ProfessorBainbridge.com

Senator Shelby Introduces Dodd-Frank "Roll Back" Bills

Yesterday, Senator Richard Shelby (R-AL) introduced two Dodd-Frank bills. One bill is labeled a technical corrections bill but it includes exemptive authority for Section 953 - ie. pay versus performance and pay disparity - so that the SEC could adopt a rule exempting "small issuers" (see Section 11.3.c).

The other bill is called the "Financial Regulatory Responsibility Act of 2013" (guess "Even More JOBS Act" was already taken; Shelby introduced a similar bill in 2011). Based on a quick read (and a big hat tip to Lynn Turner for his analysis!), it appears to impose such stringent cost-benefit hurdles that I doubt any rulemaking would ever get off the ground. Remember that GAO recently reported that over half of the required rulemaking under Dodd-Frank has yet to be conducted.

Under Section 3, the bill requires a complete an extensive cost-benefit analysis - before an agency can even propose a rule! Normally, conducting a cost-benefit analysis is part of the proposal process and during that process, the agencies asks for input from the public and those affected, as to what the costs and benefits would be from the proposed rule. In addition, the bill requires agencies to compare quantified benefits with quantified costs - and if quantified costs outweigh the quantified benefits, the bill in essence stops the proposal before it is proposed. Bear in mind that the benefits of legislation often cannot be readily quantified.

The bill also requires agencies to provide all of its data & analysis to the public so that they can perform the cost-benefit analysis themselves (Section 5). And under Section 8, it makes challenges easier to bring in the US Court of Appeals for the DC District (which is the court that has been quite unfriendly to the SEC over the past decade). Plus it makes it harder for agencies to withstand such challenges (ie. if an agency is found to have not complied with this law, the rule is overturned unless the agency provides "clear and convincing evidence that vacating the rule would result in irreparable harm"). I believe this overturns decades of legal precedent about how agency rules are judicially reviewed.

The bill requires the SEC to adopt similar cost-benefit tests for agencies under its oversight, such as the PCAOB (Section 11). The bill also requires agencies to examine rules five years after adoption to see if they are achieving desired results (Section 6). A Chief Economists Council is established under Section 9.

via www.thecorporatecounsel.net

Sounds great.

Elite partisanship

The most recent Pew surveys suggest that most educated elites are either Solid Liberals, who take the liberal position on almost all constitutional issues of the day, or Staunch Conservatives, who take the conservative position on almost all constitutional issues of the day. The Pew surveys and thers find that conservative elites are more conservative than the average Republican and, unlike most less educated, less affluent and less politically involved Republicans, take the most conservative position on virtually all constitutional issues of the day. Liberal elites are similarly more liberal than the average Democrat, and, unlike most less educated, less affluent and less politically involved Democrats, take the most liberal position on virtually all constitutional issues of the day. These findings differ considerably from similar, but not identical, surveys taken during the heyday of the Warren Court. Those surveys found that elite Republican and Democratic often had more in common with each other than with the average member of their partisan coalition, that elites tended on most issues to be more liberal than other citizens, but that liberalism in one issue (i.e., race) did not necessarily predict liberalism on other issues (i.e., free speech). In short, Americans have moved from a society structured by elite consensus and conflict diffusion to one structured by elite polarization and conflict.

via www.concurringopinions.com

Is "fraud on the market" back on the agenda?

Apparently so:

A divided Supreme Court ruled on February 27th that proof of materiality is not a prerequisite to certification of a Rule 10b-5 securities fraud class action.Amgen Inc. v. Connecticut Retirement Plans and Trust Funds, No. 11-1085 (Feb. 27, 2013).

The elements of a Rule 10b-5 claim include proof of a material misrepresentation or omission and reliance upon such misrepresentation or omission. Plaintiffs in securities fraud class actions typically seek to invoke the “fraud-on-the-market” presumption set out in Basic Inc. v. Levinson, 485 U.S. 224 (1988) to establish reliance. In Basic, a case in which only a bare quorum of six Justices participated, a bare majority of four Justices permitted plaintiffs who trade in an impersonal and efficient market to invoke a rebuttable presumption of reliance on public, material misrepresentations, and thus proceed with a class action even absent proof of individual reliance. ...

Notably, four Justices expressed a willingness to revisit Basic’s fraud-on-the-market presumption. Justice Thomas’ dissent (in which Justices Kennedy and Scalia joined all or in part) stated that the Basic decision is “questionable”. Justice Thomas noted that only four Justices had joined the portion of the Basic opinion adopting the fraud-on-the-market theory and that two other Justices had dissented from that portion of Basic and had expressed concern that the Court had replaced “traditional legal analysis” “with economic theorization”. Indeed, one law professor (whose article Justice Thomas referenced) has described the line-up of Justices that decided Basic as “remarkably skewed”. Justice Alito concurred in the majority opinion, but on the understanding that whether the Court should revisit Basic’s fraud-on-the-market presumption was not before the Court in Amgen and, he too, stated that “reconsideration of the Basic presumption may be appropriate”.

I did not see that one coming. But I direct your attention to William W. Bratton & Michael L. Wachter, The Political Economy of Fraud on the Market, available at SSRN: http://ssrn.com/abstract=1824324, which argues that:

The fraud on the market class action no longer enjoys substantive academic support. The justifications traditionally advanced by its defenders - compensation for out-of-pocket loss and deterrence of fraud - are thought to have failed due to the action’s real world dependence on enterprise liability and issuer funding of settlements. The compensation justification collapses when considered from the point of view of different types of shareholders. Well-diversified shareholders’ receipts and payments of damages even out over time and amount to a wash before payment of litigation costs. The shareholders arguably in need of compensation, fundamental value investors who rely on published reports, are undercompensated due to pro rata distribution of settlement proceeds to all class members. The deterrence justification fails when enterprise liability is compared to alternative modes of enforcement. Actions against individual perpetrators would deter fraud more effectively than does enterprise liability. If, as the consensus view now has it, fraud on the market makes no policy sense, then its abolition would seem to be the next logical step. Yet most observers continue to accept it on the same ground cited by the Supreme Court in 1964 when it first implied a private right of action under the 1934 Act in J.I. Case v. Borak - a private enforcement supplement is needed in view of inadequate SEC resources. Restating, even a private enforcement supplement that makes no sense is better than no private enforcement supplement at all. 

But then again, maybe not. Contrary to their argument that there are "sticking points retarding movement toward fraud on the market's abolition" by the courts, that door now appears to be wide open.

The latest developments in the SEC v. Mark Cuban insider trading case

I've blogged a lot about this case over the years, but I honestly don't have anything to add to Matt Levine's excellent diagnosis of the recent developments, which I think is spot on. So just go read him.

Obama gives Paul the Right Answer

Attorney General Eric Holder wrote Sen. Rand Paul,R-Ky., to confirm that President Obama does not have the authority to kill an American on U.S. soil in a non-combat situation, Obama’s spokesman announced today.

White House Press Secretary Jay Carney quoted from the letter that Holder sent to Paul today. “Does the president have the authority to use a weaponized drone to kill an American not engaged in combat on an American soil?” Holder wrote, per Carney. “The answer is no.”

Paul said that was good enough for him. “I’m quite happy with the answer,” he said during a CNN interview. “I’m disappointed it took a month and a half and a root canal to get it, but we did get the answer.”

via washingtonexaminer.com

But why was getting it like pulling teeth?

The Economist is ineducable on shareholder activism

I still enjoy reading The Economist even though it seems at times to be drifting away from its classical liberal roots towards a mushy center-leftist space. But the people who work there seem to be ineducable on the issue of shareholder activism. Latest case in point from the new print edition:

Shareholders own companies. Managers and directors should serve them. If the owners do not like the way their servants are performing, they have a right to do something about it. Trying to improve the way a firm is run is more constructive than the traditional “Wall Street walk”, whereby disgruntled shareholders simply sell their shares.

Wrong. Shareholders do not own corporations. Shareholders own a security representing a bundle of rights that typically includes the residual claim and a vote. See this post for a quick summary of the argument and links to other, longer posts. For the full treatment, see Stephen M. Bainbridge, The Board of Directors as Nexus of Contracts. Available at SSRN: http://ssrn.com/abstract=299743.

To be sure, part of the shareholders' contract with the corporation is the proposition that "A business corporation is organized and carried on primarily for the profit of the stockholders. The powers of the directors are to be employed for that end." Dodge v. Ford Motor Co., 204 Mich. 459, 170 N.W. 668 (1919). But that doesn't give the shareholders the "right to do something."

To encourage freedom of action on the part of directors, or to put it another way, to discourage interference with the exercise of their free and independent judgment, there has grown up what is known as the “business judgment rule.” ... “Questions of policy of management, expediency of contracts or action, adequacy of consideration, lawful appropriation of corporate funds to advance corporate interests, are left solely to their honest and unselfish decision, for their powers therein are without limitation and free from restraint, and the exercise of them for the common and general interests of the corporation may not be questioned, although the results show that what they did was unwise or inexpedient.” Bayer v. Beran, 49 N.Y.S.2d 2 (Sup.Ct.1944).

As I have noted time and again, often in response to this sort of argument from The Economist, corporate law--at least in the United States--is a system of director primacy, not one of shareholder primacy. See The New Corporate Governance in Theory and Practice, for a full defense of shareholder primacy. For those with short attention stands, here are the usual bullet points:

• Director primacy is board-centric, but shareholder wealth focused.
• Director primacy thus differs from both shareholder primacy and Stout & Blair’s team production model, not to mention the various stakeholder theories.
• I claim that the debate between these models has conflated the means and ends of corporate governance.
• For example, shareholder primacy really makes two distinct claims. As to the ends of corporate governance—in other words, the social purpose and role of the corporation—shareholder primacy claims that the duty of directors and managers is to maximize shareholder returns within the bounds of law. Director primacy concurs.
• As to the means of corporate governance—who ultimately has decision-making authority—shareholder primacy says it is—or, rather, ought to be—the shareholders. Here, director primacy says no.
• The powers of the board of directors are original and undelegated. The board of directors is the nexus of corporate contracts. The shareholders’ claim on the corporation is merely one of those contracts.
• The intersection of the power of directors to manage the corporation and their obligation to do so in the shareholders’ interest creates a variant of the principal-agent problem.
• There is a core tension between the board’s authority and the need to ensure that the board uses its authority responsibly.
• Shareholder voting rights are one of the mechanism by which directors are held to account.
• If we try to make more of shareholder voting, if we try to elevate it into a functioning part of the governance system, however, we undermine the centralization of power in the board that makes the modern public corporation possible.
• The power to review, after all, is the power to decide. Every time we increase the shareholder’s right to review board decisions, we are thus undermining the core of corporate governance by shifting the power of decision to shareholders.
• This transfer of authority from board to shareholders is undesirable in itself.
• Worse yet, the interests of activist investors likely to differ from those of shareholders as a whole
• State/local and union funds are among the most active on governance issues. They have private interests: 
  “progress on labor rights desired by union fund managers and enhanced political reputations for public pension fund managers.” (Romano)
• Director primacy thus calls for constraints on proposals to expand the role of shareholders in corporate governance.

The Economist disputes the claim that left-wing shareholder activism by Democrat Party-affiliated union and state/local employee pension funds is a problem, by claiming that:

... shareholder activists are unloved. From the right comes the gripe that they have the wrong motives. Last year only 1% of shareholder resolutions in America were proposed by investors “unaffiliated with organised labour or a social, religious, or public-policy purpose”, says the Manhattan Institute, a think-tank. But so what? Last year only 1% of shareholder resolutions in America were proposed by investors “unaffiliated with organised labour or a social, religious, or public-policy purpose”, says the Manhattan Institute, a think-tank. But so what? Activists prevail only when they persuade a majority of shareholders that their ideas will make money. An eco-warrior who buys a few Exxon shares and tries to stop the firm from pumping oil will not get far.

Wrong again. In the first place, people who are risk averse by definition will seek to avoid a loss even if the event in question has a positive expected value. As shareholder activism’s chief priest, Lucian Bebchuk puts it, managers “prefer not to lose votes” and, as he has put it elsewhere, “managers are risk-averse.”  Accordingly, managers may still give in to blackmail by activist shareholders even where an objective analysis suggests the proposal has little chance of passage.

Second, there are several situations in which a rent-seeking proposal by activists plausibly could threaten to achieve majority support. The rent seeking institution might propose a value-increasing change, for example, which it will agree to drop in exchange for some private benefit.  Bebchuk has conceded this possibility, but dismissed it on grounds that “a blackmail argument can be made not only against increasing shareholders’ power, but also against maintaining the power that shareholders currently have,” which no one proposes reducing on this account.  It’s not clear, however, why the absence of proposals to further disempower shareholders necessarily provides a case for granting them extensive new powers.

Alternatively, an activist seeking private benefits could bundle a value-increasing and value-decreasing proposal in hopes of increasing the prospects of passage. The considerable attention paid to the recent anti-bundling decision invalidating Apple’s proxy notwithstanding, courts almost never invalidate proposals for being bundled. The activist also might offer side payments to other shareholders seeking their support. Vote buying, after all, is only illegal when management does it. In lieu of side payments, the activist might seek to assemble a coalition of other shareholders that would also receive private benefits, which is perhaps the most likely scenario in which an investor coalition would coalesce.

Accordingly, the majority vote requirement is an inadequate constraint on rent seeking by union and public pension funds (or other institutional investors, such as hedge funds, for that matter). To be sure, like any other agency cost, the risk that management will be willing to pay private benefits to an activist is a necessary consequence of vesting discretionary authority in the board and the officers. It does not compel the conclusion that we ought to limit the board’s power. It does, however, suggest that we ought not give investors even greater leverage to extract such benefits by further empowering them. 

Finally, in response to The Economist's claim that "Empowering shareholders is a good idea," see my essay Director Primacy and Shareholder Disempowerment, which you can download here. This essay was a response to Lucian Bebchuk's article The Case for Increasing Shareholder Power, 118 Harvard Law Review 833 (2005). In that article, Bebchuk put forward a set of proposals designed to allow "shareholders to initiate and vote to adopt changes in the company's basic corporate governance arrangements."

In response, I make three principal claims. First, if shareholder empowerment were as value-enhancing as Bebchuk claims, we should observe entrepreneurs taking a company public offering such rights either through appropriate provisions in the firm?s organic documents or by lobbying state legislatures to provide such rights off the rack in the corporation code. Since we observe neither, we may reasonably conclude investors do not value these rights.

Second, invoking my director primacy model of corporate governance, I present a first principles alternative to Bebchuk's account of the place of shareholder voting in corporate governance. Specifically, I argue that the present regime of limited shareholder voting rights is the majoritarian default and therefore should be preserved as the statutory off-the-rack rule.

Finally, I suggest a number of reasons to be skeptical of Bebchuk's claim that shareholders would make effective use of his proposed regime. In particular, I argue that even institutional investors have strong incentives to remain passive.

Where were the Democrats?

Senate Republicans took the floor on Wednesday, launching an historic filibuster in an attempt to extract an answer from the White House to a simple question: Does the administration believe it has the legal authority to kill an American citizen on American soil with a drone strike?

It's a question that seems fairly nonpartisan on its face, but a second one occurred to those watching the C-SPAN broadcast late into the morning: Where are all the Democrats?

via www.huffingtonpost.com

What happened to the "progressives" who constantly berated Bush for his handling of the GWOT? Why are they silent?

Wiretaps need warrants, drones don't, which makes no sense

Today, the government needs court approval to wiretap a U.S. citizen suspected of terrorism overseas – but it doesn’t need one to kill him.

via cnnradio.cnn.com

The New Investor Cliffhanger

University of Florida Tom Lin is here at UCLA today to present his paper, The New Investor, to a law review symposium. (The New Investor. 60 UCLA Law Review 678 (2013). Available at SSRN: http://ssrn.com/abstract=2227498.)

I've been asked to comment on the article. So here's what I plan to say:

There is much to like about Professor Lin’s article, The New Investor. The article provides a comprehensive survey of how technology is changing the capital markets and thus, inevitably, providing new challenges for securities regulation. Lin writes well and clearly, even about highly technical legal and technological issues. The article is exhaustively researched, reflecting a command of literatures from a number of disciplines.

As a lifelong tech geek and science fiction fan, moreover, the many explicit and implicit references to classic science fiction tropes tickled my fancy. Indeed, it is in my fanboy capacity that I must take issue with Lin’s foundation metaphor; namely, We are all cyborgs now.

But when we think of cyborgs, we think of organisms that are part man and part machine, such as the Borg of the Star Trek franchise or Darth Vader of the Star Wars franchise.  Instead, a better model would be the working relationship between humans and computers.

A classic science fiction trope is the ironically named “the computer is your friend,” in which a super computer becomes a super-villain. Before there was The Matrix there was Skynet.  Before there was Skynet there was Colossus. (I digress to note that The Forbin Project is one of those movies that’s so bad it’s good.) And so on back to at least Isaac Asimov’s The Machines. An apt metaphor for the hazards Professor Lin identifies in the computerization of the markets.

Conversely, of course, there are some science fiction supercomputers that turn out to be super-heroes. Holmes IV of Robert Heinlein’s novel The Moon is a Harsh Mistress springs to mind as an apt metaphor for the positive potentialities of technology.

So, first criticism, Borgs out, Skynet in.

On to a more serious point. As I said, there is much to like about this article, but I must confess to being left rather frustrated by it.

For one thing, like most law review articles, it is too long. (Mea culpa.) Consider, for example, Part I.A of the article, in which Lin traces the rise of the machines in society. That section easily could have been boiled down into the single sentence “computers are really important.”

In addition to being too long, law review articles all too often suffer from grandiose ambition, which detracts from their utility for end users such as practitioners, judges, legislators, and regulators.  I’m afraid that Part V of Professor Lin’s article is a case in point. In it, Lin takes on the question of whether technological advances “necessitate the fall of humans in society and finance,” concluding that they do not. I have no doubt that it is also a question worthy of serious philosophical musing, but I am not convinced that an article on regulating the impact of technology on capital markets is the right venue for it.

Turning to my principal criticism, however, as I thought about why the article left me frustrated, it occurred to me that I felt the same way when I finished George R.R. Martin’s book A Dance with Dragons. When a 1040 page book that is the fifth in a series ends on a cliffhanger, one is—I think—entitled to be a tad peeved. But by my count Professor Lin leaves us with not just one but 11 cliffhangers.

Lin’s article thus called to mind my former University of Illinois College of Law colleague John Nowak’s advice that the way to become a successful professor is to “[t]ake an obscure little problem that no one has thought much about, blow it all out of proportion, and solve it, preferably several times, in prestigious law reviews.”  Unfortunately, other than publishing in a prestigious law review, that is not advice Professor Lin chose to follow in The New Investor.

Let’s start with John’s recommendation that one select “an obscure little problem.” Lin violated all three precepts. Instead of one problem, he chose many. Instead of an obscure problem, he chose very important ones. Instead of a little problem, he chose very big ones. But then he doesn't solve them.

The discussion of how cyber crimes threaten capital markets, for example, concludes with the observation that “[c]ybersecurity prevention and protection efforts are undoubtedly difficult, but they must also be sensible, thoughtful, and not obstruct the promise and progress of cyborg finance.”  Lin therefore urges that the endeavor to balance these competing concerns “must be pursued vigorously because, ultimately, technological advances in finance may hold more promise than threat in the future.”  But the reader is left wondering (1) assuming all turns out well, how do we effect such a balance and (2) what happens if the future of computerized finance looks more like Skynet than HOLMES IV?

Lin’s failure to provide solutions is particularly frustrating when one comes to his discussion of the implications technological change has for the legal definition of the “reasonable investor.” Here indeed was a “problem that no one has thought much about,” albeit not a little one, crying out for a solution. I left the analysis fully persuaded that technological changes and new insights from behavioral economics require us to rethink what it means to be a reasonable investor, but I also left it with no idea of how courts might go about reframing the existing legal definition to take cognizance of those developments. Telling the reader that “regulators need to become more mindful of the dynamism and realism of the new investor model if they hope to remain relevant” is not a solution.

What makes Lin’s failure to offer solutions here even more frustrating is that this is one context in which his interest in broader social questions may well prove relevant. In U.S. v. Sayre, the Ninth Circuit held that a district court had not abused its discretion by refusing to instruct the jury in a securities fraud case as to the meaning of “reasonable investor.” The appellate court explained that “[t]he term ‘reasonable investor’ is a concept within the jury's ordinary experience and understanding.” But if Lin is right about the way technology is changing what it means to be a reasonable investor and I’m right that most investors are not cyborgs, will it remain the case that the everyday experiences of ordinary jurors will equip them to decide questions of materiality? Put another way, will Wall Street’s Skynets be able to find a jury of their peers?

In sum, if one wants a broad survey of technology and capital markets from which one could mine multiple problems one could proceed to solve, “preferably several times, in prestigious law reviews” Professor Lin’s article will serve the purpose admirably. Indeed, in closing, I hope that Professor Lin himself will do so. His article demonstrates a command of several relevant literatures that will give him a launching platform from which to move on to detailed analyses of the problems he has identified herein. Just skip the cliffhangers from here on out, okay?

Manne on McDougal

When I took International Law at Virginia, it turned out to be a course not about law but about the legal methodology of Myres McDougal. I hated it. No, I mean I hated it. Incomprehensible mumbo jumbo. So imagine my amusement when I ran across this tidbit in Henry Manne's oral history:

I went [to Yale Law School on a post-graduate fellowship] and discovered a man named Myres McDougal, who was one of the more famous law professors of the era. He and Harold Lasswell, the famous political scientist, had devised a schemata for using the social sciences to approach law. It was called Law, Science, and Policy. All graduate students were required to immerse themselves in this, if you’ll pardon me, garbage. I say “garbage” because I think there’s only one rigorous social science and that’s economics, and Law, Science, and Policy had no economics in it whatsoever. What they thought they were doing, I don’t know. Today there are no remnants of it around. 

Henry's a lot smarter than I am (I take solace in the fact that he's a lot smarter than pretty much everybody), so if Henry thought it was garbage I find myself in the best of company.

Update: Tony Arend responds in his typically civil and intelligent manner, concluding that:

So, while I don’t recommend McDougal and Lasswell as bedtime reading, I do find their work to have continuing relevance in international law. But if you have not read any of their writings, I recommend beginning with John Norton Moore’s “Prolegomenon to the Jurisprudence of Myres McDougal and Harold Lasswell.” It is the Rossetta Stone for their work!

Manne's oral history

As regular readers know, Henry Manne is one of my heroes. Father of law & economics and, I'm proud to say, a mentor and friend. He was and remains one of the great legal minds of our time. The SEC Historical Society collects oral histories from notable contributors to securities law. They've finally gotten around to doing Henry's (it's about damned time). You can download it from here.

Now, when are they doing me?

Where am I?

No, I'm not on hiatus or vacation. But I had an idea for a very short law review article (sub-5000 words) that I wanted to crank out in time to make the Spring submission round. It's flowing really fast, so I should be back to blogging a day or two.

Want to know what it's about? Well, here's a hint. What does Model Business Corporaton Act sec. 6.22(b) have to do with Obamacare?

Chateau Meyney (St. Estephe) 1989

When last noted in 2004, "this was still a remarkably young and backward wine." Nine years later at age 23+, it is much further along in its evolution but even so remains surprisingly fruity.

Decanted off moderate sediment 45 minutes before service. The bottle showed some ullage, with the wine level at the bottom of the neck. The cork was intact but showed some staining.

The bouquet suggested raspberry, black cherry, black currant, cedar, and the humidor. The flavor associations were similar, with somewhat more maturity markers such as leather and tobacco. The finish is a little short, betraying its cru bourgeois origins.

I think this wine will easily hold its own and even continue developing at least through age 30. So I plan to hold on to my last bottle until 2019.

Grade: A-/A

I served it with medallions of boneless lamb loin, which I had marinated for 6 hours in a pomegranate juice/blood orange marinade, and then grilled for about 3 minutes per side. I prepared a cup of Israeli couscous according to the package directions,except for substituing 1/2 cup blood orange juice and 3/4 cup white wine for the 1-and-1/4 cup water for which the recipe called, and mixing in at the last minute some dried parsley, pistachio nuts, and pomegranate seeds. Yum.

Behrens & Hitchcock The Change Up (Napa Valley) 2009

This red wine is a blend of 50% Cabernet Sauvignon, 20% Petit Verdot, 20% Merlot, and 10% Syrah. At age 4 it is an incredibly deep purple--almost black--and has thrown almost no sediment. After double decanting 45 minutes before serving it, the bouquet was enormous. Blackberries, black cherries, anise, herbs, and something floral that I can't pin down. The palate was dominated by cassis and mocha java. The firm tannins suggest it will age well (maybe 10 years?), but the forward fruit is hard to resist now. Fortunately this was just the first of a half case I had laid down, so I'll be able to follow it (and report on it) for quite a while. Grade: A-