ProfessorBainbridge.com

Now is the time for Bush to keep his promise

Developing meme: John Roberts has been confirmed as the next CJOTUS. Good. Now it's time to go back to 2000 and dust off a promise Bush made repeatedly:

During the 2000 presidential campaign, Gov. George W. Bush repeated a number of times that, if elected and if a Supreme Court slot opened up, he would nominate a judge that held the same judicial philosophy as Justices Clarence Thomas and Antonin Scalia.

On "Meet the Press" in 1999, the future President Bush said that the justices he most admired were Scalia and Thomas. Bush referred to Scalia during one of the nationally-televised debates as his favorite Supreme Court judge, and the kind he would nominate during his presidential tenure. (Link)

It's time for him to come through on that one. More to follow.

Laube on Taber on the Judgment of Paris

From the Wine Spectator:

Thirty years ago, as the U.S. prepared to celebrate its bicentennial, a showdown between French and Californian wines in Paris resulted in one of those "man bites dog" stories.

In a blind tasting, a panel of French experts compared Napa Valley Chardonnays with white Burgundies, and Napa Cabernet Sauvignons with red Bordeaux. The upstart Americans—"the kids from the sticks"—won both flights, led by a 1973 Chardonnay from Chateau Montelena (a blend of Napa and Alexander Valley grapes) and a 1973 Napa Valley Cabernet from Stag's Leap Wine Cellars. ...

Judgment of Paris is an intelligently written, well-researched, smooth-paced account of the events leading up to the tasting and its aftermath. Fans of California wine will particularly enjoy the first half of the book, which follows the paths of such vintners as Warren Winiarski and Miljenko Grgich from their birthplaces to Napa Valley (where, ironically, they both had their first jobs at Lee Stewart's Souverain winery on Howell Mountain).

The story of how Winiarski's Stag's Leap Wine Cellars Cabernet, and Grgich's Chardonnay, made at Chateau Montelena, won the Paris tasting is both a "rags to riches" and "David beats Goliath" tale. Those kinds of stories help keep the American Dream alive.

Federalism and Consistency

My friend and UCLAW colleague Eugene Volokh has a very thoughtful post on the difference between federalism and localism, which nicely rebuts charges that conservatives who generally favor federalism are being inconsistent when they occasionally advocate national solutions to select problems. As an example of that principle in action, might I suggest my own post Can you be a Competitive Federalist and still want Spitzer to shut the #@!% up?

Frist's Alleged Insider Trading

T he Baseball Crank has a great post on the legal and political aspects of the controversy over Senate Majority Leader Bill Frist's HCA stock sale. It's probably the best analysis I've read so far in either the blogosphere or MSM (proving once again how the former offers insights on issues the latter just doesn't have the expertise to deal with).

New Paper: Director Primacy and Shareholder Disempowerment

I've got another new paper out, which continues my exploration of how shareholder voting rights fit into my director primacy model of corporate governance. The article has been accepted for publication by the Harvard Law Review, but the editors say it will need to be shaved by at least one-third due to space constraints. Where and how to do that strikes me as somewhat of a puzzle, as the piece is already pretty lean, at least by my standards. In any event, the full version will be available on SSRN. You can down load Director Primacy and Shareholder Disempowerment here.

Abstract: This essay is a response to Lucian Bebchuk's recent article The Case for Increasing Shareholder Power, 118 Harvard Law Review 833 (2005). In that article, Bebchuk put forward a set of proposals designed to allow "shareholders to initiate and vote to adopt changes in the company's basic corporate governance arrangements."

In response, I make three principal claims. First, if shareholder empowerment were as value-enhancing as Bebchuk claims, we should observe entrepreneurs taking a company public offering such rights either through appropriate provisions in the firm?s organic documents or by lobbying state legislatures to provide such rights off the rack in the corporation code. Since we observe neither, we may reasonably conclude investors do not value these rights.

Second, invoking my director primacy model of corporate governance, I present a first principles alternative to Bebchuk's account of the place of shareholder voting in corporate governance. Specifically, I argue that the present regime of limited shareholder voting rights is the majoritarian default and therefore should be preserved as the statutory off-the-rack rule.

Finally, I suggest a number of reasons to be skeptical of Bebchuk's claim that shareholders would make effective use of his proposed regime. In particular, I argue that even institutional investors have strong incentives to remain passive.

Keywords: corporations, corporate governance, shareholders, stockholders, institutional investors, board of directors, managers, voting

JEL Classifications: K22

Tags: Business Organizations Research Law

Manne's Primer on Corporate Governance

Famed law and economics scholar Henry Manne has a very fine essay on corporate governance in today's WSJ($). He begins with an analysis of proposals to increase disclosure of executive compensation and to enhance the power of shareholders, concluding:

Only in the make-believe world of SEC regulation could anything like the proxy fight be seen as a significant solution to the agency-cost problem of exorbitant salaries.

I agree, for the reasons detailed at length in my article The Case for Limited Shareholder Voting Rights.

Henry's proposed alternative solution to the ills of corporate governance will come as no surprise to those who know him; namely, a reinvigorated market for corporate control.

Tags: Business Organizations Research Law

Henry writes:

... free markets do not tolerate economic inanities for long, even in the case of large, publicly held companies. Contrary to the popular liberal shibboleth, markets do not often fail on their own. It usually requires help from the government. In the late '50s and '60s, we witnessed the early development of the hostile tender offer -- the most powerful market tool ever devised for dealing with non-profit-maximizing managers in publicly held companies. It did not appear before this time for the simple reason that there were very few companies that had the wide diffusion of stock ownership prerequisite to hostile tender offers. Tax laws and a growing understanding of the virtues of share diversification changed all that, and hostile takeovers were not slow then in making their appearance.

But their appearance was, for incumbent managers, a terrifying thing: surprise offers for almost all outstanding shares at a huge premium over current market price -- and with little time for shareholders or the corporation to shop the offer, or for the incumbents to mount a counterattack or defense. The opportunity for affording such a premium, of course, was created by the low stock market value generated by the policies of the incumbent managers. There were no inefficiencies in the stock market that generated incorrectly low prices for these companies' shares.

... Until we return to something like the pre- Williams-Act market for corporate control, we shall continue to see egregious salaries, crazy option grants, and golden handshakes and parachutes. Disclosure as a solution to that problem is a bit like a New Orleans levee faced with Katrina. A return to the takeover law of the '60s would substantially solve the compensation problem without ungainly regulation, and it would also deliver us from vacuous and harmful notions of corporate social responsibility. All that is required is a little guts from Mr. Cox, confidence in free markets from the managers of large corporations, and some humility about economic regulation from the U.S. Congress.

I would quibble with Henry on a couple of points. First, I don't entirely share his faith in the efficiency of the stock market. As I detail in my book Mergers and Acquisitions (at 54-56): In standard economic theory, a control premium is not inconsistent with the efficient capital markets hypothesis. The pre bid market price represented the consensus of all market participants as to the present discounted value of the future dividend stream to be generated by the target?in light of all currently available public information. Put another way, the market price represents the market consensus as to the present value of the stream of future cash flows anticipated to be generated by present assets as used in the company's present business plans. A takeover bid represents new information. It may be information about the stream of future earnings due to changes in business plans or reallocation of assets. In any event, that pre bid market price will not have impounded the value of that information. To the extent the bidder has private information, moreover, the market will be unable to fully adjust the target's stock price.

Some commentators contend that the demand curves for stocks slope downwards and may even approximate unitary elasticity. If so, buying 50% of a company's stock would require a price increase of 50%. If so, little or no new wealth is created by takeovers. Instead, takeover premia are largely an artifact of supply and demand.

Put another way, the downward sloping demand curve hypothesis takeover premium implies that many investors have a reservation price higher than the pre-bid market price of the target corporation?s stock. Indeed, because investors with a reservation price below the prevailing market price should already have sold, most investors? reservation price will be near or above the prevailing market price. Accordingly, a bidder must offer a control premium simply to induce those investors to sell. As to those investors, however, the portion of the control premium reflecting their reservation price really should not be considered new wealth.

Second, I find the notion that takeovers are driven by disciplinary concerns unpersausive. If there are alternative explanations of how takeovers create value, the market for corporate control loses some of its robustness as a policy engine. Put another way, awarding the lion's share of the gains to be had from a change of control to the bidder only makes sense if all gains from takeovers are created by bidders through the elimination of inept or corrupt target managers and none of the gains are attributable to the hard work of efficient target managers.

The empirical evidence suggests that takeovers produce gains for many reasons, of which the agency cost constraining function of the market for corporate control is but one. Studies of target corporation performance, for example, suggest that targets during the 1980s generally were decent economic performers. Second, studies of post takeover workforce changes find that managers are displaced in less than half of corporate takeovers. Third, as already noted, acquiring company shareholders frequently lose money from takeovers. If displacing inefficient managers was the principal motivation for takeovers, acquiring company shareholders should make money from takeovers. Finally, there is little convincing evidence that acquired firms are better managed after the acquisition than they were beforehand. In sum, displacement of inefficient managers is a plausible way in which takeovers create value, but it is hardly the only way?and it may not even be a particularly important way. (I cite these studies at pages 48-49 of my Mergers and Acquisitions text.)

Finally, there is a very strong argument for allowing incumbent target managers to at the very least compete to retain control. (I discuss this argument in my recent paper Un ocal at 20: Director Primacy in Corporate Takeovers, which also makes a number of other arguments for granting target management a gatekeeping function in takeover fights.)

Michael Dooley has suggested that management resistance to unsolicited tender offers may not deserve the opprobrium to which it is usually subjected. Michael P. Dooley, Fundamentals of Corporation Law at 561-63. Observing that it would be naive to assume that takeovers displace only ?bad? or ?inefficient? managers, while acknowledging that blamelessness does not eliminate the managers? conflict of interest, he suggests that ?resistance may not deserve the opprobrium usually attached to self-dealing transactions.? Id. at 562.

Indeed, Dooley observes, it may often be shareholders rather than managers who act opportunistically in the takeover context. Id. Much of the knowledge a manager needs to do his job effectively is specific to the firm for which he works. As he invests more in firm specific knowledge, his performance improves, but it also becomes harder for him to go elsewhere. An implicit contract thus comes into existence between managers and shareholders. On the one hand, managers promise to become more productive by investing in firm specific human capital. They bond the performance of that promise by accepting long promotion ladders and compensation schemes that defer much of the return on their investment until the final years of their career. In return, shareholders promise job security. See Stephen M. Bainbridge, Interpreting Nonshareholder Constituency Statutes, 19 PEPPERDINE L. REV. 971, 1004-08 (1992).

Viewed in this light, the shareholders? decision to terminate the managers? employment by tendering to a hostile bidder ?seems opportunistic and a breach of implicit understandings between the shareholders and their managers.? DOOLEY at 562. Shareholders can protect themselves from opportunistic managerial behavior by holding a fully diversified portfolio. By definition, a manager?s investment in firm specific human capital is not diversifiable. Shareholders? ready ability to exit the firm by selling their stock also protects them. In contrast, the manager?s investment in firm specific human capital also makes it more difficult for him to exit the firm in response to opportunistic shareholder behavior. See John C. Coffee, Jr., Shareholders versus Managers: The Strain in the Corporate Web, 85 MICH. L. REV. 1, 73-81 (1986).

Dooley concedes that this analysis certainly helps explain the courts? greater tolerance of conflicted interests in this context than in, say, garden variety interested director transactions. But he also argues that the possibility that the shareholders? gains come at the expense of the managers does not justify permitting management to block unsolicited tender offers. Rather, he argues, the managers? loss of implicit compensation appears to be a particularly dramatic form of transaction costs, which could be reduced by alternative explicit compensation arrangements, such as payments from shareholders to managers who lose their jobs following a takeover. It thus may be that courts tolerate management involvement in the takeover process not because they perceive management as having a right for management to defend its own tenure, but rather a right to compete with rival managerial teams for control of the corporation. By allowing management to compete with the hostile bidder for control, the courts provide an opportunity for management to protect its sunk cost in firm- specific human capital without adversely affecting shareholder interests. Indeed, allowing them to compete for control will often be in the shareholders? best interests. There is strong empirical evidence that management-sponsored alternatives can produce substantial shareholder gains. See Michael C. Jensen, Agency Costs of Free Cashflow, Corporate Finance, and Takeovers, 76 AM. ECON. REV. 323, 324- 26 (1986) (summarizing studies of shareholder gains from management- sponsored restructurings and buyouts). A firm?s managers obviously have significant informational advantages over the firm?s directors, shareholders, or outside bidders, which gives them a competitive advantage in putting together the highest valued alternative. Management may also be able to pay a higher price than would an outside bidder, because to a firm?s managers? the company?s value includes not only its assets but also their sunk costs in firm specific human capital. Shareholders thus have good reason to want management to play a role in corporate takeovers, so long as that role is limited to providing a value maximizing alternative.

It is certainly true that any management response to an unsolicited tender offer, other than pure passivity, triggers a competition between two or more rival managerial teams for control of the corporation. The competition is obvious when an unsolicited tender offer is made to the shareholders of the target of a locked-up negotiated acquisition. But a competition also results when management defends against a standard hostile takeover bid by putting forward a management-endorsed white knight bid, a management-sponsored leveraged buyout proposal, a restructuring of the corporation?s control structure transferring effective voting control to management and its allies, a restructuring preserving management?s incumbency by making the target unpalatable to hostile bidders, or even merely a management statement urging shareholder to reject the bid. Revlon?s progeny appear to encourage this sort of competition, so long as it is conducted fairly, by making it clear that the board in conducting an auction must have a very good reason for skewing the auction in favor of one of the competing bidders. Paramount Communications Inc. v. QVC Network Inc., 637 A.2d 34, 45 (Del. 1993); Barkan v. Amsted Indus., Inc., 567 A.2d 1279, 1286 (Del. 1989); Mills Acquisition Co. v. Macmillan, Inc., 559 A.2d 1261, 1286-87 (Del. 1989).

Yet, to focus on competition between incumbent management and the outside bidder would obscure the critical role played by the board of directors. The Delaware courts have rejected formalistic and formulaic approaches to takeovers. Instead, they have adopted a case-by-case search for conflicted interests. Where the facts suggest that the directors have allowed self-interest to affect their decisions, they have lost, but where the directors pursued the shareholders? interests, Delaware courts have deferred to their decisions, even where the court might not have made the same decision.

Update: Larry Ribstein has a nice post on Henry's essay, which takes a somewhat different approach to the problem than I do. (No surprise there to those who know us both!)

This Hedge Bet is No Winner

My TCS Column

New Securities and Exchange Commission Chairman Chris Cox recently told the Wall Street Journal that he plans for the Commission to go forward with its controversial rule requiring hedge fund managers to register with the SEC. Under the rule, registration of a hedge fund with the SEC also would give the SEC power to engage in administrative investigations of fraud or other misconduct, screen out undesirable persons (such as felons) from serving as fund managers, and require funds to adopt internal compliance controls.

Cox's announcement came as somewhat of a surprise, since the rule originally had been proposed over strong dissents by Republican Commission members Cynthia Glassman and Paul Atkins, and the controversy over the rule was widely seen as one of the principal reasons former SEC Chairman William Donaldson stepped down with several years left on his term (presumably under pressure from the White House).

Various political factors may have weighed in Cox's decision, but the likeliest explanation is that he allowed himself to be spooked by several recent high-profile hedge fund problems, most notably the alleged fraud at Bayou Securities. According to a detailed NY Times account:

        "... Bayou was founded by Samuel Israel III, a scion of a commodity
        -trading family that is well known to Wall Street. [In 1998] Mr. Israel called 
        two of his colleagues into a conference room. All three men knew the situation 
        was dire at Bayou - the funds' losses had vastly overwhelmed their gains 
        for more than two years. Something had to be done, and fast. The solution, 
        devised by Mr. Israel and a lieutenant, James Marquez, was simple: 
        produce a fake audit of the funds' performance and try to make up the losses 
        next year. In the end, of course, the plan failed. The losses compounded 
        and the results Bayou reported to its investors -- several years of market-beating 
        returns -- were consistently false."

There is no moral or economic justification for the sort of fraud allegedly perpetrated at Bayou, of course; but neither does this incident justify the SEC's hedge fund rule.

*****

When the SEC sets out to regulate some aspect of the securities markets, it has two basic tools at its disposal: mandatory disclosure and anti-fraud prohibitions. In many cases, of course, the two are deployed in tandem; when a corporation makes an IPO, for example, it must provide investors with a prospectus prepared in accordance with the SEC's disclosure rules under Reg S-K and, under a number of provisions, is subject to liability for any fraud committed in connection with the offering. In other cases, however, the SEC limits its regulatory oversight to ex post application of the rules against fraud; the various categories of so-called "exempt securities," for example, are exempt from the SEC's disclosure rules but remain subject to anti-fraud provisions such as the famous Rule 10b-5.

Many prominent securities law scholars doubt the utility of mandatory disclosure rules, arguing that firms have more than adequate incentives to voluntarily provide disclosures to potential investors. (I summarized this debate in my article Mandatory Disclosure: A Behavioral Analysis.) But wherever one comes out on that question, there is little dispute that the strongest case for government-mandated corporate disclosure is when a firm makes a large public offering to numerous unsophisticated investors. In such a situation, it is argued, the combination of information asymmetries, collective action problems, and investor vulnerability justifies regulatory intervention.

In contrast, it is generally accepted that the case for government-mandated corporate disclosure is far weaker with respect to smaller private placements of securities to a select group of wealthy and knowledgeable investors. Such investors are assumed to be able to take care of themselves. Indeed, it is precisely for that reason that the SEC adopted Reg D, which allows issuers to sell securities to such investors with far less extensive disclosures than would be required in a public offering.

Hedge funds, of course, look a lot more like the latter than the former. To be sure, as pointed out by the SEC's analysis of the rule when proposed, there has been a slight trend towards retailization of the hedge fund industry. Most hedge funds, however, retain very high minimum account size requirements that effectively exclude everyone except very wealthy individual and institutional investors. As a result, we are dealing here with a product marketed almost exclusively to wealthy, experienced, and knowledgeable investors for whom caveat emptor rather than regulatory oversight is the appropriate answer.

Indeed, for investors wealthy enough to take the risks associated with hedge fund investing, the lack of regulatory oversight is a real blessing. As Morningstar Investments explains:

        "Being free of many of the guidelines that constrain mutual funds allows hedge 
        funds greater flexibility in their strategies. They can borrow money to 
        invest -- also known as using leverage. Or they can sell borrowed stocks they 
        expect to plummet -- known as selling short. Or they can engage in trading 
        currencies and use exotic derivatives to boost returns."

But what about Bayou Securities, you ask? The answer is simple: mandatory disclosure does not prevent fraud. Securities managers who are going to commit fraud will not be deterred from doing so by government disclosure rules -- they will simply use the approved disclosure form to do so. Hence, rigorously enforced proscriptions of fraud seem far more important than mandatory disclosure, insofar as one is the sort of thing that allegedly happened Bayou Securities.

*****

In Chapter 3 of Revelations, St. John passes along the following message to the church in Laodicea: "I know your works; I know that you are neither cold nor hot. I wish you were either cold or hot. So, because you are lukewarm, neither hot nor cold, I will spit you out of my mouth."

It would be an equally apt fate for the SEC's hedge fund rule. The SEC was loath to impose the full panoply of mutual fund policy and disclosure rules on hedge funds, yet the SEC was also unwilling to leave hedge fund regulation to enforcement of the anti-fraud laws already on the books.

Accordingly, it adopted a sort of half-baked compromise that imposes costs without corresponding benefits. On the one hand, nothing about the rule will require that hedge fund investors receive better quality information. On the other hand, given that the SEC is unlikely to devote significant enforcement resources to conducting administrative investigations absent pretty clear evidence of fraud, it's hard to see how the new rule adds much in the way to deterrence of fraud.

Worse yet, what does a cook do with lukewarm food? You stick it in the microwave and heat it back up. Analogously, future hedge fund scandals inevitably will put political and media pressure on the SEC to expand regulation of hedge funds.

Chairman Cox had a golden opportunity to derail the Commission's half-baked plan to regulate hedge funds. Commissioners Glassman and Atkins almost certainly would have joined in support of an effort to repeal the rule. It's a pity he lacked the will to do so.

Followup on Frist's HCA Stock Trade

The WaPo is now explicitly raising the question of whether Senate majority leader Bill Frist committed insider trading in connection with his June sale of HCA stock:

The timing ... raised questions about whether Frist had somehow traded on information he obtained in advance from the company. "Frist has been in the Senate for many years now, and the conflict is not new," said Melanie Sloan, executive director of the watchdog group, Citizens for Responsibility and Ethics in Washington. "Why did he decide to sell it then? Why not years ago? What's changed? Did he know that the stock was about to take a fall?"

Josh Marshall asks a pertinent question:

Is Frist in some real trouble over this? And if he is, who can explain how a guy with such vaunting ambitions for higher office would do something so foolish and, it would appear, easy to detect?

The Democrat Party's official blog hopes "the SEC takes the question seriously." Meanwhile, the Cunning Realist makes an interesting connection between this dal and the losses Frist's campaign fund previously suffered in the stock market, asking: "Did Frist's ongoing painful experience with losses in his campaign fund cause him to "panic first" when it came to his own wallet?"

One would think a heart surgeon would be smart enough to have avoided even the appearance of impropriety, let alone actual malfeasance, but smart people routinely do really stupid things when it comes to insider trading. Who can forget the way former ImClone CEO Sam Waksal dumped his ImClone stock - and told members of his family to do the same - immediately after hearing from the FDA that the firm's drug wasn't going to be approved for sale. Did he really think nobody at the SEC would notice a little thing like a huge stock dump by the firm's CEO right before an adverse FDA announcement?

Anyway, I discussed the relevant legal issues applicable to Frist's trade in my post Frist's HCA Stock Sale: Insider Trading?. You might also want to check out an oldie but a goodie: Senators and Insider Trading.

Director Compensation as a Constraint on Executive Compensation

In my review of Lucian Bebchuk and Jesse Fried's book Pay Without Performance, I noted their argument that outside directors fail to act as an effective constraint on management:

According to Bebchuk and Fried, boards of directors -- even those nominally independent of management -- have strong incentives to acquiesce in executive compensation that pays managers rents (i.e., amounts in excess of the compensation management would receive if the board had bargained with them at arms'-length). Among these are: Directors often are chosen de facto by the CEO. Once a director is on the board, pay and other incentives give the director a strong interest in being reelected; in turn, due to the CEO's considerable influence over selection of the board slate, this gives directors an incentive to stay on the CEO's good side. Directors who work closely with top management develop feelings of loyalty and affection for those managers, as well as becoming inculcated with norms of collegiality and team spirit, which induce directors to "go along" with bloated pay packages. Finally, Bebchuk and Fried argue that those few directors who resist these incentives and seek to put shareholder interests first face a number of obstacles in both the law and practice of corporate governance.

I rejected this argument, pointing out that outside directors have countervailing incentives that encourage them to effectively oversee management. A new research paper on Director Compensation and Board Effectiveness lends considerable support to my argument:

The increase in director incentive compensation in recent years has potentially created greater alignment between directors and owners. Focusing on corporate financing and dividend policies, this paper examines the effect of compensation structure of outside directors on the reliability of financial information; managers' overinvestment and entrenchment behavior; CEO influence on the board and the riskiness of the investment strategy. The results suggest that director stock options not only align the interests of directors and shareholders that manifest in improving the reliability of financial information and monitoring of management but also align their risk preferences that result in adopting riskier investment strategies. In addition, the paper argues that, whereas CEO stock options are used along side other control mechanisms to reduce the agency problem between managers and owners, director stock options are used as substitutes for these other mechanisms. Overall, the results are consistent with the argument that incentive compensation to outside directors promotes board effectiveness and inconsistent with the claim that boards are inactive monitoring institutions.

It may not be "Game. Set. Match.," but you can definitely score one for my side of this debate.

Anabtawi on Shareholder Primacy

My friend and UCLA law colleague Iman Anabtawi has posted a very interesting new paper - Some Skepticism about Increasing Shareholder Power - in which she explains that:

This Article examines shareholder primacists' claims that making  boards more accountable to shareholders would go a long way  toward solving the agency problem between shareholders and  managers and enhancing shareholder welfare. I argue that in the  shareholder power debate over whether to vest corporate  decisionmaking authority primarily in a firm's shareholders or  in its board of directors, shareholder primacists underplay deep  rifts among the interests of large-block shareholders - those  shareholders most likely to make use of increased shareholder  power. The argument for reapportioning decisionmaking authority  within the firm away from boards toward shareholders assumes  that shareholders are a monolith with the single, overriding  objective of maximizing share value. Some of the most  significant modern shareholders, however, have private interests  that conflict with (1) the goal of maximizing shareholder value  generally or (2) the interests of other shareholders who would  choose to maximize shareholder value differently, given their  peculiar characteristics. Such private interests may induce  influential shareholders to engage in rent-seeking behavior at  the expense of overall shareholder welfare. In light of this  possibility, which I argue is substantial, we would do well to  pause before implementing corporate governance measures designed  to further empower shareholders.

I found her analysis very helpful in working up my own recent article Shareholder Activism and Institutional Investors, which argues:

Recent years have seen a number of efforts to extend the shareholder franchise, principally so as to empower institutional investors. The logic of these proposals is that institutional investors will behave quite differently than dispersed individual investors. Because they own large blocks, and have an incentive to develop specialized expertise in making and monitoring investments, institutional investors could play a far more active role in corporate governance than dispersed individual investors traditionally have done. Institutional investors holding large blocks thus have more power to hold management accountable for actions that do not promote shareholder welfare. Their greater access to firm information, coupled with their concentrated voting power, might enable them to more actively monitor the firm's performance and to make changes in the board's composition when performance lagged.

In fact, however, institutional investor activism is rare and limited primarily to union and state or local public employee pensions. As a result, institutional investor activism has not - and cannot - prove a panacea for the pathologies of corporate governance. Activist investors pursue agendas not shared by and often in conflict with those of passive investors. Activism by investors undermines the role of the board of directors as a central decision-making body, thereby making corporate governance less effective. Finally, relying on activist institutional investors will not solve the principal-agent problem inherent in corporate governance but rather will merely shift the locus of that problem.

Frist's HCA Stock Sale: Insider Trading?

WaPo report:

Senate Majority Leader Bill Frist, a potential presidential candidate in 2008, sold all his stock in his family's hospital corporation about two weeks before it issued a disappointing earnings report and the price fell nearly 15 percent.

Frist held an undisclosed amount of stock in Hospital Corporation of America, based in Nashville, the nation's largest for-profit hospital chain. On June 13, he instructed the trustee managing the assets to sell his HCA shares and those of his wife and children, said Amy Call, a spokeswoman for Frist.

Frist's shares were sold by July 1 and those of his wife and children by July 8, Call said. The trustee decided when to sell the shares, and the Tennessee Republican had no control over the exact time they were sold, she said. ... To keep the trust blind, Frist was not allowed to know how much HCA stock he owned, Call said, but he was allowed to ask for all of it to be sold.

Frist, a surgeon first elected to the Senate in 1994, had been criticized for maintaining the holdings while dealing with legislation affecting the medical industry and managed care. Call said the Senate Select Committee on Ethics has found nothing wrong with Frist's holdings in the company in a blind trust. ... "To avoid any appearance of a conflict of interest, Senator Frist went beyond what ethics requires and sold the stock," Call said. Asked why he had not done so before, she said, "I don't know that he's been worried about it in the past."

Insider trading is trading while in possession of material nonpublic information. Although the sale was effected by a trustee on bahelf of a blind trust, Frist could still face insider trading liability because he is the trust beneficiary and retained the power to direct the sale of trust assets.

The left half of the blogosphere is already calling for investigations or even implying guilt.

If some SEC enforcement lawyer in fact were to start looking into this, the first question will be whether Frist had material nonpublic information about HCA at the time he ordered the sale. If he had the common sense God gave gravel, the answer to that will be a resounding no. For somebody in his position to retain access to such information would exacerbate the inherent conflict of interest that arises when he deals with health care issues, as well as potentially exposing him to insider trading liability.

Assuming Frist did not possess such information, there's no legal problem with the sale.

{Related post: Senators and Insider Trading}

Let's assume for the sake of argument, however, that Frist did have such information. In that case, a very interesting doctrinal question would arise; namely, is insider trading liability under Rule 10b-5 properly premised on trading "while in possession of" or trading "on the basis of" material nonpublic information.

The distinction arises here because Frist could argue that even if he possessed material nonpublic information, he didn't trade on the basis of such information. Specifically, he could argue that his trade was motivated by a desire to resolve the long-standing conflict of interest issue and that he did so at this time as part of a process of clearing the decks for a 2008 run for President.

The discussion in the extended post of the legal issue is adapted from pages 568 to 570 of my book Corporation Law and Economics.

The SEC long has argued that trading while in knowing possession of material nonpublic information satisfies Rule 10b-5’s scienter requirement. In United States v. Teicher, the Second Circuit agreed, albeit in a passage that appears to be dictum. ...

In SEC v. Adler, the Eleventh Circuit rejected Teicher in favor of a use standard. Under Adler, “when an insider trades while in possession of material nonpublic information, a strong inference arises that such information was used by the insider in trading. The insider can attempt to rebut the inference by adducing evidence that there was no causal connection between the information and the trade—i.e., that the information was not used.” Although defendant Pegram apparently possessed material nonpublic information at the time he traded, he introduced strong evidence that he had a plan to sell company stock and that that plan predated his acquisition of the information in question. If proven at trial, evidence of such a pre-existing plan would rebut the inference of use and justify an acquittal on grounds that he lacked the requisite scienter.

The choice between Adler and Teicher is difficult. On the one hand, in adopting the Insider Trading Sanctions Act of 1984, Congress imposed treble money civil fines on those who illegally trade “while in possession” of material nonpublic information. In addition, a use standard significantly complicates the government’s burden in insider trading cases, because motivation is always harder to establish than possession, although the inference of use permitted by Adler substantially alleviates this concern. On the other hand, a number of decisions have acknowledged that a pre-existing plan and/or prior trading pattern can be introduced as an affirmative defense in insider trading cases, as such evidence tends to disprove that defendant acted with the requisite scienter. Dictum in each of the Supreme Court’s insider trading opinions also appears to endorse the use standard. In light of the Circuit split that now exists between Teicher and Adler, the Supreme Court may eventually have to resolve the conflict.

To be sure, in 2000, the SEC addressed this issue by adopting Rule 10b5-1, which states that Rule 10b-5’s prohibition of insider trading is violated whenever someone trades “on the basis of” material nonpublic information. Because one is deemed, subject to certain narrow exceptions, to have traded “on the basis of” material nonpublic information if one was aware of such information at the time of the trade, Rule 10b5-1 formally rejects the Adler position. In practice, however, the difference between Adler and Rule 10b5-1 usually should prove insignificant. On the one hand, Adler created a presumption of use when the insider was aware of material nonpublic information. Conversely, Rule 10b5-1 provides affirmative defenses for insiders who trade pursuant to a pre-existing plan, contract, or instructions. As a result, the two approaches should lead to comparable outcomes in most cases.

The Frist hypothetical, however, would seem to be one of those cases in which the validity of the Rule would matter. Under Adler, Frist could rebut the presumption of use if he persuaded the court that trade was effected so as to resolve the conflict of interest issue as part of clearing the decks for a 2008 run for President. Under the Rule, I don't see how that would absolve him. Hence, it would starkly present the question of whether the SEC had the authority to adopt the Rule.

Update: A reader emails:

One problem with the Adler test is that it allows a person to use insider info to take advantage of an "up" while still avoiding a "down".  For example,  if I had a preexisting plan to sell shares and learned via insider info that the shares were headed down, I could go ahead and sell as planned.  If however, I learned via insider info that the shares were headed up, I could postpone my sale to take advantage of the price increase.  Thus, the Adler test allows a person to take advantage of insider information under certain cirsumstances.  To create a level playing field, I believe the SEC's rule is both proper and ethical--a person who comes into possession of insider information who does not already have an irrevocable contract to buy or sell must postpone the sale until the info is public.  Under this rule, persons with plans to trade who are concerned their plans may be disrupted by coming into possession of insider info can address this concern in advance by entering into a binding contract to trade (in essense, a future), but once they have the info, they should not be permitted to trade until the info is public.

And another writes:

To me, the 10b5-2 question is even more interesting than the 10b5-1 issue. I, frankly, don't see how Frist could fit into either 10b5-1 or Adler.  How could he show there was a pre-existing plan to dump the stock at the moment he dumped it?  That is, was there a plan to sell the stock prior to the earnings release?  Why didn't he just wait to sell it after the earnings release?  Indeed, it is for this very reason that many insider trading plans have window periods for trading, with the window only open after the earnings release (or, really, the 10-Q).  And, of course, you can't adopt a "pre-existing plan" while you are in possession of material nonpublic info.

Finally, a third opined:

Frist directed a sale on June 13 at a time when other insiders were also selling.  Presumably this was because the "trading window" was open.  It was open because the insiders did not have material non-public information (unless you assume HCA was one giant fraud, and if anybody serious (as opposed to a plaintiff's lawyer) is alleging that I have missed it).  Had that trade executed on June 13, there would be no problem.  If Frist was motivated to send his letter of instruction because he saw all the Form 4s rolling across on June 3-10, then he is doing what you are supposed to do (that is, not front-running the public on the Form 4s).  Indeed, selling when the rest of the insiders sell is the compliant way to do it.  That's what all the governance gurus say if given an opportunity to bleat.  
So, it is probable that the only issue derives from the time lag between June 13 and the date of the actual sale.  If Frist's letter of instruction to his trustee was irrevocable (and reading between the lines of the news accounts it may have been), then there is a very good chance that it falls under 10b5-1 by its terms.  That takes care of the time lag.  And even if the letter doesn't precisely comply with 10b5-1, that rule is only a "safe harbor."  Failure to comply with it does not ipso facto result in liability.
 Setting aside the politics, on the facts as reported I would argue that Frist did the right thing.  He did not front-run the huge pile of Form 4s that came piling in during the first ten days of June.  That gave HCA  stockholders the opportunity to digest the fact of massive insider selling near the end of HCA's June quarter and sell ahead of Frist if they chose.  Then, Frist's trustee delayed the sale another couple of weeks, which further extended the period in which public stockholders might say, "hmmm, why are HCA executives dumping their stock like the tea in Boston Harbor?"  Finally, after giving the public much more opportunity to sell ahead of him than was required by law or morality, Frist's trustee sold.  Apart from a universal desire on the part of the press to "get" leading Republicans and the public's ignorant association of the phrase "insider trading" with crime, I don't see what the issue is.

Hard Time and Deterrence of White Collar Crime

Ex-Tyco CEO Dennis Kozlowski and CFO Mark Swartz have each been sentenced to 8-1/3 to 25 years for stealing from Tyco. Unlike federal white collar defendants, who typically end up in one of the Club Fed minimum security prisons, Kozlowski and Swartz likely will end up doing serious hard time in a NY State maximum security facility like Attica or Sing Sing. Is that an appropriate punishment for first time white collar offenders?

Economists tell us that rational actors weigh the expected sanction in determining whether to commit crimes. Invoking that model, while also criticizing its application to non-white collar criminals, David Feige argued in the Nation that:

Put bluntly, it's not irrational to steal $10 million if the worst-case scenario is a few years in Camp Fed. But change that sentence to read Sing Sing or Attica or Pelican Bay and what emerges is a whole new calculus of crime.

In dealing with rational actors, it may well be that the conditions of confinement matter far more than the length of the sentence. ... The truth is that to most people, the prospect of even a short stint in a maximum-security prison is far more frightening than years in Camp Fed.

I think that's basically right as a matter of general deterrence (and thus respectfully would disagree with Ellen Podgor's observation that "the SHAME in the community is by far the harshest punishment felt by the white collar offender.").

Having said that, however, there are two competing considerations. First, the risk of over-deterrence. We want business executives to take risks. As we increasingly criminalize corporate governance failures, we increase the possibility that somebody eventually is going to be convicted for having taken risks that proved, with the benefit of hindsight, to be unwise. Of course, this consideration has minimal traction with respect to the sort of aggressive thievery a jury concluded Kozlowski and Swartz committed.

Second, and more pertinent to their case, general deterrence is not the only function of the law. Punishment policy also includes notions of specific deterrence and retributive justice. On those considerations, it's not clear that hard time is proportionate to the crime. Ellen Podgor blawgs:

Is this sentence necessary?  No.  The minimum would have been 1-3 years and perhaps the sentence should have been closer to that time frame.  Closer not because the crime was not wrong and should be punished, but closer because these individuals are first offenders who are unlikely to commit a crime again in the future.  Their positions of power have been stripped from them and they are unlikely to have the ability or power to ever be a menace to society again.

Stross

Greg Johnson reviews Charles Stross books The Hidden Family and Accelerando:

Taken singly, The Hidden Family and Accelerando are each highly entertaining novels, two very different stories that should each find a large audience. Taken together, published as they were in a two-month period, they are evidence of a major talent at the top of his form, a writer capable of simultaneously invoking the best of classic SF and pushing the boundaries of the field. The Hidden Family invites and lives up to comparisons to Zelazny and The Princes of Amber. Accelerando shares place with Greg Egan's Schild's Ladder as the most radical, uncompromising look yet at a future that is by definition beyond comprehension. This is writing for people who know, understand, and love science fiction. Treasure it.

I think he liked them, eh? I did too. Buy them.

The Housing Bubble and Freddie Mac and Fannie Mae

Freddie Mac and Fannie Mae are the quasi-governmental corporations that support the housing  market by securitizing mortgages. Both are highly leveraged with debt equity ratios of around 30:1. Both also benefit from an implicit government guarantee. Although the federal government technically is not obliged to bail them out if they fail, most investors believe that Congress would always bail Fannie Mae and Freddie Mac out. This has let them borrow at highly advantageous rates, which has allowed them to become far more heavily leveraged than a pure private corporation could achieve.

If there really is a housing bubble, both Freddie Mac and Fannie Mae presumably would take a major hit. Is there any alternative to a government bailout if they start down the tubes? I recently found an interesting article by law professor Richard Carnell has lots of good information on the risks we taxpayers are bearing because of Fannie Mae and Freddie Mac's borrowing habit and lousy corporate governance. He also proposes creating a mechanism for dealing with any potential insolvency on their part.

This is an issue that's been flying under everybody's radar screen, but is a key issue given the state of the housing market. Carnell's article is a good introduction to this important problem.

Glendon on Foreign Law

Harvard law professor Mary Ann Glendon is a tremendous scholar and intellectual. Her op-ed on the Supreme Court's use of foreign law in interpreting the US Constitution is a must read. Money quote:

The problem is not reference to foreign law: It is how foreign law is used by judges who usurp powers reserved under the Constitution to the people and their elected representatives, and whose desire to "learn" is limited to finding arguments in support of conclusions that have little constitutional warrant. The learning process of the foreign law enthusiasts, moreover, is selective. They have shown no disposition to explore why most democracies take a different view from theirs on exclusion of illegally obtained evidence, regulation of abortion or separation of church and state. With reason, Justice Scalia accuses them of "looking over the heads of the crowd and picking out their friends."