ProfessorBainbridge.com

Bebchuk's National Commission on Corporation Law

Harvard law professor Lucian Bebchuk has been a persistent critic of state corporation law and a persistent proponent of federalizing corporation law. I think that's a very bad idea, for reasons I explained in many articles, such as The Creeping Federalization of Corporate Law. Yale law professor Roberta Romano thinks it's a bad idea, because the feds can't even get securities regulation right, as she demonstrated in her book The Advantage of Competitive Federalism for Securities Regulation and her article The Sarbanes-Oxley Act and the Making of Quack Corporate Governance. Indeed, anybody who's ever had anything to do with the Sarbanes-Oxley mess would doubt the merits of  federal corporation law.

Debating Bebchuk is kind of like playing whack-a-mole, however, because the guy is so smart and so prolific that he keeps popping up with new ideas and arguments. Larry Ribstein takes on the latest:

Is it time for a National Corporate Law Commission?

Bebchuk & Hamdani say it is.  See Federal Corporate Law: Lessons From History. ...

B & H basically conclude that (1) state competition is broken; (2) properly conceived, federal regulation would be better; and (3) in order to improve federal regulation we just need to replace the boom-bust-regulate cycle that has characterized federal law with ongoing study.

Wrong. Wrong. Wrong.

(1) There is no reason to think that state competition is "broken," in the sense of susceptible to improvement in the real world at reasonable cost. See, e.g., Roberta Romano, Is Regulatory Competition a Problem or Irrelevant for Corporate Governance?

(2) Whatever the problems with state competition, there is no reason to think that increasing reliance on federal law would bring us a better world. Amazingly, Bebchuk and Hamdani spend no time in their paper talking about the costs of SOX!

(3) It is certainly true that a problem with federal law is the boom-bust-regulate cycle. See my article, Bubble Laws, which B & H cite. But the authors give little reason to suppose that a National Corporate Law Commission would improve this. We have a huge ongoing corporate reform industry, which produces lots of proposals. The problem is that there is (thankfully) no political will to enact them until a bust comes along. Why would a NCLC change this?

Instead, we would get more proposals. And even if we do get a regular drip of federal laws out of this, then we get back to the first two problems:  state law isn't broken; and federal law won't fix it.

Right. Right. Right.

The GOP's Fawlty Towers

In the late 1970s British cult comedy classic Fawlty Towers, John Cleese played Basil Fawlty who ran a dilapidated seaside hotel and was, quite possibly, the rudest man in England. In a particularly funny episode, The Germans, Basil is expecting hotel guests from Germany. Accordingly, he repeatedly admonishes his staff: "Don't mention the war." Naturally, Basil himself simply can't stop mentioning the war. Hilarity ensues.

The current political scene calls that episode to mind, although one doubts whether anything resembling hilarity will ensure.

On the one hand, we have a New Republic column by left-leaning law professor Cass Sunstein telling the Democrats: "Don't mention the war":

"Republicans say that national security is a winning issue for them; Democrats say the same thing. Social science evidence strongly suggests that the Republicans are right, because the politics of terrorism touches a chord that produces much more support for them than for Democrats: our own mortality. ... Unless circumstances have relevantly changed since 2004, Bush -- and almost certainly Republican candidates more generally -- are likely to benefit from any reference to terrorism or the September 11 attacks."

Likewise, we have conservative pundits like Hugh Hewitt telling Republicans, in effect: "Don't talk about anything but the war." Hence, Hewitt repeatedly pounds the same drum beat: "Any vote for any Democrat is a vote against victory and a vote for vulnerability."

I think this advice has it exactly backwards. Democrats need to talk about the war, while Republicans need to talk about something else.

I suspect a substantial number of Americans might agree with the following sentiment: The Republicans deserve to lose at the ballot box, but the Democrats don't deserve to win.

Sunstein's basically right that national security issues are good for Republicans and bad for Democrats, although his claim that behavioral economics explains that divide is wrong. Occam's razor provides a much simpler answer; namely, the history of the last 40 years.

• Most of today's national Democratic figures cut their political teeth in the anti-Vietnam War movement. Almost to a man (or woman), they were McGovernites, whose opposition to that war morphed into a set of general anti-military attitudes.
• While Democratic anti-militarism helped elect Nixon in 1972, Watergate helped elect Jimmy Carter in 1976. Under his feckless administration, our elite Delta Force badly bungled the Iranian hostage rescue effort and the country otherwise proved toothless to deal with the hostage taking. On top of which, there was a general perception that his military couldn't have held the Fulda Gap against the Salvation Army let alone the Red Army.
• Ronald Reagan knew there was a bear in the woods. While a few Democrats helped Reagan win the Cold War (Sam Nunn comes to mind), the center of gravity of the Democrat Party in those days was dead set against Reagan's military build up.
• When Bill Clinton came into office, he let 20-something political operatives treat senior military White House aides as errand boys. At times Clinton's main use for the military seemed to be bombing someone every time his poll numbers dipped. It was on his watch that Osama bin Laden grew bold enough to plan 9/11, while our intelligence and security forces slept.
• The closest thing the Democrats have these days to a Sam Nunn -- Joe Lieberman -- just got run out of his party.

In sum, the Democrats' track record on security issues does not encourage faith that they can be trusted with the national security. The Democrats simply have to change that dynamic if they are to deserve victory in 2006, let alone 2008. Hence, they must talk about the war.

In contrast, the GOP has a different problem. The party of fiscal conservatism, low taxes, and small government long talked the talk but failed to walk the walk. Neither Reagan nor Gingrich fundamentally cut government -- they mostly just kept it from growing quite as fast as it might otherwise have done. Worse yet, while Gingrich went swimming in the government shutdown, he let Clinton swipe his anti-deficit clothes. There are a lot of reasons the deficit fell in the 1990s, but the Clinton Democrats get -- and to a considerable extent deserve -- credit for fiscal responsibility.

Under George Bush, the GOP has largely stopped even pretending to talk the talk. Instead, Bush's two terms have brought us: a massive increase in government entitlements; renewed fiscal deficits; a worsening trade deficit; huge spending increases; bigger government; more intrusive government.

The GOP therefore needs to talk about these issues. They have to persuade the American people either that the war is so important that nothing else matters or that the GOP can both win the war on terror and get back to its sound fiscal roots.

I take it Hewitt and his ilk prefer the former. Hence, the constant drum beat about voting for a Democrat is a vote for defeat. But I don't buy it. Even in existential wars like the Civil War or World War II, domestic policy mattered.

A couple of recent election results tell me that the GOP base can no longer be counted on the reflexively turn out in response to the toscins of war. In Michigan, Congressman Joe Schwarz was a stalwart supporter of President Bush and the Iraq War. He was endorsed by Bush and Cheney. If the war was all that mattered in his safe GOP seat, he should have coasted to reelection. Instead, he lost a primary challenge to Tim Walberg. Walberg is pro-life; Schwarz is pro-choice. Walberg is a fiscal conservative backed by the Club for Growth; Schwarz is a member of Christine Todd Whitman's Its My Party Too, The Republican Main Street Partnership, The Republican Majority For Choice, Republicans for Choice, and Republicans For Environmental Protection.

In Colorado's 5th Congressional District, Hugh Hewitt vigorously endorsed Jeff Crank. When the GOP primary results were announced, however, Crank had lost to Doug Lamborn. Why? My guess is that the voters agreed with the Club for Growth that a comparison of Crank's and Lamborn's records showed it was the latter "who will stand for the pro-growth principles of lower taxes and limited government."

If these results turn out to be the bellwethers I expect, the GOP needs to follow Basil's advice: Don't talk about the war, at least until you've convinced us that you're again going to be the party of small government and economic growth.

Bill Padding: What's Cheating and What's Okay?

Interesting article in the W$J on alleged bill padding incident at Holland & Knight includes the following observation:

It's difficult to know how widespread billing fraud is, but Stephen Gillers, an ethics professor at New York University School of Law, says "there is a general consensus that billing fraud has increased" as law firms seek to increase profits and attract top lawyers. "Bill-padding is the perfect crime," adds William Ross, a professor at Samford University's Cumberland School of Law in Birmingham, Ala. It is seldom detected because it is almost impossible for clients to know whether "an attorney really spent three hours doing research instead of five hours," he says. He says that in a billing survey he conducted in 1996, two-thirds of the attorneys (and three-fourths of the clients) reported knowledge of bill padding.

Michael Downey writes:

Extreme examples of fabricated billing are legendary and include:

• A Norwich, CT, lawyer who billed 94 hours for a single day’s work;
• A Raleigh, NC, lawyer who billed 13,000 hours for a 13-month (approximately 9500 hour) period; and
• A Baltimore, MD, lawyer who – with approval from the chairman of his firm’s finance committee – had computers automatically increase all time billed to a particular client by 15 percent.

Some stuff strikes me as clearly unethical

• Charging time you didn't actually spend on a matter (duh).
• Double billing: You're on a plane flying to meet a client, so you charge travel time, while working on another matter and charging another client for the same time.

But other stuff strikes me as arguably more unsavory than unethical:

• "But for" billing: But for the stupid client, I wouldn't be getting up at 4 AM to catch a flight, so I'm billing time from the moment my feet hit the bedroom floor (or leave the house).
• Strategic phone/email practices: When I was in practice, we billed in quarter-hour blocks. This let you pile up your phone messages. You'd set aside an hour, say at 4 PM, to return all the day's calls. Call Client A. "Is he there?" "No." "Tell him I called." That could be billed as 15 minutes. Repeat for the next hour. If you had enough phone emssages, you could clock several hours billable time during an hour or so of real time. Today, most firms bill in 5 or 6 minute blocks, so it wouldn't work as well. On the other hand, you could try the same thing with email.
• Recycling memos: You wrote a memo to Client A on some topic. You spent 100 hours researching and writing the memo, for which you charged Client A in full. Client B later asks for advice on the same topic. You send Client B essentially the same memo and charge it for 100 hours of work, even though you just changed the names. (According to Downey, the ABA regards this as unethical and maybe even illegal.)
• Billing time for billing: Charging the client for time spent preparing the bill. Ethical?
• Not stopping the clock when taking a coffee or potty break.

Kudos to Scalzi

Congratulations to John Scalzi for winning the John W. Campbell Award as best new science fiction writer. Old Man's War and The Ghost Brigades were both excellent military SF novels.

Worstall on Wal-Mart

Tim Worstall takes on Wal-Mart's critics over at TCS. Worstall's right insofar as it goes, but mainly because Wal-Mart's liberal critics make it so easy for him to defend Wal-Mart. The liberal critique basically says: let's force Wal-Mart to pay higher wages and provide grater benefits. Worstall correctly shows that this will cause Wal-Mart to cut staff. Simple supply and demand Econ 101.

The trouble is that liberal Wal-Mart critics don't want to get after the real issue, because the real issue with Wal-Mart involves a critique of big government. As I've observed before:

even if the subsidies given Wal-Mart by many local communities to encourage opening a store are not as large as Wal-Mart's critics claim, does anyone seriously doubt that Wal-Mart often gets breaks on things like zoning, property or sales taxes, and other regulatory issues that small business competitors don't receive?

I freely admit that much of my dislike for Wal-Mart is rooted in aesthetics, but it's also got a free market component. I'd find Wal-Mart much less objectionable if it stood on its own two feet instead of leaning on government subsidies.

This is why the debate over Wal-Mart is so uninformative. Wal-Mart's liberal critics would have to admit that big government is part of the problem, while Wal-Mart's conservative defenders would have to admit that their hero would have a much harder time competing in a truly free market. And neither is willing to do so.

Prediction Markets and Insider Trading

Here at PB.com we are big fans of prediction markets, such as Tradesports, looking to them for predictions as to everything from election outcomes to Supreme Court nominations to indictments and so on. A couple of economists have just posted a very interesting paper, which raises five unresolved questions about the efficacy of prediction markets. Two of the most interesting questions (at least from my perspective) are: (1) how to attract uninformed investors and (2) how to prevent manipulation. These issues raise a question we discussed here a while back; namely, whether prediction markets should seek to ban insider trading. Watching whether prediction markets voluntarily ban insider trading will tell us something about the longstanding debate over the merits of the insider trading prohibition in the stock market.

Indeed, here is a free suggestion for somebody out there with more empirical research skills/interest than I have:

One of the traditional rationales for the SEC prohibtion of insider trading in stocks is that insider trading harms investors and thus undermines investor confidence in the securities markets. If this were true, however, we should see firms voluntarily seeking such prohibitions. In light of the now 40+ year old legal prohibition of insider trading, however, we lack empirical data on this question. Watching whether prediction markets voluntarily adopt bans on insider trading thus might be informative. Of course, I suppose there also might be transaction and enforcement costs explanations why we don't see such proscriptions. Could a good empiricist design a way of sorting out those confounding effects?

Scalia, Originalism, and Hudson v. Michigan

Cato blogger Mark Moller weighs in on Justice Antonin Scalia's decision in Hudson v. Michigan, which declined to apply the exclusionary rule to no knock raids by police:

An originalist constraint on police entry is recognized on paper, but left unenforced as a matter of breezy, factually unsupported judicial policy that would make even Justice William O. Douglas blush. As Justice Breyer says, the majority’s argument is, in essence, “the [knock-and-announce requirement] is fine, indeed, a serious matter” — wink, wink — “just don’t enforce it.”

Rights grounded in originalism backed with real remedies: That’s an interpretive method with the courage of conviction in the outcomes it produces. It’s an interpretive method that forces clear, serious judicial thinking because it doesn’t shrink from the consequences of interpretation. Scalia’s opinion, by contrast, is “let’s pretend originalism” — a Potemkin fidelity to the old ways, robbed of any force by a deceptive, lawyerly slight of hand.

A couple of thoughts:

1. The exclusionary rule long has been controversial. US Supreme Court Justice Benjamin Cardozo famously remarked:  “The criminal is to go free because the constable has blundered.” Lots of folks think that's bad public policy. Me? I think the trade-off between civil liberties and legitimate police work is a very difficult policy question and, as such, one as to which reasonable people can disagree, although I lean towards the liberty position on search and seizure issues.
2. Anybody who thinks Scalia is an originalist is either ill-informed or being disingenuous. Scalia goes back and forth between originalism, textualism, and traditionalism with no apparent hierarchy for resolving conflicts between the three approaches nor any consistent metric for deciding which to apply in any given case. It is, perhaps, his greatst weakness as a jurist and the main reason his historical legacy is lilkely to be relatively modest.

Assessing Eliot

My TCS Column

In November, Eliot Spitzer likely will be elected as New York's next governor. Whether that will be good news for New Yorkers is perhaps debatable, but it's great news for America's economy.

It would be unfair to call Washington Post journalist Brooke Masters' biography of New York's crusading attorney general, Spoiling for a Fight: The Rise of Eliot Spitzer, one-sided. Masters presents the arguments of Spitzer's many critics and does so reasonably fairly. So while Spoiling for a Fight isn't mere hagiography, at the end of the day Masters comes down on Spitzer's side of most controversies. She puts Spitzer into the crusading progressive hall of fame alongside such luminaries as Louis Brandeis, Thomas Dewey, Teddy Roosevelt, and Rudy Giuliani.

What's interesting about the other crusaders to whom masters favorably compares Spitzer, of course, is that they all used their crusades to advance their political careers. Before he was the hero of 9/11, Giuliani rode his mob and white collar prosecutions as a US Attorney in New York City to the Mayor's office. Brandeis' cause lawyering got him to the United States Supreme Court. Teddy Roosevelt's reputation as a reforming police commissioner helped get him to the White House, although San Juan Hill probably helped more (and Leon Czolgosz helped too), a pattern Giuliani apparently hopes to emulate. And, of course, Thomas Dewey got the chance to famously lose the presidency to Truman.

A fair reading of Eliot Spitzer's record as presented by Masters suggests that he is both a genuine cause crusader and a career political hack. Spitzer has consistently used -- and abused -- his authority as New York attorney general to level sweeping accusations against a wide swath of American business. In some cases, like the proverbial stopped clock, he got it right. In a lot of cases, however, the much ballyhooed charges got a lot of press attention but then quietly went away. Indeed, on the few occasions he's taken one of these high profile business cases to trial, he's lost at least as often as he's won. Instead, his record consists mainly of using media pressure to extort settlements from frightened executives.

Spitzer and the Mutual Fund Industry

Let's take just one set of Spitzer cases as our paradigm; namely, the mutual fund late trading "scandal."

Alliance Capital was one of the mutual funds caught up in the late trading/market timing scandal. In order to settle charges brought by NY attorney general Spitzer, Alliance offered to do something that had nothing to do with either late trading or market timing; namely, to cut the fees it charged investors. Alliance knew that was the fastest way to Spitzer's heart. As the Wall Street Journal reported:

"Fees, fees, fees -- that's the big money," Mr. Spitzer crowed to his top lawyers after hearing from Alliance. "When we have a company in this position, we shouldn't give up our leverage to negotiate about the issue that's the 800-pound gorilla."

The trouble was that Spitzer has no legal authority -- none, nada, zilch -- to regulate mutual fund fees. As former SEC Commissioner Ed Fleischman told the Journal:

He's showing an investing and voting public that he can be its champion and make companies shake in their boots ... But a prosecutor making policy can be dangerous if he becomes extortive.

It's as though you got busted for pot possession and the DA said you had to give up snowboarding. What business does the prosecutor have using his leverage that way? What right?

Even if he had regulatory authority over fees, moreover, Spitzer's attack on them would still be misplaced. The industry is highly competitive. Fees are fully disclosed and it's relatively easy for unhappy investors to switch from one fund to another. Put simply, there was no market failure to justify regulation of fees. Instead, Spitzer was engaged in populist paternalism.

Balkanizing the Economy

Masters correctly notes of the mutual fund and other cases that the controversy "over Spitzer and his imitators in many ways reflected the larger fight over competition between state and federal regulators." I would put the point more strongly: The controversy over Spitzer reflects the one of the fundamental reasons the Founders chose to replace the Articles of Confederation with our Constitution.

To be sure, Spitzer got away with a lot of his crusades because the SEC seemed to have fallen asleep at the switch, creating a regulatory vacuum he was only too pleased to fill. The whole point of having federal securities regulation, however, is to avoid balkanizing the capital markets by competing state regulations. Spitzer's litigation crusades reintroduced just such Balkanization, as the rules in New York either differed from those in other states or, worse yet, Spitzer tried to have New York set the rules for the whole country.

As I asked in my earlier TCS column, Spitzer Goes Over the Line, did not the Founding Fathers adopt a Constitution in large part to avoid the economic Balkanization threatened by the Articles of Confederation? And, as I explained in that column, one can be a competitive federalist and still think the SEC should have shut Spitzer down in order to protect the national capital markets.

Losing

Spitzer is a master of trying cases in the media. When forced to take cases to court, however, his record is mixed, at best. In 2005, for example, one of the few mutual fund cases to go to trial ended in a defeat. Former Bank of America broker Theodore Sihpol was acquitted on Thursday of 29 of 33 criminal charges brought by Spitzer alleging that Sihpol helped a hedge fund illegally trade mutual funds. The jury deadlocked on the other 4 charges.

In 2003, Spitzer's much ballyhooed lawsuit against the gun industry, which advanced the novel legal theory that otherwise legal guns are a public nuisance, was shot down by a 3-1 New York state appeals court decision. Master quotes Spitzer as sloughing off the loss with the quip "There are some cases you bring knowing the probability of success is not great." True, but as a matter of legal ethics, the claims made in litigation must be "warranted by existing law or by a nonfrivolous argument for the extension, modification, or reversal of existing law or the establishment of new law." In this case, Spitzer pushed the edge of that envelope, as suggested by the New York court's rebuke:

[T]he Legislative and Executive branches are better suited to address the societal problems concerning the already heavily regulated commercial activity at issue.

Doing It All for Political Gain?

The Economist magazine once called Spitzer "publicity hungry," a point Masters implicitly admits in writing that Spitzer's crusade against stock analysts had the "heady side benefit" of fawning media attention. Yet, there is a dark side to the story to which Masters gives inadequate attention. as the Wall Street Journal reported:

[T]o a host of Empire State charities and well-connected law-school deans, the crusading New York attorney general is acting a lot ... like Santa Claus.

Three civil settlements he struck in an unusual case against wealthy telecom executives and IPOs have allowed him to bestow more than $5 million in largess over the past several months to dozens of community groups across New York state. The recipients are intended as a sort of proxy for individual investors who allegedly suffered from the actions of the defendants, who were accused of profiting from undisclosed awards of sought-after initial public offerings from investment bankers seeking their business. ... But the groups receiving the windfall also represent voter constituencies that could be key to Mr. Spitzer's widely expected Democratic run for governor in 2006.

In sum, Spitzer appears to have used his prosecutorial powers for personal political gain.

We learn just a little of what makes Eliot Spitzer tick from Masters. What does clearly emerge, however, is the boundless nature of Spitzer's ambition. He is unlikely to settle for being governor of New York; instead, he clearly wants to follow the path to the White House blazed by former New York governor Theodore Roosevelt.

It's a fair bet that Spitzer's adversarial personality and penchant for conflict will serve him less well in executive office than it did as attorney general. It's also a fair bet that it will be a very long time before this country again elects a Northeastern liberal to the Presidency (see, e.g., Kerry and Dukakis). For those who have doubts about Spitzer, however, eternal vigilance would seem to be the order of the day.

Cuban's Short Selling and Insider Trading

From MSN Money:

Dallas Mavericks owner Mark Cuban has ... launched a Web site, Sharesleuth.com, and hired a financial journalist with the goal of rooting out unsavory business practices and misleading accounting by public companies. ... Cuban makes no bones about the fact that a chief goal of the site is to make him money. [PB: And what's wrong with that?]Already a billionaire from his sale of Broadcast.com to Yahoo! in 1999, Cuban plans to profit by taking short positions in stocks that Sharesleuth.com attacks. In short selling, investors borrow stock and then sell it to someone else, hoping the stock will decline so they can return it later at a cheaper price.

Ideally (for Cuban), he sells a stock short, Sharesleuth publishes an article, the stock's price goes down and Cuban reaps a profit. Even if Sharesleuth gets it wrong, Cuban's investment benefits from the negative publicity.

The reporter goes on to say:

All of this is legal because of a loophole in the insider trading rules covering journalists.

Wrong. It's doesn't have anything to do with rules for journalists.

Insider trading law is really about theft of information. (See my primer on insider trading law.) If a journalist working for the W$J inside trades on the basis of information from a story he wrote for the Journal (as Journal reporter R. Foster Winans famously did), he can be held liable because he used information that belonged to the Journal. As the law calls it, he "misappropriated" the information. But the same is true of non-journalists. If a lawyer uses confidential client information to inside trade, the lawyer can be held liable for misappropriating the client's information.

You can't steal from yourself. hence, it has always been the law the someone trading on the basis of their own plans or intentions is not subject to inside trading liability. If Carl Icahn plans to buy a company, he can buy stock in that company without violating the insider trading laws, because he's trading on the basis of his own idea. The same is true for Cuban with respect to his plans to short sell. It doesn't have anything to do with Cuban being the owner of a quasi-journalistic site.

BTW, where Cuban could get into trouble is if his stories about the companies he shorts are fraudulent. If he sold short and then intentionally put out false information, it would be analogous to a pump and dump case of manipluation. (Indeed, it would be the exact converse of a pump and dump.) One suspects Cuban's too smart to ever intentionally put out false information, but one suspects he might be perfectly happy to have false information accidentally appear. But then again, did you see him go after David Stern last year?

Condos versus Coops

I'm off this pm to see my Dean Michael Schill present a paper on the New York housing market:

One of the enduring puzzles of New York City’s housing market is the persistence of the housing cooperative, despite the prevailing wisdom that condominiums are more valuable than cooperatives. In this article, we examine the theoretical advantages and disadvantages of cooperatives and condominiums, and apply these theoretical insights to empirically test whether there is a price premium attributable to condominium housing. We then use our findings to speculate as to why the cooperative form remains dominant in New York City and whether its dominance is likely to continue in the future. The empirical analysis is based on hedonic models of house values and uses rich data on apartments sold in New York City between 1984 and 2002.

In most instances, theory suggests several reasons why the condominium may be a more efficient and desirable housing form than the cooperative. Unlike the case of cooperatives, condominium owners do not share liability on mortgage debt, they are free to transfer their apartments to whomever they choose, they are subject to fewer rules than cooperative apartment owners and, correspondingly, they need spend less time in internal governance. Our empirical findings confirm the theoretical prediction that legal form does indeed matter. With one important exception, condominium apartments are significantly more valuable than comparable cooperative apartments. The one exception suggests that for some owners, the benefits of restriction and exclusivity that the cooperative form offers, and which until recently seemed to be impossible to achieve through the condominium form, may be utility-maximizing. We speculate that, except for the segment of the market that seeks a socially exclusive residential environment, the continued dominance of cooperative housing in New York City is probably attributable to transaction costs and collective action problems which make switching to condominium form potentially difficult.

Assessing Eliot

In November, Eliot Spitzer likely will be elected as New York's next governor. Whether that will be good news for New Yorkers is perhaps debatable, but it's great news for America's economy.

It would be unfair to call Washington Post journalist Brooke Masters' biography of New York's crusading attorney general, Spoiling for a Fight: The Rise of Eliot Spitzer, one-sided. Masters presents the arguments of Spitzer's many critics and does so reasonably fairly. So while Spoiling for a Fight isn't mere hagiography, at the end of the day Masters comes down on Spitzer's side of most controversies. She puts Spitzer into the crusading progressive hall of fame alongside such luminaries as Louis Brandeis, Thomas Dewey, Teddy Roosevelt, and Rudy Giuliani.

What's interesting about the other crusaders to whom masters favorably compares Spitzer, of course, is that they all used their crusades to advance their political careers. Before he was the hero of 9/11, Giuliani rode his mob and white collar prosecutions as a US Attorney in New York City to the Mayor's office. Brandeis' cause lawyering got him to the United States Supreme Court. Teddy Roosevelt's reputation as a reforming police commissioner helped get him to the White House, although San Juan Hill probably helped more (and Leon Czolgosz helped too), a pattern Giuliani apparently hopes to emulate. And, of course, Thomas Dewey got the chance to famously lose the presidency to Truman.

A fair reading of Eliot Spitzer's record as presented by Masters suggests that he is both a genuine cause crusader and a career political hack. Spitzer has consistently used -- and abused -- his authority as New York attorney general to level sweeping accusations against a wide swath of American business. In some cases, like the proverbial stopped clock, he got it right. In a lot of cases, however, the much ballyhooed charges got a lot of press attention but then quietly went away. Indeed, on the few occasions he's taken one of these high profile business cases to trial, he's lost at least as often as he's won. Instead, his record consists mainly of using media pressure to extort settlements from frightened executives.

Spitzer and the Mutual Fund Industry

Let's take just one set of Spitzer cases as our paradigm; namely, the mutual fund late trading "scandal."

Alliance Capital was one of the mutual funds caught up in the late trading/market timing scandal. In order to settle charges brought by NY attorney general Spitzer, Alliance offered to do something that had nothing to do with either late trading or market timing; namely, to cut the fees it charged investors. Alliance knew that was the fastest way to Spitzer's heart. As the Wall Street Journal reported:

"Fees, fees, fees -- that's the big money," Mr. Spitzer crowed to his top lawyers after hearing from Alliance. "When we have a company in this position, we shouldn't give up our leverage to negotiate about the issue that's the 800-pound gorilla."

The trouble was that Spitzer has no legal authority -- none, nada, zilch -- to regulate mutual fund fees. As former SEC Commissioner Ed Fleischman told the Journal:

He's showing an investing and voting public that he can be its champion and make companies shake in their boots ... But a prosecutor making policy can be dangerous if he becomes extortive.

It's as though you got busted for pot possession and the DA said you had to give up snowboarding. What business does the prosecutor have using his leverage that way? What right?

Even if he had regulatory authority over fees, moreover, Spitzer's attack on them would still be misplaced. The industry is highly competitive. Fees are fully disclosed and it's relatively easy for unhappy investors to switch from one fund to another. Put simply, there was no market failure to justify regulation of fees. Instead, Spitzer was engaged in populist paternalism.

Balkanizing the Economy

Masters correctly notes of the mutual fund and other cases that the controversy "over Spitzer and his imitators in many ways reflected the larger fight over competition between state and federal regulators." I would put the point more strongly: The controversy over Spitzer reflects the one of the fundamental reasons the Founders chose to replace the Articles of Confederation with our Constitution.

To be sure, Spitzer got away with a lot of his crusades because the SEC seemed to have fallen asleep at the switch, creating a regulatory vacuum he was only too pleased to fill. The whole point of having federal securities regulation, however, is to avoid balkanizing the capital markets by competing state regulations. Spitzer's litigation crusades reintroduced just such Balkanization, as the rules in New York either differed from those in other states or, worse yet, Spitzer tried to have New York set the rules for the whole country.

As I asked in my earlier TCS column, Spitzer Goes Over the Line, did not the Founding Fathers adopt a Constitution in large part to avoid the economic Balkanization threatened by the Articles of Confederation? And, as I explained in that column, one can be a competitive federalist and still think the SEC should have shut Spitzer down in order to protect the national capital markets.

Losing

Spitzer is a master of trying cases in the media. When forced to take cases to court, however, his record is mixed, at best. In 2005, for example, one of the few mutual fund cases to go to trial ended in a defeat. Former Bank of America broker Theodore Sihpol was acquitted on Thursday of 29 of 33 criminal charges brought by Spitzer alleging that Sihpol helped a hedge fund illegally trade mutual funds. The jury deadlocked on the other 4 charges.

In 2003, Spitzer's much ballyhooed lawsuit against the gun industry, which advanced the novel legal theory that otherwise legal guns are a public nuisance, was shot down by a 3-1 New York state appeals court decision. Master quotes Spitzer as sloughing off the loss with the quip "There are some cases you bring knowing the probability of success is not great." True, but as a matter of legal ethics, the claims made in litigation must be "warranted by existing law or by a nonfrivolous argument for the extension, modification, or reversal of existing law or the establishment of new law." In this case, Spitzer pushed the edge of that envelope, as suggested by the New York court's rebuke:

[T]he Legislative and Executive branches are better suited to address the societal problems concerning the already heavily regulated commercial activity at issue.

Doing It All for Political Gain?

The Economist magazine once called Spitzer "publicity hungry," a point Masters implicitly admits in writing that Spitzer's crusade against stock analysts had the "heady side benefit" of fawning media attention. Yet, there is a dark side to the story to which Masters gives inadequate attention. as the Wall Street Journal reported:

[T]o a host of Empire State charities and well-connected law-school deans, the crusading New York attorney general is acting a lot ... like Santa Claus.

Three civil settlements he struck in an unusual case against wealthy telecom executives and IPOs have allowed him to bestow more than $5 million in largess over the past several months to dozens of community groups across New York state. The recipients are intended as a sort of proxy for individual investors who allegedly suffered from the actions of the defendants, who were accused of profiting from undisclosed awards of sought-after initial public offerings from investment bankers seeking their business. ... But the groups receiving the windfall also represent voter constituencies that could be key to Mr. Spitzer's widely expected Democratic run for governor in 2006.

In sum, Spitzer appears to have used his prosecutorial powers for personal political gain.

We learn just a little of what makes Eliot Spitzer tick from Masters. What does clearly emerge, however, is the boundless nature of Spitzer's ambition. He is unlikely to settle for being governor of New York; instead, he clearly wants to follow the path to the White House blazed by former New York governor Theodore Roosevelt.

It's a fair bet that Spitzer's adversarial personality and penchant for conflict will serve him less well in executive office than it did as attorney general. It's also a fair bet that it will be a very long time before this country again elects a Northeastern liberal to the Presidency (see, e.g., Kerry and Dukakis). For those who have doubts about Spitzer, however, eternal vigilance would seem to be the order of the day.

Stock Spam Works

Lately I've been getting tons of spam touting various stocks. It turns out that the stock manipulators have discovered that spam works, at least when you're dealing with an inefficient market:

Based on a large sample of touted stocks listed on the Pink Sheets quotation system, we find that stocks experience a significantly positive return on days when they are heavily touted via spam, and on the day preceding such touting. Volume of trading also responds positively and significantly to heavy touting. Indeed, on a day when no tout has been detected in our database, the likelihood of a touted stock being the most actively traded stock that day is only 6%. On the other hand, on days when there is touting activity, the probability of a touted stock being the single most actively traded stock is 81%. Returns in the days following touting are significantly negative. The evidence accords with a hypothesis that spammers "buy low and spam high," purchasing penny stocks with comparatively low liquidity, then touting them - perhaps immediately after an independently occurring upward tick in price, or after having caused the uptick themselves by engaging in preparatory purchasing - in order to increase or maintain trading activity and price enough to unload their positions at a profit. Selling by the spammer then results in negative returns following touting. Investors who respond to touting are losing, on average, 5.25% in the two day period following touting. For the quintile of stocks in our sample that are touted most heavily, this 2-day loss approaches 8%. These estimates are conservative, as they do not account for transaction costs.

Two thoughts. First, the strategy shouldn't work in an efficient market - or, at least, shouldn't work as well. To be sure, even efficient markets can be deceived (hence, the fraud on the market theory), but it's a lot harder (hence, the criticisms of the fraud on the market theory). Second, although it might be theoretically possible to devise a trading strategy that allowed you to profit by piggy backing on the manipulators, you'd have to get into and out of the right touted stocks really fast. Any potential profit likely would get chewed up by transaction costs, which is true of virtually all market timing strategies. So the best advise might be to just delete the stock advise spam the same way you delete every other spam.

iPod Gadget Report

For about the last year and a half, I've been using a Monster iCarPlay to play my iPod through my car stereo. When the unit stopped working last week, I popped down to the local Apple store where a helpful clerk pointed me to the Kensington 33185. It's twenty bucks more then the Monster, but she claimed the performance was significantly better. She was right. Here in Los Angeles, it's very hard to find a truly clear frequency. In my part of town, 104.7 seems to work best, but the Monster sometimes got interference from a distant Spanish language station broadcasting on 104.5. The Kensingtom overpowers the 104.5 station and provides quite good sound. Is it as good as a hardwired connection? Of course, not? Is it a reasonable alternative to replacing the whole stereo/nav set up with a more iPod-friendly system? I think so. Until the good folks in Zuffenhausen come up with a hard wired fix , I'll use the Kensington.

This One's for the Tax Nuts

If you troll about the internet long enough, you'll run into a facinating (if somewhat scary) subculture of tax protestors (of varying political stripes) who argue that various taxes (or, indeed, the entire tax code) are unconstitutional:

Around the web you can find scores of people and organizations touting the concept that there is no obligation to pay income taxes. They have dozens of theories, each kookier than the last. There is an eerie fascination to these theories, many of which are laced with so many references to the tax code and regulations that they have a veneer of plausibility that just might fool a very naive lay person. (Link with rebuttals to the more common arguments)

A recent DC Circuit decision likely will have the unintended effect of giving those folks new hope. Orin Kerr explains:

This morning the D.C. Circuit decided a fascinating case holding that the Constitution does not permit the federal government to collect income taxes on compensation for a non-physical work-related injury not related to wages or earnings.

In Murphy v. IRS, Murphy received $70,000 from the state of New York for anxiety suffered and injury to her reputation for being unlawfully "blacklisted" after becoming a whistleblower aaginst her former employer, the New York Air National Guard. The government wanted to tax the $70,000 as income, but Murphy claimed that it was not taxable either because it was excludable as compensation for "personal physical injuries" or because the Internal Revenue Code is unconstitutional for trying to tax such earnings as income.

Paul Caron has commentary, including a historical perspective by my friend and colleague Steve Bank.

Let a 1000 lawsuits bloom. Evey tax nut in the country is probably getting ready to file suit challenging some tax or another using Murphy as a template.

Some will protest my use of the term "nut." I quote Wikipedia:

Almost every United States Court of Appeals has made a blanket statement repudiating tax protester arguments. For example, see United States v. Buckner^[3]:

"For the record, we note that the following beliefs, which are stock arguments of the tax protester movement, have not been, nor ever will be, considered 'objectively reasonable' in this circuit:

"(1) the belief that the Sixteenth Amendment to the Constitution was improperly ratified and therefore never came into being;

"(2) the belief that the Sixteenth Amendment is unconstitutional generally;

"(3) the belief that the income tax violates the Takings Clause of the Fifth Amendment;

"(4) the belief that the tax laws are unconstitutional;

"(5) the belief that wages are not income and therefore are not subject to federal income tax laws;

"(6) the belief that filing a tax return violates the privilege against self-incrimination; and

"(7) the belief that Federal Reserve Notes do not constitute cash or income."

I'd say people holding those beliefs qualify for the epithet.

Regulating IPOs Out of Country

It's no great secret that the US IPO market remains depressed. A decade ago, 9 out of the 10 larged IPOs had a US component. Today, only 1 in 10 does. In large part, this decline can be blamed on the high cost of US securities regulation, especially Sarbanes-Oxley. But law professor Dale Oesterle sees a technical fix for at least part of the problem:

Lowering the cost of IPOs would not only enable small companies to net more money per offering, it would also enable small companies to float smaller offerings. And lowering the cost of IPOs is something that the Securities and Exchange Commission could do by allowing small companies to make their IPOs over the Internet. The SEC's foot-dragging on the use of the Internet for IPOs is depressing venture capital in the United States. The most active venture capital IPO market for small companies is now the AIM market in London.