advantages.