ProfessorBainbridge.com

Bloggers on the Financial Regulation White Paper

Arnold Kling has some preliminary thoughts.

So does Megan McArdle.

The Slow Motion Walk to a Managed Economy

The Business Law Prof's post on the titular walk is well worth a read.

A Survey of Delaware Corporation Law Developments in 2008

Focusing on cases involving charter and bylaw provisions and indemnification agreements.

Smoking Bans and Social Norms

Henry Farrell has a very thoughtful post on the role social norms play in the enforceability of laws, focusing on the an argument that social norms about public smoking were extremely fragile and therefore subject to quick reversal by legal intervention:

I haven’t seen any research on this (if someone knows of any, let me know in comments), but my best guess in the absence of good evidence would be that the success of the ban reflected instabilities in previously existing informal norms about where people could or could not smoke. Laws that work against prevailing social norms face an uphill battle in implementation – unless people come to a general belief that non-compliers are highly likely to be sanctioned by the public authorities, they are likely to carry on doing what they always do. ... Laws that broadly fit with prevailing informal norms, will, obviously, have few implementation problems.

But what we may have seen (if my guess is right) with smoking bans is an unusual case in which prevailing norms (that ... people can smoke in pubs to their hearts’ content, and that others will just have to put up with it) were much more fragile than they appeared to be, and that the change in law made it easier for those disadvantaged by the prevailing norms to challenge smokers and to shame them into stopping smoking in certain places, hence creating a new set of robust norms. I’ve no evidence beyond anecdote and personal observations to support this claim – but I do think that it is hard to imagine that norm fragility isn’t involved somewhere along the causal chain, given that state enforcement capacities are obviously insufficient to push something like this through.

Some thoughts: (1) As far as I'm concerned, the seminal work on the relatoinship between law and norms remains Robert Ellickson's Order without Law: How Neighbors Settle Disputes , which should be on the reading list of anyone with an interest in these issues.

(2) Norms vary radically in their strength. When fragile norms are subjected to a strong exogneous shock, you can get a cascade effect in which the norm changes very quickly. The seminal piece in the legal literature on this issue is Cass R. Sunstein, Social Norms and Social Roles, 96 Colum. L. Rev. 903 (1996). Sunstein argues that:

Existing social conditions are often more fragile than might be supposed, because they depend on social norms to which -- and this is the key point -- people may not have much allegiance. What I will call norm entrepreneurs -- people interested in changing social norms -- can exploit this fact. If successful, they produce what I will call norm bandwagons and norm cascades. Norm bandwagons occur when small shifts lead to large ones, as people join the “bandwagon”; norm cascades occur when there are rapid shifts in norms.

Farrell's description of the change in smoking behavior is consistent with such a cascade.

(3) Sunstein further argues that legal change can produce just such a cascade:

Many laws have an expressive function. They “make a statement” about how much, and how, a good or bad should be valued. They are an effort to constitute and to affect social meanings, social norms, and social roles. Most simply, they are designed to change existing norms and to influence behavior in that fashion.

Of course human goods are valued in different ways; people have a wide variety of evaluative stances toward relationships and goods. Laws with expressive functions are often designed to promote a certain way of valuing certain goods. Many such laws are intended to say that specified goods should be valued in a way that deters thinking of them as mere objects for use. Laws forbidding the purchase and sale of certain goods can be so understood.

It may well be the case that smoking bans are an example of a successful effort to use law in this expressive mode. Richard H. McAdams's article, A Focal Point Theory of Expressive Law, 86 Va. L. Rev. 1649 (2000), for example, offers an extensive game theory analysis of smoking bans, which argues they can have powerful social effects. In an article in the same symposium (at 1603), Robert Scott explained that pooper-scooper laws and smoking bans in airports are "the favorite examples used by norms scholars to describe the expressive and internalization effects of law." He continued:

Pooper-scooper laws, even without effective enforcement by the state, change the incentives of individuals facing a preference conflict between a taste for clean yards and a taste for allowing “dogs to be dogs.” No smoking ordinances in airports not only solve coordination problems but resolve a cooperation problem as well: the preferences of those who prefer clean air over those who prefer to smoke. The law in either case informs those with the preference that favors clean air or clean yards that general local sentiment supports their preference. This raises the benefits and lowers the costs of shaming violators. Similarly, the violator is informed of the prospect of informal sanctions and of the character of any shaming interaction, and thus the costs of the forbidden activity are increased.

(4) I remain skeptical that norm entrepreneurship works very well when norms are less fragile. I explained in my article Stephen M. Bainbridge, Mandatory Disclosure: A Behavioral Analysis , 68 U. Cin. L. Rev . 1023 (2000), that:

Some scholars contend that law can create or destroy norms. By raising the cost of compliance with a social norm, law can destroy the norm, albeit without changing individual value systems or utility functions. Alternatively, however, by expressing social values, law may be able to destroy (or create) a norm by changing individuals' preferences. ...

There are a number of objections to this thesis, however. First, query whether legal reform would precede cultural change, especially in the teeth of rent-seeking by special interest groups. The objection is especially pertinent in [those contexts in which] the interest group whose norms are to be reshaped ... wield significant political power with respect to changes that affect their interests.

Second, the thesis reflects an optimism about the ability of law to effect social change that may not be warranted. Much (probably most) social intercourse is carried on with little regard to legal rules. Here we must take into account Robert Ellickson's observation that “large segments of social life are located and shaped beyond the reach of law.” Ellickson famously studied the way in which residents of Shasta County, California resolved disputes over trespassing cattle. He found that laypersons had only rudimentary knowledge of trespass law and that what little they did know was partly erroneous. Strikingly, in some respects legal specialists (lawyers and insurance adjusters) knew even less trespass law than did laypersons. To be sure, the use of law in a securities disclosure regime driven by public enforcement differs from the use of law in private dispute resolution, but Ellickson's finding nonetheless casts doubt on the ability of law to reshape cultural norms. At the very least, just as one proverbially must hit the mule over the head to get its attention, law may have to use a heavy hand in order to change behavior determined by social norms.

(5) Like Megan McArdle, I still think smoking bans are bad policy.

Update: Jonathan Adler discusses the Farrell post in connection with his own analysis of recent legislation authorizing the FDA to regulate tobacco. Of the new bill, Adler opines:

For reasons I explain in this NRO article, I am not convinced the legislation does much for public health, let alone the public good. Among other things, the legislation could frustrate the development and marketing of reduced-risk tobacco products, impose troubling limitations on commercial speech, and cement Philip Morris' position as the tobacco industry's dominant player. Is it any wonder Philip Morris was a big backer of the bill?

As for the social norms issue, Adler poses and then discusses the interesting question of "What would happen were such bans to be repealed? "

Go read the whole thing.

Shareholder Power and the Fiscal Crisis

Is the problem that shareholders are too weak or too powerful? The Defining Tension notes the competing views:

Both the Turner Review and the Maas Committee agree that excessive risk-taking has been one of the causes. But they seem to have different views on the relation between shareholder influence and excessive risk-taking. According to the Turner Review, there were many cases where “boards failed adequately to identify and constrain excessive risk taking,” while “shareholder influence seems to have been relatively ineffective in the past in constraining risky strategies.” (In similar vein, the introduction of the US Shareholder Bill of Rights Act states that boards have failed "to appropriately analyze and oversee enterprise risk" and that "a key contributing factor to such failure was the lack of accountability of boards to their ultimate owners, the shareholders.") From this point of view, shareholder influence is a solution to the problem.
4. By contrast, according to the Maas Committee, a

“disproportionate increase in the power of shareholders (…), whereby the shareholders (who usually have a short-term focus) impeded a sustainable, long-term focus in business strategy of banks. This resulted in increasing attention being paid to short-term profit development, which therefore weakened longer-term risk management.

From this point of view, shareholder influence is the problem.

Whether shareholder influence was a causal factor in the financial crisis, I'm reasonably confident that increasing shareholder power will not be helpful in preventing future crises, but rather would compound them.

Democrat Populism Run Amok

The Democrats are giving way to some (albeit not yet all) of their worst populist instincts. AP reports that:

The Obama administration struck a delicate balance on executive pay Thursday, blaming flawed compensation packages for encouraging disastrous risk-taking but insisting it doesn't want to dictate how corporations reward their top people.
Gene Sperling, a top counselor to Treasury Secretary Timothy Geithner, conceded to a congressional committee that imposing compensation caps on companies could lead to a flight of talent.
"I can say with certainty that nobody in the Obama administration is proposing such a thing," he said.

Good. Pay caps are a form of price control and price controls don't work. Yet what the Dems plan to do is almost as bad:

The administration plans to seek legislation that would try to rein in compensation at publicly traded companies through nonbinding shareholder votes and by decreasing management influence on pay decisions.
But some Democrats on the House Financial Services Committee said Thursday the administration's efforts to hector the private sector into reforming executive pay might not go far enough.
"I do differ with the administration in that hope springs eternal and their position seems to be that if we strengthen the compensation committees we will do better," said the committee chairman, Rep. Barney Frank, D-Mass.
Rep. Brad Sherman, D-Calif., said that shareholders' votes on pay should be made binding on boards of directors.

Say on pay is an asinine idea, as I've explained on this site too many times to bear repetition. (See, e.g., my essay Say on Pay: An Unjustified Incursion on Director Authority.) Mandatory say on pay, such as Sherman proposes would be even worse. 

"We are not talking here about the amount. We are talking here about the structure of compensation," [Frank] said. "And I believe the structure of compensation has been flawed."

The problem is that Frank and his party are largely responsible for the current structure of compensation. It was Bill Clinton's 1993 budget (for which Frank voted) that capped non-performance based compensation at $1 million but, by exempting options and the like, encouraged the proliferation of stock option-based form of compensation. That shift gave us the shenanigans at Enron, stock option-back dating, and the preference for excess risk taking. So the same folks who laid the ground for the present structure are going to fix it? Spare me.

Update: Larry Ribstein poses some typically pointed questions:

Now we see that bank pay regulation is politically motivated populist-feeding, and not really about systemic risk. The systemic risk argument for regulation assumes that this risk is an externality not taken into account by banks’ owners. If the owners care about the risks their banks pose to the financial system enough to micromanage pay to reduce these risks, then why can’t we trust the shareholders to manage the banks in other ways to contain these risks? Conversely, if we need systemic risk regulation because we can’t trust the shareholders, then why give the shareholders the power to control pay?
Another thing:  why should the SEC be the agency to dictate shareholder control over bank pay? Isn’t that agency supposed to be about disclosure?

Martha Minow named Harvard Law dean

Boston Globe says so. Damn. I really thought I was going to get the job!

Why Have a Board of Directors?

In honor of the AALS Business Associations Teachers' Conference I'm attending, here's an old TCS column:

Fortune editor-at-large Justin Fox asks: "Why do companies have boards of directors, anyway?" Why aren't corporations run using "direct democracy—putting all major corporate decisions, including the choice of a new CEO, to a shareholder vote"? Or by "absolute corporate monarchy—allowing management to make all the decisions without oversight"? Good questions, all. On close examination, however, the modern system of corporate governance in which the corporate hierarchy is topped by a small committee of independent board members, who typically lack both day-to-day management power and any significant equity stake in the corporation, turns out to be a highly efficient solution to the problems of making decisions in complex organizations.

Why Not Direct Shareholder Democracy?

Nobel laureate economist Kenneth Arrow's seminal work on organizational decision making identified two basic decision-making structures: "consensus" and "authority." Consensus is utilized where each member of the organization has identical information and interests and will therefore select the course of action preferred by all the other team members. In contrast, authority-based decision-making structures arise where team members have different interests and amounts of information. They are characterized by the existence of a central agency to which all relevant information is transmitted and which is empowered to make decisions binding on the whole.

It is very hard to imagine a modern public corporation that could be effectively run using consensus-based decision-making mechanisms. At the most basic level, the mechanical difficulties of achieving consensus amongst thousands of shareholders impede direct democracy.

Even if those collective action problems could be overcome, however, active shareholder participation in corporate decision making still would be precluded by the shareholders' widely divergent interests and distinctly different levels of information. As to the former, while neoclassical economics assumes that shareholders come to the corporation with wealth maximization as their goal, and most presumably do so, once uncertainty is introduced it would be surprising if shareholder opinions did not differ on which course will maximize share value. As to the latter, shareholders lack incentives to gather the information necessary to actively participate in decision making and thus are rationally apathetic.

Consequently, it is hardly surprising that, among public companies, corporate governance precisely fits Arrow's model of an authority-based decision-making system. Shareholders lack the information and the incentives necessary to make sound decisions on either operational or policy questions. Under these conditions, Arrow predicts, it is "cheaper and more efficient to transmit all the pieces of information to a central place" and to have the central office "make the collective choice and transmit it rather than retransmit all the information on which the decision is based," which is precisely what a board-centered system of corporate governance does.[1]

Why Not Monarchy?

The more interesting question Fox poses can be rephrased as: Why a board rather than an individual autocrat? In theory, corporate governance has always been board-centered. As the Delaware General Corporation Law, for example, has long put it: the corporation's "business and affairs . . . shall be managed by or under the direction of the board of directors." The statutory model of corporate governance thus contemplates not a single hierarch, but rather a multi-member body that typically will act by consensus.

In practice, however, corporations were de facto run by an imperial CEO or a team of senior managers, with little or no interference from other stakeholders. Shareholders were essentially powerless and typically quiescent. Boards of directors were little more than rubber stamps.

Today, corporate governance looks very different. In recent years, several trends coalesced to encourage more active and effective board oversight. Much director compensation is now paid in stock, for example, which helps align director and shareholder interests. Courts have made clear that effective board processes and oversight are essential if board decisions are to receive the deference traditionally accorded to them under the business judgment rule, especially insofar as structural decisions are concerned (such as those relating to management buy-outs). Third, director conduct is constrained by an active market for corporate control, ever-rising rates of shareholder litigation, and, some say, activist shareholders. As a result, modern boards of directors typically are smaller than their antecedents, meet more often, are more independent from management, own more stock, and have better access to information. Real world practice thus increasingly has come into line with the statutory model of board primacy.

The economic advantages associated with board primacy vis-à-vis CEO primacy come into play when we consider the three major functions of the board of directors: (1) providing an in-house set of specialists and access to a network of outside resources; (2) broad policy making; and (3) monitoring and disciplining top management. A sizeable body of research suggests that groups are superior to individuals in all three areas.

Networking is the easiest context in which to make the case for groups, of course. Unlike a single CEO, who often came up through the ranks, specializing in a particular area of the firm's business, a diverse board comprised mainly of outsiders links the firm to a network of other companies who may be useful suppliers or customers. Likewise, such a board often includes persons with specialized expertise, such as lawyers or bankers, who can bring valuable outsider perspectives to the table.

As for policy making and monitoring, both of these involve the exercise of critical evaluative judgment. A wealth of research in psychology, sociology, and behavioral economics confirms that groups often make better decisions than individuals. Even more strikingly, the conditions under which groups outperform individuals in laboratory settings have important similarities to board decision making.

Two examples might suffice. In the 1930s, Marjorie Shaw conducted a classic experiment in which four-person teams of undergraduates solved various problems with single, self-confirming solutions (so-called "Eureka" problems.) One set of problems involved three variants on the classic missionaries and cannibals game.[2] The other set of problems required subjects to solve two word puzzles and another involving spatial relationships. The proportion of correct solutions in a sample of groups was significantly higher than a sample of individuals working alone.

Some 50 years later, Frederick Miner devised another classic experiment to test the ability of groups to exercise evaluative judgment vis-à-vis that of individuals. Miner's experiment required 69 self-selected groups, each composed of 4 undergraduate business students, to solve the so-called winter survival exercise. This exercise, which is variously attributed, has become something of a benchmark standard in the field. The subject group is told that they are survivors of an airplane crash at a remote location. They first must decide whether to walk out or remain at the crash site. They then must rank the utility of 15 survival aids. Miner found that group rankings were more accurate than those of the average individual subject.[3]

Although Miner's experiment may not seem relevant to corporate governance, it has certain instructive features. First, it used business students, who presumably resemble corporate directors more closely than other plausible experimental subjects. Second, the subjects knew one another before becoming members of the group and were allowed to form their own groups, both of which somewhat replicate the process by which boards form. Finally, and most importantly, the subjects shared a single goal (i.e., survival). Granted, the experiment thus did not require them to aggregate preferences as to which there might be value differences, but rather to pool their collective knowledge and use that knowledge to evaluate alternatives in light of the shared goal. If we assume that directors generally share a primary goal of shareholder wealth maximization, however, this experimental condition also replicates corporate governance.

Even the limitations of Miner's study bear some resemblance to corporate boards, at least insofar as outsider dominated boards are concerned. Students subjects bring to the task only general human capital, and the experimental design cannot capture any equivalent to firm-specific human capital. Yet, outside directors accumulate significant firm-specific knowledge and human capital only after very long tenure. The subjects also had relatively little stake in the outcome, but many outside directors likewise lack a direct economic stake in the firm.

A wealth of other studies confirm these results, suggesting that decision making by groups will generally be preferable to decision making by an individual autocrat when it comes to the sort of critical evaluative judgments boards are asked to make. This is not to say that group decision making is always preferable. The old joke about the camel being a horse designed by a committee captures the valid empirical observation that individuals are often superior to groups when it comes to matters requiring creativity. But while individuals may well be better at devising a brilliant plan, individuals often become wedded to their plans and fail to see flaws that others might identify. As such, you may want an individual to write a symphony, but a group to evaluate it. Group decision making checks individual overconfidence by providing critical assessment and alternative viewpoints.

As we have seen, most of what boards do requires the exercise of critical evaluative judgment, but not creativity. Even the board's policymaking role entails judgment more than creativity, because the board is usually selecting between a range of options presented by subordinates. The board thus serves to constrain subordinates who have become wedded to their plans and ideas, rather than developing such plans in the first instance.[4]

Why Not a Management Team?

Fox points out that "the chief decisionmaking group at most large corporations is top management, not the board." True, day-to-day decision making may be vested in the hands of a top management team, but ultimate power to hire and fire remains with the board.

In theory, the CEO could be monitored by his or her subordinates. Indeed, economist Eugene Fama contends that lower level managers in fact monitor more senior managers. Such up-stream monitoring, however, does not take full advantage of specialization. One response to the agency costs inherent in the corporate separation of ownership and control is separation of "decision management"—initiating and implementing decisions—from "decision control"—ratifying and monitoring decisions. Such separation is a defining characteristic of the central office typical of M-form corporations. The M-form corporation replaces the simple pyramidal hierarchy with a more complex structure in which the central office has certain tasks and the operating units have others, which allows for more effective monitoring through specialization, sharper definition of purpose, and savings in informational costs. In particular, the central office's key decision makers—the board of directors—specialize in decision control. Because executives specialize in decision management, expecting them to monitor the CEO thus calls on the former to perform a task for which they are poorly suited.

A different critique of Fama's hypothesis is suggested by evidence with respect to meeting behavior from research on group decision making. In mixed status groups, higher status persons talk more than lower status members. Managers, for example, talk more than subordinates in business meetings. Such disparities result in higher status group members being more inclined to propound initiatives and having greater influence over the group's ultimate decision.

One function of the board of directors thus is providing a set of status equals for top managers. As such, corporate law's insistence on the superiority of the board to management begins to make sense. To the extent law shapes social norms, corporate law empowers the board to constrain top management more effectively by creating a de jure status relationship favoring the board.

New Institutional Economics has taught us that the firm must be viewed as an institution—more precisely, as a set of institutions—rather than as a mere production function. Specifically, the corporation consists of a set of production teams embedded within a hierarchical structure. At the apex of that hierarchy stands not an individual, but yet another team—the board of directors.

Team production is imperfect, whether the product is a manufactured good or a corporate decision. Teams are subject to unique cognitive biases, such as groupthink, and unique sources of agency costs, such as social loafing. With respect to the exercise of critical evaluative judgment, however, groups have clear advantages over autonomous individuals. Not only do groups clearly outperform average individuals in a given sample, there is considerable evidence that the process of group interaction has synergistic effects allowing groups to outperform even the best decision makers in the sample.

The author teaches law at UCLA and is a TCS Contributing Editor.

---

[1] [1] For more on this topic, see my article The Case for Limited Shareholder Voting Rights, 53 UCLA Law Review 601 (2006).

[2] In this game, subjects were given three disks representing missionaries and three disks representing cannibals. The missionaries and cannibals are on one side of a river. The decision maker must get all six to the other side of the river using a boat that can only carry two discs at a time. All missionaries and one cannibal can row. Cannibals must never outnumber missionaries in any location for obvious reasons, albeit politically incorrect ones. See Marjorie E. Shaw, Comparison of Individuals and Small Groups in the Rational Solution of Complex Problems, 44 Am. J. Psych. 491, 492-93 (1932) (describing problems).

[3] Frederick C. Miner, Jr., Group v. Individual Decision Making: An Investigation of Performance Measures, Decision Strategies, and Process Losses/Gains, 33 Org. Beh. and Human Performance 112 (1984).

[4] For more on the merits of group decision making, see my article Why a Board? Group Decision Making in Corporate Governance, 55 Vanderbilt Law Review 1 (2002).

The Function of Transactional lawyers

In honor of the AALS Business Associations Teachers Conference I'm attending this week, here's an old TCS Daily column:

Transactional lawyers play a critical role in virtually all business transactions. But why is this so? The reason people hire litigators is obvious—either they are being sued or they want to sue somebody else. Unauthorized practice of law statutes and bar admission rules give lawyers a near-total monopoly on litigation. The rationale for hiring transactional lawyers, by contrast, is less obvious. Much of the work of transactional lawyers entails giving advice that could be given by other professionals. Accordingly, it seems fair to ask: why does anybody hire transactional lawyers?

The question is neither an idle nor a rhetorical one. As Ronald Gilson and Bernard Black have observed, business people often have a "quite uncharitable view of what business lawyers do. In an extreme version, business lawyers are perceived as evil sorcerers who use their special skills and professional magic to relieve clients of their possessions."

In his book, The Terrible Truth About Lawyers, Mark H. McCormack, founder of the International Management Group, a major sports and entertainment agency, wrote that "it's the lawyers who: (1) gum up the works; (2) get people mad at each other; (3) make business procedures more expensive than they need to be; and now and then deep-six what had seemed like a perfectly workable arrangement. Accordingly, I would say that the best way to deal with lawyers is not to deal with them at all."

Pretty depressing stuff, especially if you hope to make a living as a transactional lawyer.

Part of the problem is that law schools mainly train their graduates to be litigators. While good litigators typically have good negotiating skills (most lawsuits being settled, after all), there is a fundamental difference between the largely zero sum context of litigation and transactional lawyering.

Successful transactional lawyers build their practice by adding value to their clients' transactions. From this perspective, the education of a transactional lawyer is a matter of learning where the value in a given transaction comes from and how the lawyer might add even more value to the deal.

Two competing hypotheses suggest themselves. The first might be termed the "Pie Division Role." In this version of the transactional lawyer story, lawyers strive to capture value—maximizing their client's gains from the deal. Although there are doubtless pie division situations in transactional practice, this explanation of the lawyer's role is flawed. Pie division assumes a zero sum game in which any gains for one side come from the other side's share. Assume two sophisticated clients with multiple advisers, including competent counsel. Is there any reason to think that one side's lawyer will be able to extract significant gains from the other? No. A homely example may be helpful: You and a friend go out to eat. You decide to share a pizza, so you need to agree on its division. Would you hire somebody to negotiate a division of the pizza? Especially if they were going to take one of your slices as their fee?

The second hypothesis might be termed the "Pie Expansion Role." In this version of the story, people hire transactional lawyers because they add value to the deal. This conception of the lawyer's role rejects the zero sum game mentality. Instead, it claims that the lawyer makes everybody better off by increasing the size of the pie.

The emphasis herein on the pie expansion model is consistent with our concomitant emphasis on transaction costs economics. For the most part, lawyers increase the size of the pie by reducing transaction costs. One way of lowering transaction cost is through regulatory arbitrage. The law frequently provides multiple ways of effecting a given transaction, all of which will have various advantages and disadvantages. By selecting the most advantageous structure for a given transaction, and ensuring that courts and regulators will respect that choice, the transactional lawyer reduces the cost of complying with the law and allows the parties to keep more of their gains.

An example may be helpful. Acme Corporation wants to acquire Ajax, Inc., using stock as the form of consideration to be paid Ajax shareholders. Acme is concerned about the availability of appraisal rights to shareholders of the two corporations. Presumably Acme doesn't care about the legal niceties of doing the deal—Acme just wants to buy Ajax at the lowest possible cost and, by hypothesis, with the minimal possible cash flow. In other words, the client cares about the economic substance of the deal, not the legal form it takes. As Acme's transactional lawyer, you know that corporate law often elevates form over substance—and that the law provides multiple ways of acquiring another company. A solution thus suggests itself: Delaware law only permits shareholders to exercise appraisal rights in connection with mergers. Appraisal rights are not allowed in connection with an acquisition structured as a sale of assets. Hence, while there is no substantive economic difference between an asset sale and a merger, there is a significant legal difference. By selecting one form over another, the transactional lawyer ensures that the deal is done at the lowest possible cost.

Parties would experience some transaction costs even in the absence of regulation, however. Reducing those nonregulatory costs is another function of the transactional lawyer. Information asymmetries are a good example. A corporation selling securities to an investor has considerably greater information about the firm than does the prospective buyer. The wise potential investor knows about this information asymmetry and, as a result, takes precautions. Worse yet, what if the seller lies? Or shades the truth? Or is itself uninformed? The wise investor also knows there is a risk of opportunistic withholding or manipulation of asymmetrically held information. Note that this is a species of the agency cost problem. One response to agency costs is monitoring, which in this context takes the form of investigation—due diligence—by the buyer. Another response to agency costs is bonding by seller, which in this context would take the form of disclosures including representations and warranties. In either case, by finding ways for the seller to credibly convey information to the investor, the transactional lawyer helps eliminate the information asymmetry between them. In turn, a variety of other transaction costs will fall. There is less uncertainty, less opportunity for strategic behavior, and less need to take costly precautions.

All of which is why both legal education and the apprenticeship served by young associates must emphasize not only legal doctrine but also economics and business. It may still be possible for someone lacking any knowledge of finance and economics to be a successful mergers and acquisitions lawyer, but I doubt it. As Mark McCormack observed, "when lawyers try to horn in on the business aspects of a deal, the practical result is usually confusion and wasted time." Transactional lawyers therefore must understand the business, financial, and economic aspects of deals so as to draft workable contracts and disclosure documents, conduct due diligence, or counsel clients on issues that require business savvy as well as knowing the law.

AALS Business Associations Conference

I'm off to beautiful Long Beach for the AALS Teaching Business Associations conference. If you're going, be sure to look me up.

Further bulletins as events warrant.

Harvard Dean Poll

Brian Leiter is conducting another poll of his readers; this time he's asking who should (will?) be named Harvard Law's next dean. Once again, as in earlier Leiter polls, I have been omitted from the list of candidates. I am beginning to see a pattern here.

Anyway, Martha Minow is currently leading Howell Jackson in the poll. If I were a betting man, however, my money would be on Jackson. 

Sotomayor's Sec Reg Record

Christine Hurt has reviewed SCOTUS nominee Sonia Sotomayor's securities regulation decisions and reports:

I gathered 26 cases, dating back to 1994. Of these 26 cases, three were actions brought by the SEC, and two were criminal actions brought by the U.S. government. Of those cases, the SEC won all three and the U.S. government won both of its prosecutions.
The remaining 21 lawsuits seem to have results typical to those of most private securities lawsuits: the defendant wins, usually on a motion to dismiss, which is affirmed by the court of appeals. Specifically, in 16 cases the defendant was granted relief. In four cases, the defendant was granted some, but not all, of the relief requested or one defendant was granted relief, but not all. Of these four cases, no plaintiff won on a core 10b-5 securities law issue (was there reliance? materiality? loss causation?). For example, in one case, the second circuit held that although the federal securities claims were dismissed, a state law duty existed for a fiduciary duty claim. In another, several individual defendants were not granted a motion to dismiss on Section 11 claims. In another, even though the case was dismissed, the court held that the lead plaintiff had standing. The other case in which plaintiffs won partial relief was Dabit v. Merrill Lynch, which Sotomayor probably got right and the Supreme Court (reversing) probably got wrong. (My colleague Larry Ribstein's post on this is here.) In the one case where the plaintiff won outright, the plaintiff won summary judgment in a bench trial against a foreign bank.
Although pundits are scouring her other opinions to find judicial activism, there's none here in the 10b-5 arena. If we're worried about the nominee showing empathy instead of following the law, there's no evidence of runaway shareholder empathy!

This is consistent with the general consensus that Sotomayor will be neither reflexively pro- or anti-business, but will decide these cases fairly fairly (so to speak).

Copland on Sotomayor

Jim Copland opines that "She's no Harold Koh...":

Having observed Sonia Sotomayor since I clerked on the Second Circuit during her first year on that court, I've generally taken a  more skeptical stance on her nomination than my friend and colleague Walter Olson. I certainly agree with him on this point, though:

"It's not as if I think Obama's incapable of nominating someone who is more adventurous and more activist by nature."

Case in point: my old Civ-Pro professor, Harold Koh, whom the POTUS has selected to serve as top lawyer in the State Department (a nomination that is still awaiting a hearing before the full Senate). Dave Kopel writes about some of Koh's Second Amendment views here.
See more on Koh here, here, here, here, and here.

And on Koh from yours truly. (BTW, Ornstein never did have the guts to respond)

The war on shorts

Go read Larry Ribstein's post on the latest round in Congress' was on short selling.

Say on Pay and Shareholder Wealth

Marc Hodak

Jie Cai and Ralph Walking of Drexel University recently published such an analysis for Say on Pay. The results will startle, well, no one. Basically, they found that firms “with high abnormal CEO compensation and low pay for performance” benefit under a Say on Pay regime. If the CEO does not fall into the overpaid camp, Imposing Say on Pay will destroy value for the firm. So, what is the net effect on shareholders if we impose Say on Pay on every public company, where the vast majority of them do not have overpaid CEOs? That’s right–shareholders as a class will suffer. But, hey, it’s a small price for the shareholders to pay so that our politicians can demogogue the issue for a few extra votes. And in the new definition that whatever is good for our politicians is “patriotic,” shareholders of well-governed firms should feel pretty darn proud.