ProfessorBainbridge.com

AOL stock falls on news of HuffPo purchase

Glenn Reynolds:

SO AOL VALUES THE HUFFINGTON POST AT $315 MILLION, but apparently the market values it at zero: AOL stock sheds $315M — HuffPo price tag. “Since Feb. 1, the price of AOL shares has dropped from $23.85 to $20.89 at yesterday’s close. With 106.7 million shares outstanding, that means AOL has shed $315 million in value over the last five trading days — which happens to be exactly the same price AOL agreed to pay to acquire HuffPo.”

Coincidence? I doubt it.

Does Arianna Huffington believe in anything other than Arianna Huffington?

Dana Milbank:

Did Arianna Huffington just sell out her fellow progressives? ... There are also some indications that she has sold out in the ideological sense and committed the Huffington Post to joining the mainstream media - the evil "MSM" of "HuffPo" blogger ire. Announcing the deal, she and her new boss went out of their way to say that the new Huffington Post would emphasize things other than the liberal politics on which the brand was built.

Is it not obvious by now that Huffington has no permanent principles, other than doing what's best for herself? When it was convenient and popular, she was an ardent GOPer, supporting folks like New Gingrich. But she craved popularity out here in Hollywood, where no conservative can ever be the belle of the ball. So she switched sides so as be embraced by the Hollywood crowd as their "intellectual" voice.

The difference between Huffington and The Real Housewives of Beverly Hills is thus revealed to be almost nonexistent. They'll all do whatever it takes to pad their bank accounts while extending their 15 minutes of fame.

Candidly, I find it a classic example of liberal gullibility. So many earnest Hollywood lefties took her so seriously. But it was all just the political equivalent of Botox and implants.

Congressional Insider Trading (Again)

My friend Donna Nagy has posted a new article on the issue of insider trading by members of Congress and their staffs, Insider Trading, Congressional Officials, and Duties of Entrustment:

A recent hullabaloo in the media put a spotlight on insider trading and Capitol Hill hypocrisy. Both topics have long fascinated the general public and the combination of the two proved irresistible. An October 11, 2010 front page article in the Wall Street Journal ignited the controversy, and by the end of that week, newspapers and the internet were filled with claims that insider trading by members of Congress and their legislative staff is "totally legal" because congressional officials are "immune" from federal insider trading laws. Enactment of the proposed "Stop Trading on Congressional Knowledge Act," dubbed by its sponsors the "STOCK Act," was heralded as the only effective way to render congressional insider trading unlawful.

This article refutes the conventional wisdom and argues that insider trading on the basis of nonpublic congressional knowledge is already illegal under Rule 10b-5 of the Securities Exchange Act, a general anti-fraud provision which prohibits deceptive conduct "in connection with" the purchase or sale of securities. The article further contends that the proposed STOCK Act, if enacted, would actually narrow the scope of the law that would otherwise apply to members of Congress and legislative staffers in the absence of a new prohibition. The principal arguments were first presented at a conference honoring the publication of Boston University Professor Tamar Frankel’s new book on Fiduciary Law. Building on the work of Professor Frankel and others, the article maintains that congressional officials owe fiduciary-like duties of trust and confidence to a host of parties including the citizen-investors whom they serve, as well as the federal government, other members of Congress, and government officials outside of Congress who rely on their loyalty and integrity. The article concludes that members of Congress and legislative staffers breach duties of entrustment, and thereby engage in fraud and deception, if they trade securities on the basis of material nonpublic information obtained through congressional service. For a variety of prudential reasons, however, the article suggests that education, rather than prosecution, may be the SEC’s most effective enforcement tool.

I've written on this topic before and come to a different conclusion. See my article Insider Trading Inside the Beltway, which argues that:

A 2004 study of the results of stock trading by United States Senators during the 1990s found that that Senators on average beat the market by 12% a year. In sharp contrast, U.S. households on average underperformed the market by 1.4% a year and even corporate insiders on average beat the market by only about 6% a year during that period. A reasonable inference is that some Senators had access to – and were using – material nonpublic information about the companies in whose stock they trade.

Under current law, it is unlikely that Members of Congress can be held liable for insider trading. The proposed Stop Trading on Congressional Knowledge Act addresses that problem by instructing the Securities and Exchange Commission to adopt rules intended to prohibit such trading.

This article analyzes present law to determine whether Members of Congress, Congressional employees, and other federal government employees can be held liable for trading on the basis of material nonpublic information. It argues that there is no public policy rationale for permitting such trading and that doing so creates perverse legislative incentives and opens the door to corruption. The article explains that the Speech or Debate Clause of the U.S. Constitution is no barrier to legislative and regulatory restrictions on Congressional insider trading. Finally, the article critiques the current version of the STOCK Act, proposing several improvements.

The difference between us comes down to how broadly one interpets the concept of fiduciary duty. With all due deference, I just don't buy Donna's analaysis of the relevant duties. But it's a very fine article and essential reading for anyone with an interest in the problem.

Pharaoh capitalism

In many parts of the world, corporate pyramids are used to enable business owners--often families--to control large corporate groups despite owning a relatively small amount of the total equity of the group. The Economist explained how it works:

In India, as in many emerging markets, companies rarely stand or fall alone. Tarun Khanna of Harvard Business School and Yishay Yafeh of the Hebrew University of Jerusalem report* that a third of Indian firms in the 1990s belonged to wider business groups, controlled by wealthy families or corporate “promoters”. These clubable firms were typically 4.4 times bigger than stand-alone companies. ...

These families exercise far more control than they pay for; their corporate reach exceeds their financial stake. This is sometimes because they hold a privileged class of shares that carry more votes than common equity. Sometimes they appoint a loyal relative as chief executive. But the most ambitious strategy for projecting control is to build a corporate “pyramid”.

The geometry works like this: the family holds a controlling stake (say 51%) in a company at the top of the pyramid. This firm then holds similar stakes in a second tier of companies, which will in turn maintain stakes in a third tier. In this way, the family controls the entire pyramid from top to bottom, even though its financial commitment to the second tier is only 26% (51% of 51%) and its stake in the third tier is only about 13%.

Pyramids solve what Yoshisuke Aikawa, the founder of the Nissan group in pre-war Japan, once called the “capitalist’s quandary”: how to raise money from outsiders without ceding control. Students of corporate governance view them less benignly. To them, pyramids combine the twin dangers of entrenched management and diffuse ownership.

The abuse typically comes into play via related party transactions:

[The pyramids] are tightly controlled by families, who have only a paltry stake in the companies at their base. When this gap between control and ownership grows too large, the pharaohs have an incentive to divert resources from companies at the bottom of the pyramid (where they might claim only 13 cents on the dollar) to the top (where their claim is 51 cents).

What about in the United States? My friend and UCLA colleague Steven Bank recently co-authored a new paper on The Corporate Pyramid Fable:

Although corporate pyramids are currently commonplace world-wide and although there have been “noteworthy pyramiders” in American business history, this controversial form of corporate organization is now a rarity in the United States. The conventional wisdom is that corporate pyramids disappeared in the U.S. when New Deal policymakers began taxing dividends paid to corporate shareholders. This version of events is more fable than truth. The introduction of the intercorporate dividend tax did not foster a rapid dismantling of corporate pyramids. Instead, pyramidal arrangements were already rare in the U.S., other than in the utilities sector, and the demise of utility pyramids was prompted by the Public Utilities Holding Company Act of 1935 rather than tax reform.

It's a very fine piece of legal history.

SEC Stretches Definition of Inside Information and Materiality Past Breaking Point

BNA reports that:

In a case that could test the parameters of “insider” information, the Securities and Exchange Commission Jan. 28 told the U.S. District Court for the Northern District of Illinois that information shared by two railroad employees with relatives that led to “dramatically different” stock transactions constituted circumstantial evidence that they had engaged in insider trading (SEC v. Steffes, N.D. Ill., No. 1:10-cv-6266, 1/28/11).

The SEC, in a brief responding to the defendants' motion to dismiss, asserted that the family members' “well-timed trading” in the stock and call options of Florida East Coast Industries Inc. resulted in profits of nearly $1 million.

The complaint contains “numerous details” about the family's communications with company insiders, and their trading and tipping activities, the SEC said. “[T]he very details of the Steffes Family's communications and trading … may constitute evidence of the materiality of the information received and their scienter in trading.”

In September, the SEC charged W. Gary Griffiths and Cliff M. Steffes and four family members with insider trading in relation to the $3.5 billion takeover of FECI by Fortress Investment Group LLC (FIG) in 2007 (42 SRLR 1858, 10/4/10). Griffiths at the time was a vice president and chief mechanical officer, while Steffes was a rail yard worker, in Florida East Coast Railway LLC, a railway operated by FECI.

According to the complaint, the two employees learned about the impending acquisition of FECI through on-the-job observations, including the unusual number of tours of FECR's Hialeah Yard by people dressed in business suits, and a trip by Fortress representatives in a special rail car reserved for visitors. In addition, other rail employees began expressing concern that FECI could be sold and their jobs could be at stake.

The SEC alleged that in the weeks preceding the acquisition, Griffiths and Steffes tipped family members. Collectively, the family bought more than $1.6 million worth of FECI stock and call options, and sold their purchases on the same day that the acquisition was announced. The news caused FECI's stock to rise 15 percent above the previous day's trading price, the SEC said.

First, there is no inside information here. Inside information long has been defined as " information intended to be available only for a corporate purpose and not for the personal benefit of anyone." SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (C.A.2 1968). What you have here are educated guesses derived from observations of events. There's nothing to suggest secrecy nor is there anything to suggest a communication conveying knowledge.

The Texas Gulf Sulphur case made clear that: " An insider is not, of course, always foreclosed from investing in his own company merely because he may be more familiar with company operations than are outside investors. ... Nor is an insider obligated to confer upon outside investors the benefit of his superior financial or other expert analysis by disclosing his educated guesses or predictions." No need to disclose educated guesses based on familiarity with company operations, which is exactly what we have here.

Second, the SEC is bootstrapping the trades to prove materiality. Granted, a footnote in the Supreme Court’s Basic v, Levinson opinion flatly stated that “trading and profit making by insiders can serve as an indication of materiality.” But Basic was not an insider trading case. Hence, there remains a legitimate question as to whether the allegedly illegal insider trading behavior can serve as proof that the facts on which the insider traded were material. The problem, of course, is the potential for bootstrapping: if the allegedly illegal trade proves that the information is material, the materiality requirement becomes meaningless—all information in the defendant’s possession when he or she traded would be material. Which would suit the SEC just fine, but is damned hard justify, especially in light of the draconian penalties for insider trading.

Third, the Supreme Court has held that plaintiff’s prima facie case must include proof defendant acted with scienter, which the court defined as a mental state embracing an intent to deceive, manipulate or defraud. Here the SEC is trying to conflate materiality and scienter, arguing that if the information is material they must have intended to defraud. This grossly compounds the SEC's effort to endrun the materiality element. they basically want the fact of the trade to prove two elements of the offense.

The SEC has long tried to fudge and finesse the insider trading law. But this case is an especially egregious example of how the SEC seeks to stretch the law beyond any reasonable stopping point. This case should be dismissed and the SEC ought to be sanctioned for having brought it.

Tung Yin on Law School Employment Disclosures

If we believe sunlight really is the best disinfectant and electric light the best policeman, those of us in legal education need to a better job of providing truthful, transparent, timely, and useful information about the job prospects of our graduates. Tung Yin weighs in, observing that:

Congress could presumably enact a law that requires law schools to provide accurate and detailed data about the employment prospects of their students (for the summers) and graduates, and to have those reports certified by the university president, chancellor, etc., with violations punishable by fines and other penalties.

By focusing on the quality of the data, this approach would, if successful, render law schools more accountable to the market.  No more sending survey letters to graduates that say, "if we don't hear from you by X date, we will assume that you have found fulltime employment" (not something that took place at the two institutions I've been employed by, but which I've heard about elsewhere).  No more lumping all non-law work with legal employment.  (To be sure, there may well be JDs who by their own choice take non-law-related work, but that's still useful information to law school applicants.)

If anything, it seems to me there's arguably a stronger call for enforcing these sorts of disclosure and accuracy provisions on law schools (and universities in general) than on corporations. After all, the cost of corporate malfeasance with regard to balance sheets and the like is diffused across a huge number of investors, who are presumably not taking out huge loans with which to invest in said corporate stock.  (I guess there are margin traders, but really, they seem a less sympathetic group for concern than poor students with huge education debt.)  The cost of law school malfeasance in terms of misleading or false employment data is visited upon a (relatively) small number of students who are saddled with $50,000 or more in student debt.  Shouldn't they be entitled to at least the same level of informational protection that stock investors now get?

I should think so.

Poison Pills

UCLA Law news reports that:

Professor Stephen Bainbridge is cited in a Philadelphia Inquirer article about a "poison pill," which is at issue in the effort by Air Products & Chemicals Inc. in Allentown to buy Radnor's Airgas Inc.

Another governance expert, Stephen Bainbridge, of the UCLA School of Law, wrote last month that shareholder votes are part of a firm's decision-making machinery, but merely an accountability tool. "While notions of shareholder democracy permit powerful rhetoric, corporations are not New England town meetings," he said.

To read the entire article, click here.

Regulating Systemic Risk

Along with Duke prof Steven Schwarcz, my friend and UCLAW colleague Iman Anabtawi has posted a new paper Regulating Systemic Risk: Towards an Analytical Framework. I disagree with portions of it, which made for some interesting conversations, but I recommend it highly nonetheless:

The global financial crisis demonstrated the inability and unwillingness of financial market participants to safeguard the stability of the financial system. It also highlighted the enormous direct and indirect costs of addressing systemic crises after they have occurred, as opposed to attempting to prevent them from arising. Governments and international organizations are responding with measures intended to make the financial system more resilient to economic shocks, many of which will be implemented by regulatory bodies over time. These measures suffer, however, from the lack of a theoretical account of how systemic risk propagates within the financial system and why regulatory intervention is needed to disrupt it. In this Article, we address this deficiency by examining how systemic risk is transmitted. We then proceed to explain why, in the absence of regulation, market participants cannot be relied upon to disrupt or otherwise limit the transmission of systemic risk. Finally, we advance an analytical framework to inform systemic risk regulation.

Regulated professions

Larry Ribstein's got a great post following up a WSJ article on regulated professions, such as "cat groomers, tattoo artists, tree trimmers," and, yes, lawyers.

I have previously written about IJ suits involving licensing horse-teeth floaters and Philadelphia tour guides.  In the first post I noted that “fifty years ago, just 3% of American workers were regulated or licensed by government agencies, according to the Institute for Justice. Today, it’s 35%.”  In the second I observed that licensing laws were ” a business talking, but with a government stick.” 

True, in some cases there is arguably a threat to public or consumer safety.  But mostly this is about some squeaky wheel interest group’s quest for status and higher pay.  The social costs are mounting just when the corporate jobs are drying up and people are trying to go into business for themselves.  And it’s important to keep in mind that there are market alternatives to licensing:  reputation, dissemination of information through the internet, certification by private trade groups.

In almost all cases, professional licensing schemes are little more than a legislative barrier to entry.

Hedging Stock-based Executive Compensation

Steve Bradford:

The modern world of derivatives is making it very difficult to regulate business behavior.  Here’s the latest example, reported by the New York Times.

In response to regulatory pressure, many banks have shifted employee compensation more towards stock.  The theory is simple—to align the interests of bank employees with the interests of investors.   If the bank does well, its stock price increases, and the employees make more money.  If the bank does poorly, its stock price falls, and the employees lose money (or, depending on the structure of the plan, at least don’t make any additional money). 

But employees are limiting their risk by hedging, using call options and collars.  These transactions allow bank employees to avoid the downside risk, usually at the cost of giving up some potential upside gain.  Hedging thus allows employees to obtain something that, in terms of risk, looks much more like traditional non-stock compensation.

According to the story, most banks have not yet caught up to what their employees are doing.  Hedging is prohibited by most banks only for executives at the very highest levels.  Of course, banks may not really want to do anything about it, as long as regulators are satisfied.

When it comes to compensation, smart people who understand how financial markets work and get paid enough to justify accessing them will always be at least one step ahead of the regulators.

State Trial Judges Failing to Follow State Supreme Court Rulings

Orin Kerr:

Recent VC comment threads suggest that some commenters at the VC admire lower courts judges who are less concerned with following Supreme Court precedent than getting the law right as they see it. Yesterday’s Washington Post highlights an example of this happening in the state court system. A few weeks ago, the Virginia Supreme Court ruled unanimously that a common law writ known as “the writ of coram nobis” could not be used to reopen convictions imposed on immigrants who were ordered deported as a result of their convictions. In a decision handed down two weeks later, Loudoun County trial judge Dean Worcester decided that he found the Supreme Court’s decision unpersuasive and announced he would not follow it.

Pretty damned shocking. When I was a law clerk, my judge wrote an opinion explaining that he had to follow binding Fourth Circuit precedent but explaining in detail why he thought that precedent was wrong. I think that's how judges ought to handle such things.

I can't think of a corporate law decision quite as blatant as the Virginia case. I suppose Chancellor William Allen's decision in Caremark comes closest. He basically tossed the Delaware Supreme Court's decision in Graham v. Allis-Chalmers under the proverbial bus. I've often argued that Graham was correctly decided despite Allen's derision. See, e.g., The Convergence of Good Faith and Oversight.

If Chancellor Chandler were to broadly invalidate poison pills in the Airgas v Air Products case, in which I'm told by a couple of reporters that a decision is expected tomorrow, however, that would go to the head of the list. As I recently explained in this space in considerable detail, I don't think Delaware precedent would permit a blanket ruling against pills. As I also explained in that post, I don't think such a ruling would be consistent with sound public policy. Not that that stopped Allen in Caremark, however.

Obama Preaches the False Religion of Corporate Social Responsibility

The Hill:

“Businesses have a responsibility, too,” said Obama in his weekly address on Saturday. “If we make America the best place to do business, businesses should make their mark in America. They should set up shop here, and hire our workers, and pay decent wages, and invest in the future of this nation. That’s their obligation.”

Wrong. The social obligation of business is to sustainably maximize long-term profits for shareholders. Nothing more. Nothing less.

The case against corporate social responsibility is too complex and nuanced to be readily boiled down into a blog post. But let's take a shot. Because even a post of this length cannot do the subject justice, I direct your attention to the following post, which links my extensive scholarship on CSR.

One of the chief tenets of corporate law theory is that the law ought to facilitate private ordering; hence, the preference for default rules the parties are free to modify. So long as the default rule is properly chosen, most parties will be spared the need to reach a private agreement on the issue in question. Default rules in this sense provide cost savings comparable to those provided by standard form contracts, because both can be accepted without the need for costly negotiation. At the same time, however, because the default rule can be modified by contrary agreement, idiosyncratic parties wishing a different rule can be accommodated. Given these advantages, a fairly compelling case ought to be required before we impose a mandatory rule. Yet, the law should not always facilitate private ordering. Where there is a market failure, regulatory intervention may be appropriate. Welfare economics classically recognizes four basic sources of market failures: producer monopoly; the good to be produced is a public good; informational asymmetry between producer and consumer; and externalities. Of these, the latter is most pertinent for our purposes.

Corporate conduct doubtless generates negative externalities.[1] In appropriate cases, such externalities should be constrained through general welfare legislation, tort litigation, and other forms of regulation. The question here is whether the law should also seek to constrain them through the fiduciary duties of corporate directors.

Properly understood, fiduciary duties are gap-fillers by which courts resolve disputes falling through the cracks of incomplete contracts. More specifically, however, fiduciary duties prevent corporate directors and officers from appropriating quasi-rents through opportunistic conduct unanticipated when the firm was formed. Quasi-rents arise where investments in transaction specific assets create a surplus subject to expropriation by the contracting party with control over the assets.[2] A transaction specific asset is one whose value is appreciably lower in any other use than the transaction in question. Once a transaction specific investment has been made, it generates quasi-rents—i.e., returns in excess of that necessary to maintain the asset in its current use.[3] If such quasi-rents are appropriable by the party with control of the transaction specific asset, a hold up problem ensues. Investments in transaction specific assets therefore commonly are protected through specialized governance structures created by detailed contracts. Under conditions of uncertainty and complexity, however, bounded rationality precludes complete contracting. Under such conditions, accordingly, fiduciary duties provide an alternative source of protection against opportunism.

The shareholder’s investment in the firm is a transaction specific asset, because the whole of the investment is both at risk and turned over to someone else’s control. In contrast, many corporate constituencies do not make firm specific investments in human capital (or otherwise). Many corporate employees, for example, lack significant firm specific human capital. For such employees, mobility is a sufficient defense against opportunistic conduct, because they can quit and be replaced without productive loss to either employee or employer. If the employee’s general human capital suffices for him to do his job at Firm A, it presumably would suffice for him to do a similar job at Firm B. Such an employee resembles an independent contractor who can shift from firm to firm at low cost to either employee or employer.[4] Because the relationship between such employees and the corporation does not create appropriable quasi-rents, opportunism by the board is not a concern.

Consequently, shareholders are more vulnerable to director misconduct than are most nonshareholder constituencies. Consider a classic case of self-dealing. Assume a solvent corporation able to pay its debts and other obligations (especially employee salaries) as they come due in the ordinary course of business. Further assume that the corporation has substantial free cash flow—i.e., cash flows in excess of the positive net present value investments available to the corporation. If the directors siphon some portion of the corporation’s free cash flow into their own pockets, shareholders are clearly hurt, because the value of the residual claim has been impaired. Yet, in this case, there is no readily apparent injury to the value of the fixed claim of all other corporate constituents.

For the sake of argument, however, assume that appropriation of quasi-rents is an equally severe problem for both shareholders and nonshareholder constituencies. Many employees do invest in firm specific human capital. Creditors may also develop firm specific expertise, particularly in long-term relationships with a significant number of repeat transactions.

Relative to many nonshareholder constituencies, shareholders are poorly positioned to extract contractual protections.[5] Unlike bondholders, for example, whose term-limited relationship to the firm is subject to extensive negotiations and detailed contracts, shareholders have an indefinite relationship that is rarely the product of detailed negotiations. The dispersed nature of stockownership, moreover, makes bilateral negotiation of specialized safeguards especially difficult:

Arrangements among a corporation, the underwriters of its debt, trustees under its indentures and sometimes ultimate investors are typically thoroughly negotiated and massively documented. The rights and obligations of the various parties are or should be spelled out in that documentation. The terms of the contractual relationship agreed to and not broad concepts such as fairness [therefore] define the corporation’s obligation to its bondholders.[6]

Put another way, bond indentures necessarily are incomplete.[7] Even so, they still provide bondholders with far greater contractual protections than shareholders receive from the corporate contract as represented by the firm’s organic documents. Accordingly, we can confidently predict the majoritarian default that would emerge from the hypothetical bargain. Shareholders will want the protections provided by fiduciary duties, while bondholders will be satisfied with the ability to enforce their contractual rights, which is precisely what the law provides.[8]

Like bondholders, employees regularly bargain with employers both individually and collectively. So do other stakeholders, such as local communities that bargain with existing or prospective employers, offering firms tax abatements and other inducements in return for which they could and should extract promises about the firm’s conduct. In general, the interests of such constituents lend themselves to more concrete specification than do the open-ended claims of shareholders. Those nonshareholder constituencies that enter voluntary relationships with the corporation thus can protect themselves by adjusting the contract price to account for negative externalities imposed upon them by the firm.

Granted, the extent of negotiations between the corporation and nonshareholders is likely to vary widely. In many cases, such as hiring shop floor employees, the only negotiation will be a take it-or-leave it offer. But so what? Is a standard form contract any less of a contract just because it is offered on a take it-or-leave it basis? If the market is competitive, a party making a take it-or-leave it offer must set price and other terms that will lead to sales despite the absence of particularized negotiations. As long as the firm must attract inputs from nonshareholder constituencies in competitive markets, the firm similarly will have to offer those constituencies terms that compensate them for the risks they bear.

This point persistently eludes proponents of the stakeholder model, who ask: “Can it really be said that employees (or local communities or dependent suppliers) are really better able to ‘negotiate’ the terms of their relationship to the corporation than are shareholders?”[9] While they presumably intend this to be a purely rhetorical question, in fact it has an answer and the answer is an affirmative one.

Shareholders have no meaningful voice in corporate decisionmaking. In effect, shareholders have but a single mechanism by which they can “negotiate” with the board: withholding capital. If shareholder interests are inadequately protected, they can refuse to invest. The nexus of contracts model, however, demonstrates that equity capital is but one of the inputs that a firm needs to succeed. Nonshareholder corporate constituencies can thus “negotiate” with the board in precisely the same fashion as do shareholders: by withholding their inputs. If the firm disregards employee interests, it will have greater difficulty finding workers. Similarly, if the firm disregards creditor interests, it will have greater difficulty attracting debt financing, and so on.

In fact, withholding one’s inputs may often be a more effective tool for nonshareholder constituencies than it is for shareholders. Some firms go for years without seeking equity investments. If these firms’ boards disregard shareholder interests, shareholders have little recourse other than to sell out at prices that will reflect the board’s lack of concern for shareholder wealth. In contrast, few firms can survive for long without regular infusions of new employees and new debt financing. As a result, few boards can prosper for long while ignoring nonshareholder interests.

Let us assume, however, that nonshareholder constituencies are unable to protect themselves through contract. The right rule would still be director fiduciary duties incorporating the shareholder wealth maximization norm. Many nonshareholder constituencies have substantial power to protect themselves through the political process.[10] Public choice theory teaches that well-defined interest groups are able to benefit themselves at the expense of larger, loosely defined groups by extracting legal rules from lawmakers that appear to be general welfare laws but in fact redound mainly to the interest group’s advantage. Absent a few self-appointed spokesmen, most of whom are either gadflies or promoting some service they sell, shareholders—especially individuals—have no meaningful political voice. In contrast, many nonshareholder constituencies are represented by cohesive, politically powerful interest groups. Consider the enormous political power wielded by unions, who played a major role in passing state anti-takeover laws. Because those laws temporarily helped kill off hostile takeovers, the unions helped slay the goose that laid golden eggs for shareholders. From the unions’ perspective, however, hostile takeovers were inflicting considerable harm on workers. The unions were probably wrong on that score, but the point is that the unions used their political power to transfer wealth from shareholders to nonshareholder constituencies.

Collective bargaining obviously does not protect nonunionized workers, but they receive comparable protections from both legal and market forces. Various market mechanisms have evolved to protect employee investments in firm specific human capital, such as ports of entry, seniority systems, and promotion ladders. As private sector unions have declined, moreover, the federal government has intervened to provide through general welfare legislation many of the same protections for which unions might have bargained. The Family & Medical Leave Act grants unpaid leave for medical and other family problems.[11] The Occupational Safety & Health Administration (OSHA) mandates safe working conditions.[12] Plant closing laws require notice of layoffs.[13] Civil rights laws protect against discrimination of various sorts.[14] And so on.

Such targeted legislative approaches are a preferable solution to the externalities created by corporate conduct. General welfare laws designed to deter corporate conduct through criminal and civil sanctions imposed on the corporation, its directors, and its senior officers are more efficient than stakeholderist tweaking of director fiduciary duties. By virtue of their inherent ambiguity, fiduciary duties are a blunt instrument. There can be no assurance that specific social ills will be addressed by the boards of the specific corporations that are creating the problematic externalities.[15]

---

[1] It is for this reason that one cannot justify the shareholder wealth maximization norm by claiming that a rising tide lifts all boats. In many cases, this will be true. Nonshareholder constituencies have a claim on the corporation that is both fixed and prior to that of the shareholders. So long as general welfare laws prohibit the corporation from imposing negative externalities on those constituencies, the shareholder wealth maximization norm redounds to their benefit. In some cases, however, the rising tide argument is inapplicable because it fails to take into account the question of risk. Pursuing shareholder wealth maximization often requires one to make risky decisions, which disadvantages nonshareholder constituencies. The increased return associated with an increase in risk does not benefit nonshareholders, because their claim is fixed, whereas the simultaneous increase in the corporation’s riskiness makes it less likely that nonshareholder claims will be satisfied. Hence, the rising tide argument cannot be a complete explanation for the shareholder wealth maximization norm.

[2] See Benjamin Klein et al., Vertical Integration, Appropriable Rents and the Competitive Contracting Process, 21 J. L. & Econ. 297 (1978).

[3] The asset may also generate true rents—i.e., returns exceeding that necessary to induce the investment in the first place—but the presence or absence of true rents is irrelevant to the opportunism problem.

[4] This is not to say that exit is costless for either employees or firms. All employees are partially locked into their firm. Indeed, it must be so, or monitoring could not prevent shirking because disciplinary efforts would have no teeth. The question is one of relative costs.

[5] The analysis herein applies mainly to voluntary constituencies of the firm, although the political process point is not wholly inapt with respect to involuntary constituencies. In any case, corporate law is an exceptionally blunt instrument with which to protect involuntary constituencies (and voluntary constituencies, as well, for that matter). Tort, contract, and property law, as well as a host of general welfare laws, provide them with a panoply of protections. See generally Jonathan R. Macey, An Economic Analysis of the Various Rationales for Making Shareholders the Exclusive Beneficiaries of Corporate Fiduciary Duties, 21 Stetson L. Rev. 23 (1991).

[6] Katz v. Oak Indus. Inc., 508 A.2d 873, 879 (Del. Ch. 1986).

[7] See Thomas A. Smith, The Efficient Norm for Corporate Law: A Neotraditional Interpretation of Fiduciary Duty, 98 Mich. L. Rev. 214, 234 (1999) (stating that “[a]ll contracts have gaps”). The claim here is simply that the shareholder-corporation contract is especially “gappy.” The ownership-like rights conferred by the shareholder’s contract follow from this phenomenon.

[8] See, e.g., Katz v. Oak Indus. Inc., 508 A.2d 873, 879 (Del. Ch. 1986) (holding that “the relationship between a corporation and the holders of its debt securities, even convertible debt securities, is contractual in nature”); see also Metropolitan Life Ins. Co. v. RJR Nabisco, Inc., 716 F. Supp. 1504, 1524-25 (S.D.N.Y. 1989); Simons v. Cogan, 549 A.2d 300, 304 (Del. 1988); Revlon, Inc. v. MacAndrews & Forbes, Inc., 506 A.2d 173, 182 (Del. 1986).

[9] Ronald M. Green, Shareholders as Stakeholders: Changing Metaphors of Corporate Governance, 50 Wash. & Lee L. Rev. 1409, 1418 (1993).

[10] Where the board has been captured by senior management, nonshareholders also are indirectly protected because management’s interests are more likely to be aligned with those of nonshareholder constituencies than with those of the shareholders. Salaried managers hold what amounts to a fixed claim on the corporation’s assets and earnings, which is not too dissimilar from the claims of other nonshareholder constituencies. Moreover, much of corporate managers’ wealth is tied up in nondiversified firm specific human capital. These factors tend to make them more concerned with ensuring the firm’s survival than with taking risks that would maximize shareholder wealth.

[11] 29 U.S.C. § 2612.

[12] 29 U.S.C. § 651.

[13] 29 U.S.C. §§ 2101(b)(1), 2102.

[14] See, e.g., 42 U.S.C. § 2000e-2 (prohibiting employment discrimination on the basis of race, color, sex, or national origin); id. § 2000e-3 (prohibiting employment discrimination for the bringing of charges, testifying or other participation in law enforcement proceedings or for employer publication or advertisement of a preference for employees of a specific race, color, religion, sex, or national origin).

[15] Targeted legislation becomes an even more attractive alternative to fiduciary-based norms of corporate social responsibility when one realizes that consideration of nonshareholder interests is a task for which corporate directors are poorly suited. The shareholder wealth maximization principle dominates both legal and managerial thinking about fiduciary duties. Given the socialization and training of modern U.S. corporate managers, shareholder wealth maximization is the norm most likely to prevail in any consensus-building process.

Bainbridge on Corporate Social Responsibility: Selected Readings

In the preceding post, I discussed at length why I reject the tenets of the corporate social responsibility canard. Really, however, even a post of that length cannot do the subject justice. For more detailed analyses of the problem by yours truly, see:

In Defense of the Shareholder Wealth Maximization Norm

This essay, "In Defense of the Shareholder Wealth Maximization Norm, appeared in the Symposium on New Directions in Corporate Law published in volume 50 of the Washington & Lee Law Review. This essay was written as a reply to an article in the same symposium by Professor Ronald M. Green - "Shareholders as Stakeholders: Changing Metaphors of Corporate Governance," 50 Wash. & Lee. L. Rev. 1409 (1993) - in which Professor Green criticized the dominant view of corporate governance, according to which directors have a fiduciary duty to maximize shareholder wealth. In sharp contrast, this essay argues that the principle of shareholder wealth maximization is both a valid positive account of corporate law and also a legitimate normative proposition.

The essay is grounded in a contractarian approach to corporate governance. The essay begins by observing that in the nexus of contracts theory the concept of ownership goes out the window, along with its associated economic and ethical baggage. Consequently, the traditional justification for shareholder wealth maximization - i.e., that shareholders own the corporation - is unavailing. There is a considerable difference between showing that the traditional private property model is inadequate, however, and showing that we should adopt a new decisionmaking norm to which corporate officers and directors must conform their behavior.

The essay then identifies and critiques the two principal normative arguments running through Professor Green's article. First, Green treats the limited liability rule as a privilege conferred by society, in return for which society can demand socially responsible corporate behavior. My essay points out that this is little more than a revival of the long-dead concession theory of corporate governance. Second, Green contends that limited liability is a mechanism through which shareholders harm nonshareholders by externalizing certain costs onto them. Although this is a more substantial argument, my essay contends that it is not persuasive. Although limited liability does permit such externalities, Green's proposed solution - i.e., allowing/requiring directors to consider the effects of their decisions on nonshareholder constituencies of the corporation - is highly flawed. Such a multi-constituency fiduciary duty would be unworkable, at best, and would significantly increase the agency costs inherent in the separation of ownership and control.

Much Ado about Little? Directors' Fiduciary Duties in the Vicinity of Insolvency

Where the contract between a corporation and one of its creditors is silent on some question, should the law invoke fiduciary duties as a gap filler? In general, the law has declined to do so. There is some precedent, however, for the proposition that directors of a corporation owe fiduciary duties to bondholders and other creditors once the firm is in the vicinity of insolvency.

Courts embracing the zone of insolvency doctrine have characterized the duties of directors as running to the corporate entity rather than any individual constituency. This approach is incoherent in practice and insupportable in theory. Courts should focus on whether the board has an obligation to give sole concern to the interests of a specific constituency of the corporation.

Concern that shareholders will gamble with the creditors' money is the principal argument for imposing a duty on the board running to creditors when the corporation is in the vicinity of insolvency. On close examination, however, this argument proves unpersuasive. It is director and manager opportunism, rather than strategic behavior by shareholders that is the real concern. Because bondholders and other creditors are better able to protect themselves against that risk than are shareholders, there is no justification for imposing such a duty.

This article also argues that the zone debate is much ado about very little. The only cases in which the zone of insolvency debate matters are those to which the business judgment rule does not apply, shareholder and creditor interests conflict, and a recovery could go to directly to those who have standing to sue. In those cases, as this Article explains, there is a strong policy argument that creditors should be limited to whatever rights the contract provides or might be inferred from the implied covenant of good faith.

Catholic Social Thought and the Corporation

This brief essay explores Catholic social thought on corporate governance. Human dignity and freedom are central principles of Catholic social thought. This essay argues that preserving the economic freedom of corporations to pursue wealth is an essential part of effective means for achieving human freedom. To the extent prudential judgments about corporate regulation are required, the Church and civil society should strive towards a nuanced balancing of freedom and virtue.

The Bishops and the Corporate Stakeholder Debate

Prepared for a conference on faith-based investing practices, this essay critiques Catholic social teaching on corporate social responsibility. Specifically, the essay focuses on one of the policy recommendations made by the U.S. Bishops in their pastoral letter on economic justice, Economic Justice for All: Pastoral Letter on Catholic Social Teaching and the U.S. Economy. In that letter, the Bishops addressed the so-called stakeholder debate; i.e., whether decisionmaking by directors of public corporations should take into account the interests of corporate constituencies other than shareholders. This essay focuses on the Bishops' position as matter of public policy rather than as a matter of theology. The essay evaluates three ways in which the Bishops' position might be translated into public policy: (1) directors could be given nonreviewable discretion to make trade-offs between shareholder and stakeholder interests; (2) directors could be given reviewable discretion to make such trade-offs; or (3) directors could be required to make such trade-offs subject to judicial (or regulatory) oversight. None of these approaches is an improvement on current law; to the contrary, all are worse. The first approach would be toothless, the second would increase agency costs, and the third would either prove unworkable or pose an unwarranted threat to economic liberty (or both).

Interpreting Nonshareholder Constituency Statutes

Nonshareholder constituency statutes permit directors to consider the effects of their decisions on a variety of nonshareholder interests, such as employees, customers, suppliers, and local communities. Although highly controversial within the corporate law academy, such statutes are on the books in well over half the states and are likely to remain so for the foreseeable future. Because the statutes offer surprisingly little guidance to directors faced with corporate decisions or to courts faced with reviewing those decisions, however, courts urgently need a coherent interpretation of the statutes. But coherence alone is not enough; courts must also be faithful to the legislative intent behind the statutes. Courts cannot ignore the statutes, wish them away, or fairly interpret them as having no meaning or impact. This article therefore proposes an interpretation of nonshareholder constituency statutes that is faithful to the apparent legislative intent while also maintaining continuity with well-established principles of director fiduciary duties. The proposed approach distinguishes between two basic categories of director decisions: (i) operational issues, such as plant closings; and (ii) structural decisions, such as takeovers. The latter pose a much more serious conflict of interest for directors than do the former and therefore demand closer scrutiny. Accordingly, while arguing that director decisions with respect to operational matters should be conducted under the business judgment rule, the article argues that director decisions in the structural setting should be reviewed under a variant of the conditional business judgment rule developed by the Delaware supreme court in Unocal Corp. v. Mesa Petroleum Co.

The Shared Interests of Managers and Labor in Corporate Governance: A Comment on Strine

In his essay, Toward Common Sense and Common Ground?, Delaware Vice Chancellor Leo Strine seeks to identify common concerns of corporate management, labor, and shareholders. In so doing, Strine endorses a vision of the corporation as "a social institution that, albeit having the ultimate goal of producing profits for stockholders, also durably serves and exemplifies other societal values." Accordingly, he directs our attention to the prospects of creating "a corporate governance structure that better fosters [the corporation's stakeholders'] mutual interest in sustainable economic growth."

There is much that is admirable in Strine's analysis of what ails corporate governance and his proposals for reform, as well as much that is debatable. In this brief comment, I identify three aspects of Strine's analysis that strike me as underdeveloped. First, what do we mean when we call the corporation "a social institution"? Second, do managers and laborers really have common interests threatened by shareholders? Finally, even if Strine's search for common ground is a worthwhile project, is corporate law and governance the appropriate arena in which to find it? Taken together, these issues raise serious questions about the viability of Strine's project.

Tushnet on Doctrinal Scholarship

Bruce Boyden blogs:

... there has been an explosion of activity in recent decades of legal scholars shooting off in all different directions trying to establish colonies of legal scholarship grounded in other methods -- a bit like a well-fed spider plant. The idea is to avoid what lawyers do and try to do more what professors in other disciplines do--any other discipline. Economics, science, sociology, literature, political science, history, philosophy; as long as "law" is not in the title, it's fair game.

So I was particularly interested to read the very end of a recent paper Mark Tushnet posted on SSRN, recently, Harry Kalven and Kenneth Karst in the Supreme Court Review: Reflections after Fifty Years. Tushnet suggests that this casting about in other disciplines might be exactly the wrong move if law is to gain (maintain?) respectability as an academic discipline:

The issues Kalven and Karst discussed remain with us, but their sensibility has been lost. It would, I think, be good to retrieve it, but I wonder whether that is possible. An intellectually ambitious scholar today who is the same age as Kalven and Karst were when they wrote their articles would be well-advised--and I am sure is advised--to avoid doing "mere doctrinal work." Kalven and Karst were engaged with doctrine far more deeply than today’s scholars are. For obvious structural reasons those with dual degrees in law and some other discipline are unlikely to, and in my experience do not, achieve the heights that Kalven and Karst reached.¹⁰⁴ But, only by reaching those heights can one truly appreciate the difficulties faced by "responsible men of affairs," and thereby achieve the detached sympathy that Kalven and Karst had for the Supreme Court and its work. That few scholars today have the capacity to do so is unfortunate.

¹⁰⁴ Briefly: Although reasonably smart, well-trained lawyers can do doctrinal analysis to a decent level of sophistication, doing doctrinal analysis at the highest level is difficult indeed, requiring a fair amount of intellectual facility and a wide grasp of doctrine from many fields. Dividing one’s intellectual effort between acquiring facility in doctrinal analysis and achieving distinction in another discipline means that one will be unable to reach the heights of doctrinal analysis. And, on the other side, in every "other" discipline of which I am aware, the field "other discipline of law" (legal history, sociology of law, economics of law, and the like) is marginal to the discipline as a whole, which means that the most able graduate students will be drawn to the fields at the discipline’s core, leaving the subfield dealing with law populated by perfectly able but not truly exceptional students. (There are of course exceptions, quite rare in my experience.)

Jack of all trades, master of none.

I think that's mostly right. In my experience, however, law pulls in some folks from other disciplines who figured out that being a legal academic pays a lot better than being, say, a sociology professor and that the legal academy regards tenure as a birth right. Whether that's enough to attract the most able grad students is unclear (at least to me).

Personally, I am increasingly inclined to adopt "just vote no" as a rule of thumb when dealing with interdisciplinary candidates. But I'm pissing into the wind on that one.

If you're an investor, do you care about conflict mineral disclosure?

Broc Romanek:

Last Friday, the SEC extended the deadlines for submitting comments on a trio of Corp Fin proposals: conflict minerals, mine safety and resource extraction disclosure. The new deadline is March 2nd.

Last year, I blogged several times analyzing potential "sleepers" in Dodd-Frank and soliciting ideas from the community. As I define "sleeper," it should be a provision that applies to many companies. Given the feedback I've received, including the comment letters submitted to the SEC so far - and the memos in our "Conflict Minerals" Practice Area - I'm now ready to deem Section 1502 regarding conflict minerals as the Dodd-Frank sleeper for disclosure lawyers. Here is an excerpt from remarks made by Amy Goodman during our recent Dodd-Frank webcast:

From talking to a number of companies in trade associations, people are realizing that this is a huge issue and could impact upwards of 6,000 issuers. While the SEC speculates that only 1,200 will actually file reports, we're hearing from companies that it's almost impossible under the current circumstances to determine that minerals do not come from the Congo. And in that case, the SEC proposal would require the report. So I would urge people to take a look at this requirement. I think it's taken a while for people to realize the seriousness of this requirement. But it could be quite burdensome.

To understand the magnitude of the undertaking that companies face in order to comply with this requirement, check out this memo - which besides providing guidance on how to comply with the provision, it explains supply chain due diligence, what entities like the OECD recommend and what various industry organizations like the EICC-GeSI are doing. There even have been readiness rankings of various industries created, such as this report on the electronics industry from the Enough Project.

My guess is that the costs of providing this disclosure are going to vastly exceed the benefits to investors. As such, it is yet another example of how narrow interest groups were able to hijack the legislative process during Dodd-Frank's drafting so as to advance an agenda wholly distinct from the financial crisis. It's thus also an example of how Congress keeps raising the cost of being public. It's thus yet another example of why American capital markets are losing their competitive standing in the global economy.