ProfessorBainbridge.com

Dorozhko Uproar

AmLaw reports:

Securities law bloggers have been spilling virtual ink all week on the Second Circuit's July 22 ruling in Securities and Exchange Commission v. Dorozhko, which permits the SEC to proceed with a fraud case against a computer hacker, even though the hacker had no fiduciary duty to the company whose shares he traded. We feel kinda dumb for not covering the ruling until now, but on the other hand, the week's delay has crystallized the key issue in Dorozhko: Is the Second Circuit abetting SEC overreaching?

"The Second Circuit is permitting the SEC to enforce in territory where they haven't been lawfully permitted before," Dorozhko's lawyer, Charles Ross of Charles A. Ross & Associates, told us Friday. "The opinion flies in the face of 75 years of U.S. Supreme Court precedent."

Normally, we might discount Ross's view as somewhat biased, but he's not alone in questioning the Second Circuit's reasoning. UCLA professor Stephen Bainbridge called the ruling "egregious." Amy Greer of Reed Smith, guest-blogging at Securities Docket, wondered if the appellate court had "[stepped] onto that famous slippery slope." And White Collar Crime Prof Blog founder Peter Henning, writing at The Wall Street Journal's Law Blog, said, "The SEC could well start channeling its insider trading cases into the affirmative misrepresentation category to free itself from having to show a breach of duty by the defendant."

In defense of profit

Yale law professor Stephen Carter rises in defense of making a profit:

A specter is haunting America: the specter of profit. We have become fearful that somewhere, somehow, an evil corporation has found a way to make lots of money. ...

Thus, a recent news release from the AFL-CIO began with this evidently alarming fact: "Profits at 10 of the country's largest publicly traded health insurance companies rose 428 percent from 2000 to 2007." Even had the figures been correct -- they weren't -- we are seeing the same circus. Profit is the enemy. America could be made pure, if only profit could be purged.

... High profits are excellent news. When corporate earnings reach record levels, we should be celebrating. The only way a firm can make money is to sell people what they want at a price they are willing to pay. If a firm makes lots of money, lots of people are getting what they want. ... To the country, profit is a benefit. Record profit means record taxes paid. But put that aside. When profits are high, firms are able to reinvest, expand and hire. And profits accrue to the benefit of those who own stocks: overwhelmingly, pension funds and mutual funds. In other words, high corporate profits today signal better retirements tomorrow.

Another reason to celebrate profit is the incentive it creates. When profits can be made, entrepreneurs provide more of needed goods and services. Consider an example common to the first-year contracts course in every law school: Suppose that the state of Quinnipiac suffers a devastating hurricane. Power is out over thousands of square miles. An entrepreneur from another state, seeing the problem, buys a few dozen portable generators at $500 each, rents a truck and drives them to Quinnipiac, where he posts them for sale at $2,000 each -- a 300 percent markup.

Based on recent experience, it is likely the media will respond with fury and the attorney general of Quinnipiac will open an investigation into price-gouging. The result? When the next hurricane arrives, the entrepreneur will stay put, and three dozen homeowners who were willing to pay for power will not have it. There will be fewer portable generators in Quinnipiac than there would have been if the seller were left alone.

When political anger over profit reduces the willingness of investors to take risks, the nation suffers.

Of course, Carter's hypothetical Quinnipiac entrepreneur is even more likely to stay put as his marginal tax rate soars ever higher.

Obama's Secret Tax Plan

Paul Caron has the details on WK-9. Toby is appalled. 

The Second Circuit’s egregious decision in SEC v. Dorozhko

The Second Circuit’s recent decision in SEC v. Dorozhko (available here), dealt with one of the questions left open by the Supreme Court’s decision in US v. O’Hagan; namely, the liability of persons who steal inside information but have no fiduciary duty to either the source of the information or the issuer of the securities in which the thief trades.

In Dorozhko, an alleged computer hacker supposedly broke into the computer system of a company called IMS Health, Inc., and used the information he learned in doing so used put options to essentially sell the stock short.

The Second Circuit tried to finesse the rules discussed below by treating the case as one involving a misrepresentation rather than insider trading: "we recognize that the SEC’s claim against defendant—a corporate outsider who owed no fiduciary duties to the source of the information—is not based on either of the two generally accepted theories of insider trading." The problem is that the case makes no sense other than as an insider trading case.

An affirmative misappropriation can be actionable under Section 10(b) and Rule 10b-5 if it is committed in connection with the purchase or sale of a security. In order to find that the hacker committed an affirmative misrepresentation, the Court thus first must find a lie. Calling computer hacking a lie is a rather considerable stretch. At most, the hacker "lies" to a computer network, not a person. Hacking is theft; not fraud.

Even if hacking is fraudulent in the sense of an affirmative misrepresentation, it has to be in connection with a purchase or sale of a security. In S.E.C. v. Zandford, 535 U.S. 813 (2002), the SCOTUS emphasized that "the statute must not be construed so broadly as to convert every common-law fraud that happens to involve securities into a violation of § 10(b)." That case, moreover, involved "a fraudulent scheme [by a stockbroker] in which he made sales of his customer's securities for his own benefit." The SEC had taken the position that that violated 10b-5 since the 1940s. In contrast, the District Court "found it 'noteworthy' that in the over seventy years since the enactment of the Securities Exchange Act of 1934, 'no federal court has ever held that those who steal material nonpublic information and then trade on it violate § 10(b),' even though 'traditional theft (e.g. breaking into an investment bank and stealing documents) is hardly a new phenomenon, and involves similar elements for purposes of our analysis here.' Dorozhko, 606 F. Supp. 2d at 339."

In sum, this case was an attempt by the SEC to end run the fiduciary duty requirement applicable to nondisclosure cases. It's an end run around the basics of insider trading law. The Second Circuit aided and abetted it.

We won't. We'll treat this case as the insider trading case it really is.

I have long argued that the only coherent basis for imposing insider trading liability is protection of property rights in information. From a policy perspective, those who steal information ought to be liable for insider trading.

The trouble is that O’Hagan cannot be read to permit imposition of liability on such persons.

The misappropriation theory's origins are commonly traced to Chief Justice Burger's Chiarella dissent. Burger contended that the way in which the inside trader acquires the nonpublic information on which he trades could itself be a material circumstance that must be disclosed to the market before trading. Accordingly, he argued, "a person who has misappropriated nonpublic information has an absolute duty [to the persons with whom he trades] to disclose that information or to refrain from trading."

In O’Hagan, the court’s majority opinion grounded liability under the misappropriation theory on deception of the source of the information. As the majority interpreted the theory, it addresses the use of "confidential information for securities trading purposes, in breach of a duty owed to the source of the information." Under this theory, the majority explained, "a fiduciary's undisclosed, self-serving use of a principal's information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of that information." So defined, the majority held, the misappropriation theory satisfies § 10(b)'s requirement that there be a "deceptive device or contrivance" used "in connection with" a securities transaction.

The Supreme Court thus expressly declined to embrace Chief Justice Burger's argument in Chiarella that the misappropriation theory created a disclosure obligation running to those with whom the misappropriator trades. Instead, it is the failure to disclose one's intentions to the source of the information that constitutes the requisite disclosure violation under the O'Hagan version of the misappropriation theory.

In throwing out the SEC complaint, the District court—correctly, IMHO—held that “[T]he Supreme Court has in a number of opinions carefully established that the essential component of a § 10(b) violation is a breach of a fiduciary duty to disclose or abstain that coincides with a securities transaction.” This ruling is supported not only by the plain text of the relevant Supreme Court decisions, but also the Fifth Circuit’s opinion in Regents of the Univ. of Cal. v. Credit Suisse First Boston (USA), Inc., 482 F.3d 372, 389 (5th Cir. 2007) (holding that “the [Supreme] Court . . . has established that a device, such as a scheme, is not ‘deceptive’ unless it involves breach of some duty of candid disclosure”).

Leading commentary on the issue also supports the District Court’s conclusion, as the court explained it its opinion:

The SEC notes that, “While no case has addressed it, at least two academics has [sic] endorsed the theory that a hacker who steals material nonpublic information for the purpose of trading on it, violates Exchange Act § 10(b) and Rule 10b-5.” The SEC then cites Robert A. Prentice, The Internet and Its Challenges for the Future of Insider Trading Regulation, 12 Harv. J.L. & Tech, 263, 296-307 (Winter 1999), and Donald C. Langevoort, 18 Insider Trading Regulation, Enforcement and Prevention § 6:14 (Apr. 2007).

While these articles, among others, proclaim that those who ‘hack and trade’ should be liable under § 10(b), the clear majority of scholarly opinion is that, under existing law, ‘hacking and trading’ is not a violation of § 10(b). Professor Prentice's article is indicative. Professor Prentice's article contains a section entitled “Hackers as Misappropriators,” which makes a strong policy argument for why those who hack should be liable under 10b-5. The section, however, begins by acknowledging that under the current state of the law hackers are not liable. Prentice asks rhetorically, “Hackers who steal inside information and trade on it are essentially thieves. But are they also liable as inside traders? The answer to this question from a traditional point of view is ‘no.’ ” 12 Harv. J.L. & Tech. at 296. Prentice's argument as to liability for hackers, it turns out paragraphs later, stems not from precedent or a close reading of the statute, but from his own conviction as to what the law should be: “I find uncomfortable the received wisdom that someone who obtains inside information via hacking, physical breaking and entering, bribery, extortion, espionage, or similar means is not liable for insider trading.” Id. at 298.

Similarly, a couple of recent law review articles suggest that hackers should be, but are currently not liable under § 10(b) for ‘hacking and trading.’ For example, Kathleen Coles writes in The Dilemma of the Remote Tippee, 41 Gonz. L. Rev. 181, 221 (2005-2006):

“[A] computer hacker who breaches the computer security walls of a large publicly held corporation and extracts nonpublic information may also trade and tip without running afoul of the insider trading rules. The burglar and computer hacker may be liable for the conversion of nonpublic information under other laws, but the insider trading laws themselves appear not to prohibit the burglar or hacker from trading or tipping on the basis of the stolen information. This is because there was no breach of a duty of loyalty to traders under the classic theory or to the source *342 of the information under the misappropriation theory.”

41 Gonz. L. Rev at 221.

Also, Donna M. Nagy writes, in Reframing the Misappropriation Theory of Insider Trading Liability: A Post-O'Hagan Suggestion, 59 Ohio St. L.J. 1223, 1249-57 (1998): “[I]t is doubtful that securities trading by the computer hacker or the ‘mere’ thief would violate Section 10(b) and Rule 10b-5, because neither scenario would involve misappropriation through acts that would constitute affirmative deception.” 59 Ohio St. L.J. at 1255. Nagy is “troubled” by this, and argues that the current “restrictive” misappropriation theory, “will frustrate the prosecution of future cases involving trading on misappropriated information.” Id. at 1227. She illustrates with an example of a “computer hacker who unlawfully gains access to a corporation's internal network and subsequently manages to uncover confidential information.” Id. at 1253. She notes that, “Because the computer hacker was not entrusted with such access, Section 10(b) and Rule 10b-5 would not be violated under O'Hagan 's theory, even though the computer hacker would be trading securities on the basis of material, nonpublic information that had been misappropriated.” Id. To repair the lacuna, Nagy goes on to suggest a new version of the misappropriation theory, that is “premised on the ‘fraud on the investors.’ ” She believes her fraud on the investors approach “is far superior to the ‘fraud on the source’ version [of the misappropriation theory].”

I agree with these commentators that theft of information should be actionable under the insider trading laws, based on the property rights approach discussed above. But O’Hagan implicitly rejected the property rights approach in favor of a fiduciary duty-based approach. As I explained in Insider Trading Regulation: The Path Dependent Choice Between Property Rights And Securities Fraud:

The majority explained that its version of the misappropriation theory addressed the use of ‘confidential information for securities trading purposes, in breach of a duty owed to the source of the information.‘ Accordingly, ‘a fiduciary's undisclosed, self-serving use of a principal's information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of that information.‘ Someone thus can be held liable under this version of the misappropriation theory only where one deceived the source of the information by failing to disclose one's intent to trade on the basis of the information disclosed by the source. This requirement follows, the majority opined, from the statutory requirement that there be a ‘deceptive device or contrivance‘ used ‘in connection with‘ a securities transaction. The Supreme Court thus rejected Chief Justice Burger's argument in Chiarella that the misappropriation theory created a disclosure obligation, running to those with whom the misappropriator trades. Instead, failure to disclose one's intentions to the source of the information constitutes the requisite disclosure violation under the O'Hagan version of the misappropriation theory. 

The Second Circuit tried to finesse the issue by opining that “what is sufficient is not always what is necessary, and none of the Supreme Court opinions considered by the District Court require a fiduciary relationship as an element of an actionable securities claim under Section 10(b).” But this is, at best, shoddy.

O’Hagan, Dirks, and Chiarella all rest on the proposition that not all nondisclosures are securities fraud. All rest on a fiduciary duty or other relationship of trust and confidence. Indeed, the Second Circuit itself in US v. U.S. v. Chestman, 947 F.2d 551 (2d Cir. 1991), explained that:

… the fiduciary relationship question takes on special importance. This is because a fraud-on-the-source theory of liability extends the focus of Rule 10b-5 beyond the confined sphere of fiduciary/shareholder relations to fiduciary breaches of any sort, a particularly broad expansion of 10b-5 liability if the add-on, a “similar relationship of trust and confidence,” is construed liberally. One concern triggered by this broadened inquiry is that fiduciary duties are circumscribed with some clarity in the context of shareholder relations but lack definition in other contexts. Tethered to the field of shareholder relations, fiduciary obligations arise within a narrow, principled sphere. The existence of fiduciary duties in other common law settings, however, is anything but clear. Our Rule 10b-5 precedents under the misappropriation theory, moreover, provide little guidance with respect to the question of fiduciary breach, because they involved egregious fiduciary breaches arising solely in the context of employer/employee associations. For these reasons we tread cautiously in extending the misappropriation theory to new relationships, lest our efforts to construe Rule 10b-5 lose method and predictability, taking over “the whole corporate universe.”

So much for treading cautiously. After Dorozhko, 10b-5 will take over the corporate universe.

If a law student had written the Dorozhko, I’d give him a D (and only because I never ever fail anybody). It is not an interpretation of O’Hagan. It is the creation of an entirely new version of misappropriation liability., carved out of whole cloth and without any regard for precedent. It may be right on policy, but isn’t that for the Supreme Court to decide.

Shoddy is the only word for it.

WSJ Law Blog Blows Cuban Case

At the WSJ's law blog, Wayne State law professor Peter Henning offers up a post on the recent Cuban and Dorozhko insider trading cases.

He gets the Cuban case wrong, IMHO.

Henning writes:

In SEC v. Mark Cuban, a district court recently dismissed the SEC’s case against the outspoken owner of the Dallas Mavericks. The SEC had charged Cuban for selling his shares in a tech company before the public announcement of a PIPE (private investment in public equity) deal that drove down the value of his shares. Cuban, who knew about the deal, avoided losing over $750,000 by selling when he did.

But the judge in the case decided Cuban didn’t have a fiduciary duty to the tech company, even though Cuban had been given information that he promised to keep confidential prior to his selling his shares. No fiduciary duty, no insider-trading case. ...

In the Cuban case, the SEC invoked Rule 10b5-2, which defines a “duty of trust and confidence” as arising whenever “a person agrees to maintain information in confidence.” But this didn’t fly, chiefly because such a duty is not a fiduciary duty. Insider trading is not about proving someone’s untrue to his word. Rather, it is fraud based on a deception when one owes a duty to another entity not to trade on nonpublic information. Without the duty there is no fraud.

Henning's reading of the case is not supported by the plain text of the opinion.

At pages 14-15, for example, the Cuban court's opinion states that the court "rejects Cuban’s contention that liability under the misappropriation theory depends on the existence of a preexisting fiduciary or fiduciary-like relationship." Footnote 5 on page 19 likewise states that:

The court disagrees with Cuban’s assertion that, in O’Hagan, “[t]he Court [drew] a clear distinction between fiduciaries and non-fiduciaries because only a fiduciary would have a duty to make this disclosure and therefore can be said to have engaged in a ‘deception’ if he does not disclose or abstain from trading.” Although O’Hagan is written in terms of fiduciaries and fiduciary relationships, duties, and obligations, it is reasonable to infer that this is because O’Hagan was a criminal case that involved the conduct of a fiduciary. ... The Court may simply have intended that its opinion decide the case without injecting dicta to cover other circumstances in which the misappropriation theory could apply. But regardless of the reason, there is no indication in O’Hagan that such a fiduciary or fiduciary-like relationship is necessary——as opposed to merely sufficient——to impose the requisite duty, or iessential element of the misappropriation theory.

In other words, you can have liability under the misappropriation theory without having a fiduciary duty. Indeed, as the court stated at 20: "The court therefore concludes that a duty sufficient to support liability under the misappropriation theory can arise by agreement absent a preexisting fiduciary or fiduciary-like relationship." The court tossed the Cuban case not for the reasons Henning suggests, but rather because the SEC had pled the wrong kind of an agreement:

Where misappropriation theory liability is predicated on an agreement, however, a person must undertake, either expressly or implicitly, both obligations. He must agree to maintain the confidentiality of the information and not to trade on or otherwise use it.

The SEC had pled only the former, so the court tossed the case with leave to replead if the SEC believes it can show the correct agreement. In sum, I don't like it, but the Cuban opinion clearly does not stand for the proposition that "No fiduciary duty, no insider-trading case."

Who's nuttier?

The birthers or the people fixated on whether Trig was really Palin's kid? As far as I'm concerned, it's half dozen of one, six of the other.

Director Liability for Risk Management

Enterprise risk management is the process by which a business organization anticipates, prevents, and responds to uncertainties associated with the organization’s strategic objectives. It is well accepted that systemic risk management failures by major corporations, especially but not limited to financial institutions, was a root cause of the financial crisis of 2008. Boards of directors and corporate managers failed adequately to identify, prevent, prepare for, and respond to the numerous risks the faced the financial system in the years prior to the crisis.

Given that the stock market lost $6.9 trillion in 2008, shareholder losses attributable to absent or poorly implemented risk management programs likely are enormous. Will shareholders be able to recoup some of those losses by suing boards of directors of companies with lax risk management programs? In my article, Caremark and Enterprise Risk Management, 34 J. Corp. L. 967 (2009), I argued that the business judgment rule generally should insulate directors from such claims.

The risks corporations face can be broadly categorized as operational, market, and credit. Operational risk encompasses such concerns as inadequate internal controls, faulty accounting systems, management failure, fraud, and human error. Market risks are those associated with potential changes in firm valuation linked to asset performance. Credit risk is defined as the possibility that a change in the credit quality of a counterparty will affect the firm’s value. All three types of risk played important parts in the financial crisis.

To be sure, some argue that even top risk managers could not have anticipated the financial crisis that struck in 2008. Risks fall into three broad categories: known problems, known unknowns, and unknown unknowns. As the argument goes, the financial crisis was an unknown unknown, which by definition was unpredictable and therefore could not be managed.

In fact, however, there were warning signs of an approaching crisis in the housing market, including rapidly accelerating home prices that had characteristics of a classic asset bubble, which was fueled in large part by easy mortgage terms combined with lax credit standards. It should not have taken a savant to foresee the risks the housing bubble posed for the financial services industry and then the economy as a whole.

Admittedly, evaluating extremely low probability but very high magnitude risks is challenging because the outcomes associated with such risks do not follow a normal distribution. As a result, quantifying the probability and magnitude of such risks poses an extreme problem for risk managers. Yet, as the financial crisis proved, it is simply unacceptable for firms to dismiss such risks as being unmanageable. We must learn how to do better. Having said that, however, I hasten to add that liability to shareholders is an inappropriate tool for incentivizing director to do better.

Just because a firm has the ability to reduce risk does not mean that it should exercise that option. As the firm’s residual claimants, shareholders do not get a return on their investment until all other claims on the corporation have been satisfied. All else equal, shareholders therefore prefer high return projects. Because risk and return are directly proportional, however, implementing that preference necessarily entails choosing risky projects.

Even though conventional finance theory assumes shareholders are risk averse, rational shareholders still will have a high tolerance for risky corporate projects. This is so because the basic corporate law principle of limited liability substantially insulates shareholders from the downside risks of corporate activity. The limited liability doctrine, of course, states that shareholders of a corporation may not be held personally liable for debts incurred or torts committed by the firm. Because shareholders thus do not put their personal assets at jeopardy, other than the amount initially invested, they effectively externalize some portion of the business’ total risk exposure to creditors.

Accordingly, as Chancellor Allen explained in Gagliardi v. Trifoods Int’l, Inc., 683 A.2d 1049 (Del. Ch. 1996), shareholders will want managers and directors to take risk:

Shareholders can diversify the risks of their corporate investments. Thus, it is in their economic interest for the corporation to accept in rank order all positive net present value investment projects available to the corporation, starting with the highest risk adjusted rate of return first. Shareholders don’t want (or shouldn’t rationally want) directors to be risk averse. Shareholders’ investment interests, across the full range of their diversifiable equity investments, will be maximized if corporate directors and managers honestly assess risk and reward and accept for the corporation the highest risk adjusted returns available that are above the firm’s cost of capital.

Id. at 1052. In turn, the business judgment rule encourages directors to take appropriate risks by insulating them from the danger of being held liable if such a decision turns out badly. Put simply, it eliminates the possibility that hindsight bias will color judicial review of board decisions.

Shareholder litigation alleging that a board failed adequately to manage risk raises precisely the same concerns as shareholder litigation challenging the riskiness of a board decision. Risk management necessarily overlaps with risk taking because the former entails making choices about how to select the optimal level of risk to maximize firm value. In general, firms have four tools for managing risk: (1) transferring risk to third parties through hedging and insurance, (2) avoiding risk by choosing to refrain from certain business activities, (3) mitigating operational risk through preventive and responsive control measures, and (4) accepting that certain risks are necessary to generate the appropriate level of return. All of these overlap with risk taking. Operational risk management, for example, frequently entails making decisions about whether to engage in risky lines of business and, more generally, determining whether specific risks can be justified on a cost-benefit analysis basis. As a result, it is becoming increasingly difficult to draw a meaningful distinction between the ordinary corporate governance decisions protected by the business judgment rule and risk management. The business judgment rule therefore should protect the latter, just as it does the former.

Rethinking health care reform

If the CBO's right, and a core aspect of Obamacare isn't going to save any money over the next 10 years, why not scrap comprehensive reform and start over with something modest designed to help people who can't afford health insurance buy it? Expand health savings plans. Tax credits for persons of modest income who buy insurance. Portability. And leave the rest alone.

BBQ Ribs for 4 on the Gas Grill

Dry Rub

• 2 cups brown sugar
• 1/3 cup dry Colman's mustard 
• 1 tablespoon chili powder 
• 1 tablespoon cayenne pepper 
• 1 tablespoon paprika 
• 1 tablespoon Old Bay seasoning 
• 1 tablespoon ground white pepper
• 1 tablespoon kosher salt 
• 1 tablespoon onion powder 
• 1 tablespoon garlic powder 
• 2 teaspoons dried thyme 
• 2 teaspoons dried oregano 

2 slabs (about 1.75 lbs each) Kansas City style pork spare ribs.

Combine dry ingredients. Rub onto all sides of pork ribs. Put ribs in a 3.5 gallon plastic zip top bag. Stick the bag in the refrigerator and allow ribs to marinate overnight.

Soak several big handfuls of wood chips in water for about 45 minutes. Drain. Make an aluminum foil pouch to hold chips (see directions). In addition to the soaked chips, put a handful of dry chips and a cup of wood dust in the pouch. Put the pouch on the Flavorizer bars over the rear burner of your Weber Gas Grill. (A few years back, I invested in having a natural gas line run from the main household supply back to my deck and bought a Weber Genesis® S-320 natural gas grill, so that I could stop schleping to the hardware store to replace propane tanks. Not worrying about running out of gas in the middle of a long cook like this one is great.)

Light the grill and run it on full until you start getting smoke from the wood chips.

Take the ribs out of the refrigerator and transfer from plastic bag to a large, clean cutting board. Use paper towels to mop up any liquid and to wipe off excess rub. Put ribs, concave side down, in a large, disposable aluminum roasting pan and loosely tent with aluminum foil. Put roasting pan on grill, as close to the front as possible.

Turn off the front and middle burners. Turn the back burner down to its lowest setting. This should eventually maintain a stable temperature of about 250 degrees, but I like to start the process with the grill at maximum temperature. It sears the meat and helps promote good smoke.

Cook ribs 5 hours at 250 degrees. 

Remove roasting pan from grill. Turn rear burner up to full. Put rib slabs on grill, towards the front (you still want indirect heat), concave side down. Slather rib slab side facing you with your favorite BBQ sauce. (I prefer Stubbs; Helen prefers KC Masterpiece. I went with her fave tonight.) Cook 10 minutes. Turn ribs. Slather the conave side now facing you with sauce. Cook 10 minutes. Watch for flare-ups.

Remove ribs from grill, putting them on a large cutting board. Tent loosely with foil and allow to rest 10-15 minutes. Cut into individual servings and serve.

Coleslaw and corn bread are my favorite accompaniments.

What to drink? Some would say iced tea. Some would say beer. I say Sparkling Shiraz.

Shareholder Activism in the Obama Era

My paper, Shareholder Activism in the Obama Era, is now available to be downloaded from SSRN.

Abstract: The financial crisis of 2008 and the ascendancy of the Democratic Party in Washington have created an environment in which proponents of expanded shareholder corporate governance rights are making considerable progress. Even before the crisis hit, of course, there had been a number of efforts to extend the shareholder franchise, principally so as to empower institutional investors. The crisis, however, has given them new momentum.

The logic behind the shareholder empowerment project 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.

Keywords: corporate governance, corporation law, shareholders, voting rights, institutional investors

JEL Classifications: K22

Download here.

Kill UC Irvine Law

The University of California's budget problems are well documented. The system has to cut $813 million. The administration and Regents have decided to do so by a draconian combination of faculty and staff furloughs, programs cuts, and so. 

A group of UC San Diego department chairs had a radical alternative:

Every state system of public education save California manages to sustain (at best) one flagship campus. Many, including such states as New York, New Jersey, and Massachusetts, do not manage even that. We pretend we have ten such campuses. In better times, there were in reality four flagships (Berkeley, UCLA, UCSD, and – in its highly specialized way, UCSF). Rather than destroying the distinctiveness and excellence at Berkeley, UCLA, and UCSD by hiring temporary lecturers to do most of the teaching (and contribute nothing to original research, nothing to our reputation, nothing to the engine of economic growth a first rate research university represents), we propose that you urge the President and Regents to acknowledge that UCSC, UCR, and UC Merced are in substantial measure teaching institutions (with some exceptions – programs that have genuinely achieved national and international excellence and thus deserve separate treatment), whose funding levels and budgets should be reorganized to match that reality.

We suggest, more generally, that in discussions systemwide, you drop the pretense that all campuses are equal, and argue for a selective reallocation of funds to preserve excellence, not the current disastrous blunderbuss policy of even, across the board cuts. Or, if that is too hard, we suggest that what ought to be done is to shut one or more of these campuses down, in whole or in part. We have suffered more than a 30 per cent cut in our funding from the state, and we can thus no longer afford to be a ten campus system – only a nine, or an eight (and a half) campus system. Corporations faced with similar problems eliminate or sell off their least profitable, least promising divisions. Even General Motors, which for decades resisted this logic, to its near‐fatal cost, is lopping off Hummer, Buick, GMC, Opel, Saab and who knows what else.

If closing campuses makes sense, and I think it does for the reasons they identified, why not consider closing schools? Or, perhaps, not letting new ones open?

I have in mind an obvious target: the new law school at UC Irvine. 

The California  Postsecondary Education Commission did an exhaustive review of the proposal to open the UCI law school. They concluded that a law school at Irvine was not necessary because: 

1. The occupational and industry projections of the California Labor Market Information Division indicate that the current growth in the number of Bar-certified lawyers will keep pace with or exceed legal demand between now and 2014.
2. The State’s knowledge needs in the domain of legal education can be met by existing public and independent law schools.
3. The projected public costs are questionable because the need for a new public law school has not been demonstrated by the evidence contained in the proposal.

Unfortunately, the proposal was nevertheless approved back in 2006 by the regents and the legislature. Former UC Regent Velma Montoya slammed the decision, and rightly so:

UCSB's success demonstrates that Irvine law school proponents, such as Joan Irvine Smith, are simply wrong in believing that Irvine must "have a law school in addition to medical, business, and engineering schools in order for the campus to advance as a major university." And Irvine Chancellor Michael Drake is wrong in diverting scarce student enrollment growth funds to hire a law school dean to add graduates specializing in public interest law. California does not face a shortage of public interest lawyers. Indeed, notable public law interest offices have closed their doors.
Drake is mistaken in drawing an analogy between medically underserved Latino populations and the market for lawyers. And Drake is wrong to lead the Irvine campus down the slippery slope of entering the "arms race" to hire "star" faculty lawyers so as to raise the proposed law school's prestige.
With state revenue estimates falling by the day, the Regents would be wise to encourage the Irvine campus to address current problems rather than spend precious enrollment growth funds on a law school the California Postsecondary Education Commission finds unnecessary—because California has no shortage of lawyers.

In 2006, California did not need a fifth public law school. We certainly didn't need one in Irvine, when much of the growth in UC admissions is in places like Riverside.

Today, with state revenues having plummeted faster and further than Regent Montoya might have expected, we simply can't afford Irvine's law school. Odds are, with the California economy doing even worse than the nation as a whole, we have even less need for extra lawyers than we did when the Commission rejected the Irvine proposal back in 2006.

I'm firmly convinced that UC Berkeley and UCLA will come out of the current troubles in excellent shape. We have great alumni whose support continues to grow despite the economy.

But I see no reason for the state to spend a dime on Irvine. Kill it now and put the money to better use, such as helping reverse some of the cuts to undergraduate education.

The Kindle DRM Kerfuffle: A Case Book Author's Perspective

Ashby Jones:

Do we as consumers ever really own the digital stuff — books, music, etc. — that we think we’re buying?

It’s a provocative question explored in an article Thursday by the WSJ’s Geoffrey Fowler. The issue came up last week when Amazon.com reached into customers’ Kindle e-readers and deleted some e-books written — ironically — by George Orwell. Amazon, which returned the cost of the e-books, said it made the move when it realized that the publisher didn’t have the proper rights to sell the books in the U.S. ...

... according to Fowler, the incident raises some difficult questions about what it means to “own” books in the digital age. Some experts are saying that these matters might best be remedied by passing new laws that clearly define digital ownership.

“What this incident shows is that the law gives radically more control to the company than the system ought to,” says Harvard’s Lawrence Lessig.

Thing is, writes Fowler, owning an e-book is more akin to licensing a piece of software than it is to owning a bound volume: access comes with fine-print terms of service, and often digital rights management software to ensure that you abide by the rules. ...

Another difference: Real books can be shared with a friend or sold, but e-books with digital rights management software cannot. The number of devices that can play a single e-book license varies from one publisher to the next, and often confuses consumers.

Looking at the problem from the perspective of an author who royalties are a very large percentage of his annual income and an avid Kindle user, I'm totally okay with the the differences between real books and e-books. As it is, the used book market takes a huge chunk out of my annual royalties. The drop off from the first year of a new edition to the second can be as high as 30%, for example.

I can't imagine the hit my royalties would take if e-books of my texts were available without strong DRM. But it seems safe to assume that anything remotely resembling an e-book Napster would be a disaster from my perspective. My assumption is that it would make the hit we currently take from the used book market look like chicken feed. The enormous amount of time and effort put into writing and updating the books simply would no longer be worth it.

From an author's perspective, the differences between an e-book and real book thus are very large and very real. Contra Lessig, I worry that Kindle and its forthcoming ilk don't give copyright holders enough control.

More on the Mark Cuban Insider Trading Case

I blogged recently on the district court decision tossing the SEC's insider trading case Dallas Mavericks' owner Mark Cuban. As one of the amici who filed a brief in support of Cuban, I was disappointed that the court did not accept our argument that the requisite relationship of trust and confidence that is a core element of the insider trading prohibition did not require a fiduciary relationship. Although the court (wrongly, IMHO) held that a contractual duty sufficed, the court (correctly, IMHO) held that such a duty had to go beyond one of mere confidentiality and include an express obligation not to use the information.

Now our friend Larry Ribstein weighs in on the case, observing in part that:

I question the Court's interpretation of the O'Hagan case.  First, since the O'Hagan duty is based on deception of the owner of the information, arguably a lie to the owner about the intent to keep the information confidential should be enough.
Second, nobody's really talking about a bona fide fiduciaryrelationship.  As I discussed in my Are Partners Fiduciaries, 2005 Illinois Law Review 209, a fiduciary duty is a duty of unselfishness that arises from delegation of control, not merely an expectation of confidentiality arising from a promise or relationship. 
Third, even if the promise is only confidentiality rather than specifically non-use, it may be possible to argue that trading alone outed the information and therefore breached confidentiality. Ironically, this invokes the efficiency-based theory against insider trading liability -- that it informs the market.
Finally, I would not that there's a significant practical difference between the amici's argument and the one the court accepted in Cuban's case.  The SEC need now only show that the agreement Cuban made implied non-use.  This may not be easy, but I submit it would have been much harder for the SEC to show a fiduciary-type duty.

Points all well taken.

The Harvard corporate governance blog offers some practical advice:

What does this decision mean for potential providers and recipients of material nonpublic information?
For providers—for example, companies interested in sharing information with potential investors or acquirers—the case says that if you want the recipient not to trade, you had better be specific. The safest approach, of course, is to seek a written contractual standstill from recipients. But agreements of this sort are often difficult to get parties to agree to, especially where, as in this case, the recipient would be asked to sign the agreement “blind”, without knowing the nature of the information. As a practical matter, providers may have to content themselves with a “sole use” provision, along the lines of “recipient agrees to use the information solely for the purpose of considering an investment”. Had such a provision been in place, the result in this case might well have been different.
For recipients of material nonpublic information, our advice is not to rely on this decision. The case was decided at the trial court level, is not binding on other courts, and the SEC has been given the right to file an amended complaint. Whether or not the SEC chooses to replead the case or to appeal the decision, we are certain that it will not accept the case as the final word and will continue to seek enforcement action on facts like these. Thus, while the decision will provide comfort to parties who have to defend themselves for what they have done, we would not use it as a basis for deciding what you should do. The prudent judgment continues to be that if you have agreed to keep information confidential, you should not use it as a basis for trading.

Say on Pay Losing Steam?

Investor Marc Hodak reports:

My firm plows through hundreds of proxies each year in order to determine the relative quality of compensation plans for our research purposes.  We employ a team in India to get the data, and a couple of analysts in New York to plow through the data for a couple of months in order to reach opinions about specific firms.  We’re down to doing this every other year because the effort is so costly, and the quality of plans don’t really change that much from year to year for any given firm.
Some shareholder activists have gotten a taste of this tonic, and have come to a conclusion of their own:

Some shareholders say they have already gotten a taste of say on pay voting and find it unwieldy and time-consuming.  The United Brotherhood of Carpenters, whose pension funds have about $40 billion in assets, says it cast more than 200 say-on-pay votes this year at companies participating in the government’s Troubled Asset Relief Program.  These companies needed to get their pay plans ratified by shareholders…
“We think less is more,” said Edward Durkin, the union’s corporate affairs director. “Fewer votes and less often would allow us to put more resources toward intelligent analysis.”

Unfortunately, they’re making this case to congressmen who don’t even read the lawsthat they pass.

Somebody tell Lucian Bebchuk ASAP.

Dear Pres. Obama: You have to endogenize government

In an op-ed on the Obama administration's proposed Consumer Financial Protection Agency Act of 2009, Richard Posner makes some important points about libertarian paternalists like Richard Thaler (and, although he's not mentioned. Cass Sunstein):

Mr. Thaler, whose views are taken seriously by the Obama administration, calls himself a “libertarian paternalist.” But that is an oxymoron. He is a paternalist with a velvet glove—as the agency will be. Through the use of carrot and stick, the agency will steer consumers to those financial products that it thinks best for them, whatever they naïvely think.

Posner notes that Thaler's views are based on behavioral economics, which, drawing on experimental economics and cognitive psychology, asserts that one can identify systematic departures from rational decisionmaking, even in market settings. (It's worth noting that Obama regulatory guru Cass Sunstein is a big believer in behavioral economics.) Posner concludes:

Behavioral economists are right to point to the limitations of human cognition. But if they have the same cognitive limitations as consumers, should they be designing systems of consumer protection?

I'm more of a fan of behavioral economics than is Posner. I've acknowledged its usefulness and made use of its insights where appropriate. But I also agree with Posner that behavioral economics has important limitations as a regulatory tool. In my article, Mandatory Disclosure: A Behavioral Analysis, 68 University of Cincinnati Law Review 1023 (2000), I argued that:

In addition to the standard prudential arguments in favor of limited government, which counsel caution in concluding that a purported market failure requires government correction, behavioral economics itself argues against presuming the desirability of intervention:

Proposals designed to address biases generally entail the intervention of judges, legislators, or bureaucrats who are [themselves] subject to various biases. The very power of the behavioralist critique—that even educated people exhibit certain biases—thus undercuts efforts to redress such biases. In addition, the decisions of government actors also may be adversely influenced by political concerns—specifically interest group politics. Thus interventions to “cure” bias-induced inefficiency may ultimately produce outcomes that are worse than the problem itself.

In other words, the claim that law can correct market failures caused by decisionmaking biases or cognitive errors treats regulators as exogenous to the system. Once the state is endogenized, however, regulators must be treated as actors with their own systematic decisionmaking biases. It thus becomes evident that behavioral economics loops back on itself as a justification for legal intervention.

So far, I see no evidence that the Obama administration is even remotely cognizant of the need to endogenize the government.