ProfessorBainbridge.com

Ribstein Rising

Larry Ribstein's The Rise of the Uncorporation is now available at Amazon, where we are told that:

The Rise of the Uncorporation covers the history, law, and finance of unincorporated firms. These "uncorporations" including general and limited partnerships and limited liability companies, are now the dominant business form of non-publicly-traded firms. Through private equity and publicly traded partnerships, uncorporations have emerged as a significant force in the governance of a wide range of the biggest firms. This is the first general theoretical and practical overview of alternatives to incorporation, including ancillary concepts connected with the evolution of these firms, and analysis of likely future trends in business organization. The Rise of the Uncorporation provides a clear and easily understandable theoretical and practical background to this important subject.

I'm looking forward to reading it, as Larry's many articles on this topic are canonical foundations of our understanding of the uncorporation (BTW, I hate that word...it reminds me of 7-Up's stupid Uncola ads).

Protecting the trial lawyers

God knows how health care "reform" will pan out. But are we surprised to learn that trial lawyers already got a handout? BigGovernment:

The health care bill recently unveiled by Speaker Nancy Pelosi is over 1,900 pages for a reason. It is much easier to dispense goodies to favored interest groups if they are surrounded by a lot of legislative legalese. For example, check out this juicy morsel to the trial lawyers (page 1431-1433 of the bill):

Section 2531, entitled “Medical Liability Alternatives,” establishes an incentive program for states to adopt and implement alternatives to medical liability litigation. [But]…… a state is not eligible for the incentive payments if that state puts a law on the books that limits attorneys’ fees or imposes caps on damages.

So, you can’t try to seek alternatives to lawsuits if you’ve actually done something to implement alternatives to lawsuits. Brilliant! The trial lawyers must be very happy today!

As Ted Frank explains: "In other words, Congress is providing a financial incentive [for states] to uncap damages. Marvelous."

I'm a Law Professor, not a Smoking Cop

Unbelievable:

Faculty members at Widener University School of Law will have a new role to play next academic year: smoking police. 

They won't have matching uniforms or extensive training. They will be armed with small cards that detail the school's impending ban on smoking or using tobacco products anywhere on campus, indoors and outdoors. If that's not enough to keep people from lighting up on campus, repeat offenders might be fined, said Linda L. Ammons, the law school's dean. 

I, for one, didn't join the legal academy to police other people's lifestyle choices. There are enough health and safety kill-joys in the world already.

I think I'll find a nice, sunny spot on campus and light up a cigar this afternoon.

Kudos to Henderson

Our friend Todd Henderson has just received the Federalist Society's 2010 Paul M. Bator Award:

The Federalist Society for Law and Public Policy Studies established the Bator Award in memory of Paul M. Bator, who had been a professor at the University of Chicago Law School and Harvard Law School. Each year, the award is given to a young academic (under 40) who embodies Bator’s excellence in legal scholarship, commitment to teaching and concern for students, and who has made a significant public impact.

“He fits all the criteria well. He already is a first-rate scholar,” said Eugene Meyer, President of the Federalist Society. “We have senior and highly talented academics on the selection committee and they were impressed with his scholarship, and he has been very helpful to students in a variety of ways.” It also was well-noted that Henderson served in the military, Meyer added.

It's great to see the award go to a business law scholar and, especially, to one as fine as Todd. Congratulations!

Is the Pay Czar Unconstitutional?

We corporate and securities law types rarely get to play in the rarified air of The Constitution, so we are awaiting eagerly the Supreme Court's decision in Free Enterprise Fund v PCAOB, in which the argument is whether the provisions of Sarbanes-Oxley governing the selection of members of the Public Company Accounting Oversight Board violate the Appointments Clause of the US Constitution. (I have argued that it does.) 

Law professor (and former federal judge) Michael McConnell argues in today's WSJ that Kenneth Feinberg's position as TARP "pay czar" likewise violates the Appointments Clause:

The Appointments clause of the Constitution, Article II, section 2, provides that all "Officers of the United States" must be appointed by the president "by and with the Advice and Consent of the Senate." This means subject to confirmation, except that "the Congress may by Law vest the Appointment" of "inferior Officers, as they think proper, in the President alone, in the Courts of Law, or in the Heads of Departments."

There is no doubt that Mr. Feinberg is an "officer" of the United States. The Supreme Court has defined this term (Buckley v. Valeo, 1976) as "any appointee exercising significant authority pursuant to the laws of the United States." Mr. Feinberg signed last week's orders setting pay levels for executives at Bank of America, AIG, Chrysler Financial, Citigroup, GMAC, General Motors and Chrysler. They have the force of law and are surely an exercise of "significant authority" pursuant to an Act of Congress. He is not a mere "employee," acting at the direction of a superior. That means his office is subject to the requirements of the Appointments Clause.

While somewhat more disputable, Mr. Feinberg's is probably an "inferior" officer, defined as one subject to supervision and removal by a member of the cabinet. Although he has substantial discretion and independence, Mr. Feinberg reports to the secretary of the Treasury, who can fire him any time for any reason. This means that Congress could, if it wished, vest the appointment of the pay czar in the secretary, without any need for Senate confirmation.

But Congress has not done so. On the contrary, it vested the authority to implement TARP's compensation provision in the secretary of the Treasury. The secretary may sub-delegate that power to someone else—but that someone must be an "officer" properly appointed "by and with the advice and consent of the Senate."

The Supreme Court observed in Buckley v. Valeo that the provisions governing appointments under the Constitution reflect more than "etiquette or protocol." They embody the Founders' conviction that all power under U.S. laws must be exercised by officers with constitutional authority.

The Founders understood that the president and heads of the executive departments could not single-handedly carry out the law, so they required Senate confirmation as what the Federalist Papers call "an excellent check" on abuse or favoritism by the president. Yes, there are some offices so inferior that this check may be eliminated—but it is for Congress to judge which ones these may be. Congress and Congress alone has power to dispense with the safeguard of the confirmation process.

The power to set compensation at large American businesses is especially subject to potential abuse, favoritism, arbitrariness, or political manipulation. It is no reflection on Kenneth Feinberg, who has a sterling reputation and who appears to have approached these sensitive duties with a spirit of commendable integrity, to say that the checks and balances of the Constitution should be scrupulously observed. They were not. Because he is not a properly appointed officer of the United States, Mr. Feinberg's executive compensation decisions were unconstitutional.

The Coming Flood of Regulation

Larry Cunningham offers a roundup of the coming flood of financial services regulation.

Barney Frank: "We Are Trying On Every Front To Increase The Role Of Government"

If it is true that the nine most terrifying words in the English language are, "I'm from the government and I'm here to help," as I believe to be the case, this Barney Frank quote is a close second:

The Need to Define Insider Trading

Gordon Crovitz in the WSJ argues:

Rather than the end of the story, however, the Galleon case is just the latest chapter in a drama about the proper role of information in driving markets. In a world where accurate information is usually considered an unambiguously good thing, the U.S. regulatory view has become that too much information is a bad thing. ...

Information flows these days are increasingly about networks, including information about markets shared by members of various communities. Traders use Web sites to compare notes on companies and use social media like Facebook to share information, looking for an edge. Sophisticated traders such as hedge funds draw on more selected networks such as their investors. As these networks expand, including online, it will become harder to know whether market-moving information originated improperly through an insider's breach or properly through gathering of information in other ways.

Or as one banker put it last week, "The hedge fund guys all have their windows open and one leg over the ledge," wondering if they also violated the insider-trading laws, even unintentionally. This uncertainty has its costs. In one of the few insider-trading cases decided by the Supreme Court, the focus was on the need for aggressive research. In Dirks v. Securities and Exchange Commission (1983), Justice Lewis Powell wrote that imposing insider-trading liability "solely because a person knowingly receives material nonpublic information from an insider and trades on it could have an inhibiting influence on the role of market analysts."

Stephen Bainbridge, a UCLA law professor, described on his blog this growing conflict between the need for more information to make markets more efficient and prices more accurate versus a regulatory focus on equal access to information. "The SEC has always wanted a rule of equality of access: If you have more information than anybody else, you can't trade." The issue: "Can the SEC prove not just that Rajaratnam had better access to information than the market generally, but that he got that information by being a participant after the fact in the tipper's breach of fiduciary duty?"

Until recently, the vagueness of the insider-trading laws were more of an academic topic than a core issue for how markets operate day to day. In today's world of immediate, global flows of information, markets need greater clarity about how information can be gathered and used. The lesson so far is that knowing when insiders violate their duty is easier than knowing when outsiders go too far in bringing accurate information to markets.

Today is Called the Feast of Crispin

Sloppy Reporting at The Economist

In a piece on the Galleon hedge fund insider trading case, The Economist's lead begins:

MILTON FRIEDMAN argued for legalising insider trading on the grounds that it benefited all investors by quickly disseminating new information. These days such leave-it-to-the-market views are unfashionable.

In those two short sentences, there are three serious errors. First, As I explain in my book Securities Law: Insider Trading (Turning Point Series), it was Henry Manne who pioneered the information-related argument for legalizing insider trading. Friedman came along much later. So while it's true that Friedman eventually "argued for legalising insider trading," priority should go to Manne.

Second, the argument is not that insider trading promoted market efficiency "quickly disseminat[es] new information." As I explain in my book, the argument is that "insider trading acts as a replacement for public disclosure of the information, preserving market gains of correct pricing while permitting the corporation to retain the benefits of nondisclosure." In other words, insider trading does not disseminate information. Instead, it's impact on the market makes prices more efficient by causing the market to impound the value of information that nevertheless remains nonpublic. (The argument is wrong, but that's beside the point.)

Third, the point is not to "leave it to the market." The argument is not that the market can regulate insider trading. (Although some have made that argument on other grounds.) The argument is that insider trading makes markets more efficient.

Pretty sloppy.

Learning to Love Insider Trading? Let's Not

In today's WSJ, George Mason economics professor Donald Boudreaux proposed that we ought to be "learning to love insider trading":

Prohibitions on insider trading prevent the market from adjusting as quickly as possible to changes in the demand for, and supply of, corporate assets. The result is prices that lie.

And when prices lie, market participants are misled into behaving in ways that harm not only themselves but also the economy writ large. ...

In short, overall economic efficiency is reduced.

It's in the public interest, therefore, that prices adjust as quickly and as completely as possible to underlying economic realities—that prices adjust to convey to market participants as clearly as possible the true state of those realities.

As argued forcefully by Henry Manne in his 1966 book "Insider Trading and the Stock Market," prohibitions on insider trading prevent asset prices from adjusting in this way. Mr. Manne, dean emeritus at George Mason University School of Law, pointed out that when insiders trade on their nonpublic, nonproprietary information, they cause asset prices to reflect that information sooner than otherwise and therefore prompt other market participants to make better decisions.

Nope. Insider trading simply does not have the effects Boudreaux ascribes to it. In my book, Securities Law: Insider Trading (Turning Point Series), I explain that:

Basic economic theory tells us that the value of a share of stock is simply the present discounted value of the stream of dividends that will be paid on the stock in the future. Because the future is uncertain, however, the amount of future dividends, if any, cannot be known. In an efficient capital market, a security’s current price thus is simply the consensus guess of investors as to the issuing corporation’s future prospects. The “correct” price of a security is that which would be set by the market if all information relating to the security had been publicly disclosed. Because the market cannot value nonpublic information and because corporations (or outsiders) frequently possess material information that has not been made public, however, market prices often deviate from the “correct” price. Indeed, if it were not for this sort of mispricing, insider trading would not be profitable.

No one seriously disputes that both firms and society benefit from accurate pricing of securities. Accurate pricing benefits society by improving the economy’s allocation of capital investment and by decreasing the volatility of security prices. This dampening of price fluctuations decreases the likelihood of individual windfall gains and increases the attractiveness of investing in securities for risk-averse investors. The individual corporation also benefits from accurate pricing of its securities through reduced investor uncertainty and improved monitoring of management’s effectiveness.

Although U.S. securities laws purportedly encourage accurate pricing by requiring disclosure of corporate information, they do not require the disclosure of all material information. Where disclosure would interfere with legitimate business transactions, disclosure by the corporation is usually not required unless the firm is dealing in its own securities at the time.

When a firm withholds material information, its securities are no longer accurately priced by the market. In Texas Gulf Sulphur, when the ore deposit was discovered, TGS common stock sold for approximately eighteen dollars per share. By the time the discovery was disclosed, four months later, the price had risen to over thirty-one dollars per share. One month after disclosure, the stock was selling for approximately fifty-eight dollars per share. The difficulty, of course, is that TGS had gone to considerable expense to identify potential areas for mineral exploration and to conduct the initial search. Suppose TGS was required to disclose the ore strike as soon as the initial assay results came back. What would have happened? Landowners would have demanded a higher price for the mineral rights. Worse yet, competitors could have come into the area and bid against TGS for the mineral rights. In economic terms, these competitors would “free ride” on TGS’s efforts. TGS will not earn a profit on the ore deposit until it has extracted enough ore to pay for its exploration costs. Because competitors will not have to incur any of the search costs TGS had incurred to find the ore deposit, they will have a higher profit margin on any ore extracted. In turn, that will allow them to outbid TGS for the mineral rights. A securities law rule requiring immediate disclosure of the ore deposit (or any similar proprietary information) would discourage innovation and discovery by permitting this sort of free riding behavior—rational firms would not try to develop new mines if they knew competitors will be able to free ride on their efforts. In order to encourage innovation, the securities laws therefore generally permit corporations to delay disclosure of this sort of information for some period of time. As we have seen, however, the trade-off mandated by this policy is one of less accurate securities prices.

Manne essentially argued that insider trading is an effective compromise between the need for preserving incentives to produce information and the need for maintaining accurate securities prices. Manne offered the following example of this alleged effect: A firm’s stock currently sells at fifty dollars per share. The firm has discovered new information that, if publicly disclosed, would cause the stock to sell at sixty dollars. If insiders trade on this information, the price of the stock will gradually rise toward the correct price. Absent insider trading or leaks, the stock’s price will remain at fifty dollars until the information is publicly disclosed and then rapidly rise to the correct price of sixty dollars. Thus, insider trading acts as a replacement for public disclosure of the information, preserving market gains of correct pricing while permitting the corporation to retain the benefits of nondisclosure.

Despite the anecdotal support for Manne’s position provided by Texas Gulf Sulphur and similar cases, empirical evidence on point remains scanty. Early market studies indicated insider trading had an insignificant effect on price in most cases. Subsequent studies suggested the market reacts fairly quickly when insiders buy securities, but the initial price effect is small when insiders sell. These studies are problematic, however, because they relied principally (or solely) on the transactions reports corporate officers, directors, and 10% shareholders are required to file under Section 16(a). Because insiders are unlikely to report transactions that violate Rule 10b-5, and because much illegal insider trading activity is known to involve persons not subject to the §16(a) reporting requirement, conclusions drawn from such studies may not tell us very much about the price and volume effects of illegal insider trading. Accordingly, it is significant that a more recent and widely-cited study of insider trading cases brought by the SEC during the 1980s found that the defendants’ insider trading led to quick price changes. That result supports Manne’s empirical claim, subject to the caveat that reliance on data obtained from SEC prosecutions arguably may not be conclusive as to the price effects of undetected insider trading due to selection bias, although the study in question admittedly made strenuous efforts to avoid any such bias.

Evaluating the efficient pricing thesis requires a brief digression into efficient capital market theory. Along with the portfolio theory and the theory of the firm, the efficient capital markets hypothesis has been one of the three economic theories most influential on corporate and securities law. In brief, the hypothesis asserts that in an efficient market current prices always and fully reflect all relevant information about the commodities being traded. In other words, in an efficient market, commodities are never overpriced or under-priced: the current price is an accurate reflection of the market’s consensus as to the commodity’s value. Of course, there is no real world condition like this, but the securities markets are widely believed to be close to this ideal.

The so-called semi-strong form of the hypothesis posits that current prices incorporate all publicly available information. The semi-strong form predicts that prices will change only if the information is new. If the information had been previously leaked, or anticipated, the price will not change. If correct, investors cannot expect to profit from studying available information because the market will have already incorporated the information accurately into the price.

The strong form of the hypothesis holds that prices incorporate all information, whether publicly available or not. The strong form makes no intuitive sense: how can the market, which after all is not some omnipotent supernatural being but simply the aggregate of all investors, value information it does not know. If the strong form were true, moreover, insider trading could not be a profitable trading strategy.

Empirical tests of the hypothesis have generally tended to confirm the semi-strong form, while disproving the strong form. To be sure, the validity of the efficient capital markets hypothesis is still hotly debated in academic circles. It is probably fair to say, however, that most scholars regard it as the best available description of how markets behave.

In an efficient market, how does insider trading affect stock prices? Although Manne’s assertion that insider trading moves stock prices in the “correct” direction—i.e., the direction the stock price would move if the information were announced--seems intuitively plausible, the anonymity of impersonal market transactions makes it far from obvious that insider trading will have any effect on prices. Accordingly, we need to look more closely at the way in which insider trading might work its magic on stock prices.

If you studied price theory in economics, your initial intuition may be that insider trading affects stock prices by changing the demand for the issuing corporation’s stock. Economics tells us that the price of a commodity is set by supply and demand forces. The equilibrium or market clearing price is that at which consumers are willing to buy all of the commodity offered by suppliers. If the supply remains constant, but demand goes up, the equilibrium price rises and vice-versa.

Suppose an insider buys stock on good news. The supply of stock remains constant (assuming the company is not in the midst of a stock offering or repurchase), but demand has increased, so a higher equilibrium price should result. All of which seems perfectly plausible, but for the inconvenient fact that a given security represents only a particular combination of expected return and systematic risk, for which there is a vast number of substitutes. The correct measure for the supply of securities thus is not simply the total of the firm’s outstanding securities, but the vastly larger number of securities with a similar combination of risk and return. Accordingly, the supply/demand effect of a relatively small number of insider trades should not have a significant price effect. Over the portion of the curve observed by individual traders, the demand curve should be flat rather than downward sloping.

Instead, if insider trading is to affect the price of securities it is through the derivatively informed trading mechanism of market efficiency. Derivatively informed trading affects market prices through a two-step mechanism. First, those individuals possessing material nonpublic information begin trading. Their trading has only a small effect on price. Some uninformed traders become aware of the insider trading through leakage or tipping of information or through observation of insider trades. Other traders gain insight by following the price fluctuations of the securities. Finally, the market reacts to the insiders’ trades and gradually moves toward the correct price. The problem is that while derivatively informed trading can affect price, it functions slowly and sporadically. Given the inefficiency of derivatively informed trading, the market efficiency justification for insider trading loses much of its force.

Obama to Slash Exec Pay at Bailout Firms

NYT:

Responding to the growing furor over the paychecks of executives at companies that received billions of dollars in the government’s financial rescue, the Obama administration will order the companies that received the most aid to deeply slash the compensation to their highest paid executives, an official involved in the decision said on Wednesday.

Under the plan, which will be announced in the next few days by the Treasury Department, the seven companies that received the most assistance will have to cut the annual salaries of their 25 best-paid executives by an average of about 90 percent from last year. Their total compensation — including bonuses and retirement contributions — will drop, on average, by about 50 percent. The companies are Citigroup [C 4.42 -0.01 (-0.23%) ], Bank of America [BAC 16.51 -0.50 (-2.94%) ], American International Group [AIG 38.96 -1.47 (-3.64%) ], General Motors, Chrysler and the financing arms of the two automakers.

There really ought to be more outrage about this proposal. As a letter to the editor in today's WSJ aptly observed:

To those who would defend the government's ability, justification and right to negate Ken Lewis's contract and hijack his pay ("The Fall Guy," Review & Outlook, Oct. 2), I offer a John Adams quote found in David McCullough's book "John Adams." Adams stopped at a tavern for lodging. He happened to overhear several locals discussing British actions regarding taxation. One man says to the rest, ". . . if Parliament can take away Mr. Hancock's wharf and Mr. Row's wharf, they can take away your barn and my house."

Mr. Lewis might already be considered rich, as was Mr. Hancock, and the amount of severance may seem to be outrageous, but to you supporters of this confiscation I ask: If you grant the federal government's pay czar the power to confiscate or alter the pay of 175 Americans today, whose barn or house is next?

The point is exceptionally well taken. The Obama administration has shown a shocking disregard for the rule of law when contract rights interfere with the administration's ability to reorder the American economy as it sees fit.

As Todd Zywicki observed when Obama threw Chrysler lenders under the bus:

The rule of law, not of men -- an ideal tracing back to the ancient Greeks and well-known to our Founding Fathers -- is the animating principle of the American experiment. While the rest of the world in 1787 was governed by the whims of kings and dukes, the U.S. Constitution was established to circumscribe arbitrary government power. It would do so by establishing clear rules, equally applied to the powerful and the weak.

Fleecing lenders to pay off politically powerful interests, or governmental threats to reputation and business from a failure to toe a political line? We might expect this behavior from a Hugo Chávez. But it would never happen here, right?

Until Chrysler. ...

The Obama administration's behavior in the Chrysler bankruptcy is a profound challenge to the rule of law. Secured creditors -- entitled to first priority payment under the "absolute priority rule" -- have been browbeaten by an American president into accepting only 30 cents on the dollar of their claims. Meanwhile, the United Auto Workers union, holding junior creditor claims, will get about 50 cents on the dollar.

And then Obama bullied GM's bondholders to the extent that even the Obamabots on the Washington Post's editorial board were moved to protest that "the Obama administration is coming dangerously close to engaging in financial engineering that ignores basic principles of fairness and economic realities to further political goals."

So set aside the question of whether compensation at financial firms is "too high," however you propose to measure it. Set aside the question of whether these troubled firms will be able to keep their best people, who presumably now will be targeted by unregulated firms like hedge funds that will be free to pay market rates.

The basic problem is here is that many (most?) of the compensation deals the Obama administration is shredding were set in employment contracts. Granted, some of those employment contracts were signed after the law setting up pay "czar" Kenneth Feinberg's position and empowering him to review pay packages at TARP firms. But a lot of them are pre-existing contracts and it's those contracts that are the main concern.

Feinberg in fact is trumpeting his success at forcing so-called renegotiation "even for contracts over which he did not have explicit authority."

The bottom line thus is that Obama is having his minion coerce TARP executives and employees into ripping up contracts Obama doesn't like so as to assuage the populist public. In doing so, Obama and his appropriately entitled "czar" are exhibiting a basic lack of respect for the rule of law.

Unfortunately, these are not isolated incidents. As I wrote back in May, they are each "of a piece with the totality of Obama's program."

Russell Kirk wrote that:

Separate property from private possession, and Leviathan becomes master of all. Upon the foundation of private property, great civilizations are built.  ...

Sir Henry Maine, in his Village Communities, puts strongly the case for private property, as distinguished from communal property: “Nobody is at liberty to attack several property and to say at the same time that he values civilization. The history of the two cannot be disentangled.” For the institution of several property—that is, private property—has been a powerful instrument for teaching men and women responsibility, for providing motives to integrity, for supporting general culture, for raising mankind above the level of mere drudgery, for affording leisure to think and freedom to act. To be able to retain the fruits of one’s labor; to be able to see one’s work made permanent; to be able to bequeath one’s property to one’s posterity; to be able to rise from the natural condition of grinding poverty to the security of enduring accomplishment; to have something that is really one’s own—these are advantages difficult to deny.

No American President has posed as profound a threat to those advantages as Obama, because none has shown as little regard for the rule of law when it comes to property and contract rights.

Update: David Frum offers an interesting analogy:

Suppose we discovered that during the tense days of September and October 2008, executives at the big banks were ordering lavished catered dinners for themselves at their offices. WE'd all disapprove. Those executives should have been eating sandwiches at their desks! But would it be OK for the government to order the banks to refuse the invoices from the catering company?

The service was contracted by the people who had the legal authority to make the contract. THe contract must be paid, unless the company goes into bankruptcy - at which point all creditors would have to be treated equally, without the government picking and choosing its favorites to be paid first.

What's happening with these executive contracts is the equivalent of bouncing the bills from some disfavored suppliers. It's lawless and it's wrong.

Update: Larry Ribstein comments on the "czar" business:

There's a process concern here that is being overlooked. The WSJ notes that Feinberg was brought in to take the heat off Geithner:

Since bringing Mr. Feinberg to the Treasury Department, the Obama administration has largely stayed out of his business, preferring instead to let him make the controversial calls unlikely to please many people. Mr. Feinberg has met with Mr. Geithner just twice and hasn't spoken with White House officials at all.

Perhaps the worst aspect of this whole thing is the Obama administration's attempt to avoid political accountability by creating a "czar." Process is supposed to matter in a democratic system. This is, in fact, what's at stake in the PCAOB case. I wonder if the Supreme Court will have in mind the current administration's approach to governance when considering the constitutionality of a past effort to create an agency with executive power but not executive accountability.

Larry also observes:

As Alex Tabarrok says, "[t]here is no way this will work as advertised. * * * [M]ost of these executives will quit and get higher paying jobs elsewhere. Executives not directly affected by the pay cuts will also quit when they see their prospects for future salary gains have been cut. Chaos will be created at these firms as top people leave in droves." Commenters responded that the executives were incompetent anyway, so who cares? But if that's so, why are taxpayers flushing billions down incompetently managed firms, and then constructing pay rules so they can't attract better ones?

Update: James Joyner put together an excellent selection of commentary, adding his own editorial observations. Check it out.

Update: I know Obamabots think it's not a real news organization and that being associated with it raises my risk of ending up on Obama's enemies list (BTW, Kimberly Strassel's WSJ column on the "Chicago way" is a must read), but I was quoted by Foxnews on this issue:

"He has a lot of authority with respect to not just the seven but with respect to all TARP firms," said Stephen Bainbridge, law professor at UCLA. "It's an enormous expansion of federal power over corporations." 

Under authority granted by Congress through legislation passed in February, Feinberg has decided to order cuts for the top 25 earners at the firms that received the most aid from the $700 billion Wall Street rescue package. He's looking to cut salaries by 90 percent from last year's levels, and to cut total pay by half. 

The fact that Washington is again meddling with contracts -- following a stalled attempt by Congress in March to halt AIG bonuses -- has revived charges that the federal government is overstepping its bounds. Lawyers say Feinberg could be trampling on legally binding agreements. 

But Bainbridge and others said he nevertheless has an "informal" authority to get his way. "Certainly he has the ability to cajole even where he doesn't have the ability to directly regulate," he said. 

The Ineffable Dreariness of the Greens

Top Gear is the most entertaining program on television. I state this with the same degree of conviction that, say, John Calvin articulated the doctrine of predestination. It is a simple, eternal truth.

As usual, however, the ecomentalists fail to get it:

Top Gear has shunted straight into a row after its series of extravagant stunts in Belfast this week. ... Their madcap stunts included firing a Renault Twingo into the sea, drag racing and hoisting a vehicle to the top of one of Harland and Wolff's famous twin gantry cranes, Samson. ...

Environmental group Friends of the Earth, meanwhile, criticised the Top Gear team claiming it appeared to have gone out of its way to be as crass and juvenile as possible. ... The wrecking of vehicles for the show has not impressed Friends of the Earth campaigner Declan Allison.

“The wanton destruction of tens of thousands of pounds worth of machinery impresses no-one. It’s a wasteful extravagance and, in the middle of a global recession, in very poor taste,” he said.

Here we see Homo Ecomentalist displaying the defining characteristics of the species: Humorless, puritanical, painfully earnest, dour, overzealous, and just plain annoying.

It seems fitting to conclude with a quote from Jeremy Clarkson:

Recently, Boris Johnson jokingly wondered what had happened to all those Trots and Bolsheviks from the 1970s. Boris, my dear chap, they never went away. And now there are many more of them, living among us, posing as normal, respectable members of the human race. It’s just that they’re not called Trots and Bolsheviks any more. They’re called environmentalists and health and safety officers. Think about it. A single health and safety man can inflict more damage on business and industry than an army of Red Robboes. And the goals of an environmentalist far exceed the aspirations of even the most hardbitten 1970s communist.

Insider Trading or Legitimate Market Research?

Market research by analysts and professional investors makes important contributions to the capital markets by promoting the liquidity and efficiency of those markets. As Professors Gilson and Kraakman explain, there are four principal mechanisms by which markets process information and set equilibrium prices in response to new information:

First, market prices immediately reflect information that all traders know, simply because this information necessarily informs all trades, just as perfect markets theorists assumed (“universally-informed trading”). Second,information that is less widely known but nonetheless public, is incorporated into share prices almost as rapidly as information know to everyone through the trading of savvy professionals (“professionally-informed trading”). Third, inside information known to only a very few traders would find its way into prices more slowly, as uninformed traders learned about its content by observing tell-tale shifts in the activity of presumptively informed traders or unusual price and volume movements (“derivatively-informed trading”). Finally,information known to no one might be reflected, albeit slowly and imperfectly, in share prices that aggregated the forecasts of numerous market participants with heterogeneous information (“uninformed trading”).

Take away the ability of professional investors and analysts to ferret out information and we weaken both the professionally-informed trading and the derivatively-informed trading mechanisms. The result will be less liquid markets with greater price anomalies.

The late US Supreme Court Justice Lewis Powell was aware of the valuable contributions market research makes and deeply concerned that an over expansive prohibition of insider trading would deter legitimate market research. Hence, he wrote in Dirks v. SEC, 463 U.S. 646 (1983), that:

Imposing [insider trading liability] solely because a person knowingly receives material nonpublic information from an insider and trades on it could have an inhibiting influence on the role of market analysts, which the SEC itself recognizes is necessary to the preservation of a healthy market. [Footnote 17] It is commonplace for analysts to "ferret out and analyze information," 21 S.E.C. Docket at 1406, and this often is done by meeting with and questioning corporate officers and others who are insiders. And information that the analysts obtain normally may be the basis for judgments as to the market worth of a corporation's securities. The analyst's judgment in this respect is made available in market letters or otherwise to clients of the firm. It is the nature of this type of information, and indeed of the markets themselves, that such information cannot be made simultaneously available to all of the corporation's stockholders or the public generally.

[Footnote 17] The SEC expressly recognized that "[t]he value to the entire market of [analysts'] efforts cannot be gainsaid; market efficiency in pricing is significantly enhanced by [their] initiatives to ferret out and analyze information, and thus the analyst's work redounds to the benefit of all investors." 21 S.E.C. Docket at 1406. The SEC asserts that analysts remain free to obtain from management corporate information for purposes of "filling in the interstices in analysis'. . . ." Brief for Respondent 42 (quoting Investors Management Co., 44 S.E.C. at 646). But this rule is inherently imprecise, and imprecision prevents parties from ordering their actions in accord with legal requirements. Unless the parties have some guidance as to where the line is between permissible and impermissible disclosures and uses, neither corporate insiders nor analysts can be sure when the line is crossed. Cf. Adler v. Klawans, 267 F.2d 840, 845 (CA2 1959) (Burger, J., sitting by designation).

Accordingly, the Dirks case confirmed the basic principle that insider trading liability does not arise simply because the defendant had more information than other market actors. Instead, liability arises only when the defendant breached a fiduciary duty by trading on the basis of that information or by tipping the information to a corporate outsider (I oversimplify somewhat). See generally my book Securities Law: Insider Trading (Turning Point Series). Hence:

"Just saying, we want better information, even we want information no one else has, there's absolutely nothing illegal about that," said Christopher Clark, a former federal prosecutor who is now a defense lawyer. "The only illegality is when it comes in breach of a fiduciary duty or in another similar duty that requires them not to use the information."

As I document in my Insider Trading text, the SEC hates the Dirks rule. The SEC has always wanted a rule of equality of access: If you have more information than anybody else, you can't trade. The SEC has consistently by rule and by positions it takes in litigation sought to undermine the Dirks regime. As Peter Wallison observed, for example, this attitude drove the adoption of Reg FD:

Over the years, the SEC has been pursuing the idea that it is inherently unfair when one party to a securities trade has more information than another. The prime example of this is Regulation FD, initially proposed under the chairmanship of Arthur Levitt in 2000, which attempted to ensure that companies do not provide material information to analysts unless that information is made public at the same time.

Wallison contrasts the SEC's position to that of Justice Powell, explaining that:

... there is also an important idea implicit in the Court’s statement that “it is the nature of this type of information” that it “cannot be made simultaneously available to all the corporation’s stockholders or the public generally.” The Court’s point was that the information would have no value to the analyst, and hence would not be collected, if it had to be made public before it could be used. In other words, the Court recognized that incentives are necessary to ensure that information gets into the market. In effect, the Supreme Court in 1983 was drawing a fine line between two competing values. On one side was the notion that corporate insiders should be punished for violating their fiduciary obligations to the company or its shareholders by disclosing inside information improperly. But on the other side was a desire to ensure--through appropriate incentives--that important information gets into the market and affects the market price of shares for the benefit of all investors.

The SEC’s approach is quite different. ... [The] agency focuses on the inequality of information between the informed and the uninformed traders at the moment of the trade. This approach naturally devalues incentives to supply information to the market, and in the end prefers a market in which both sides of a trade are equally ignorant rather than a market in which one trader profits at the expense of another.

It is precisely this set of concerns that is implicated by the so-called Galleon insider trading case. It may be that Raj Rajaratnam got information via tips from people who thereby breached a fiduciary duty they owed to the source of the information. But did Rajaratnam know they were doing so? Can the SEC prove not just that Rajaratnam had better access to information than the market generally, but that he got that information by being a participant after the fact in the tipper's breach of fiduciary duty?

There is a very serious risk that this case could chill aggressive but legitimate research by hedge funds and other professional investors. If so, the SEC will have done a serious disservice to the ordinary investors it claims to be protecting. Those investors will be left with a less efficient and less liquid market.

These concerns are particularly pronounced because, as the WSJ reported, this is not a one off case:

The investigation comes as the SEC has been increasing its focus on hedge funds and has ramped up surveillance to look for patterns and trends in trading. Over two years ago, the SEC expanded its focus beyond looking solely at individual stocks that had suspicious trading patterns. The agency put in place a new computer system that looks for traders who pop up repeatedly in insider-trading referrals, people familiar with the matter said.

All of which raises an age-old question: Quis custodiet ipsos custodes?

The Shadow National Debt

JW Verret's got a nice post arguing that "the Obama Administration’s deceptive accounting practices for its ownership in the automotive and financial sectors hide a big slice of the real national debt and annual budget deficit."

It has been a rare opportunity to share with this forum my new paper, Treasury Inc.: How the Bailout Reshapes Corporate Theory and Practice, forthcoming with the Yale Journal on Regulation and available here. ...

When Peter Orszag ran the Congressional Budget Office, he fought the Bush administration over consolidating Fannie and Freddie’s debt into the national budget. His position was that two principles of government accounting require consolidation. Principle one, we control these companies; principle two, we guarantee their debt.  For more, take a look at, after I testified on this issue here, this press release from the Congressional House Oversight Committee about how I discovered the problem described in this post.

Orszag has been noticeably silent since joining the Obama Administration.  Omitting appropriate liabilities from our government’s books is deceptive, allows us to borrow more than we should and feeds our habit for deficit spending.

The administration disputes its control of TARP companies. Yet the government tells GM what kind of cars to build and GM and Citigroup which directors to elect. It tells Fannie and Freddie which mortgages to subsidize.  Secretary Geithner affirms that we stand behind the banks, which means we stand behind their debt as well.  Budget consolidation principle one, check. Principle two, check. ...

Administrations are short-lived.  In three or seven years President Obama and his staff will retire to the benefits of speaking fees, consulting contracts and cable news appearances.  But the debt remains, and it is a legacy by which our children will rightly judge us. If we permit this administration to use accounting wizardry to hide our debts, we should not be surprised when we are judged harshly.

The full faith and credit of the U.S. is not a depthless well, and the administration’s current budget policies risk turning Treasury bonds into the ultimate subprime loan.  Future generations could be saddled with inflation, increased taxes and interest payments on Treasury bonds that take up an ever-increasing share of the federal budget. It’s time for this administration to bring transparency to the federal budget process by accounting for TARP holdings properly.