ProfessorBainbridge.com

What are the social functions of a stock market?

Merritt Fox offers an interesting primer.

The Economist on the Uptick in Public Offerings: Telling its Readers What Mine Have Known for Years

From The Economist:

FOR years, discussions of America’s public markets have usually featured a lament for their dwindling appeal. According to Jay Ritter of the University of Florida, the number of publicly listed companies peaked in 1997 at 8,491 (see chart). By 2017 it had slumped to 4,496. True, many of the companies that went public in the internet’s early days should never have done so. But the decline worries anyone who sees public markets as the best way for ordinary investors to benefit from the successes of corporate America.

The mood right now is more buoyant. ... “There are plenty of signs that IPO activity is about to surge,” says Kathleen Smith of Renaissance Capital, a research firm.

The question is whether one quarter a revival makes. ...  

Underlying these concerns is an older one—that the vast and varied costs of first bringing shares to market, and then remaining public, are just too high. These costs include bankers’ and lawyers’ fees, the risk of class-action litigation, the need to reveal commercially sensitive information that could benefit rivals, and the prospect of fights with corporate raiders who want juicier returns for shareholders and social activists who want executives to pay heed to their values. Added to all these are public reporting and tax requirements that private companies can often avoid.

Mr Ritter attributes much of the decline in the number of companies that are listed to the difficulty of being a small public company.

Hello? Haven't I been saying that for years? See, e.g., Corporate Governance and U.S. Capital Market Competitiveness (October 22, 2010). UCLA School of Law, Law-Econ Research Paper No. 10-13. Available at SSRN: https://ssrn.com/abstract=1696303

This essay was prepared for a forthcoming book on the impact of law on the U.S. economy. (The American Illness: Essays on the Rule of Law) It focuses on the impact the corporate governance regulation has had on the global competitive position of U.S. capital markets.

During the first half of the last decade, evidence accumulated that the U.S. capital markets were becoming less competitive relative to their major competitors. The evidence reviewed herein confirms that it was not corporate governance as such that was the problem, but rather corporate governance regulation. In particular, attention focused on such issues as the massive growth in corporate and securities litigation risk and the increasing complexity and cost of the U.S. regulatory scheme.

Tentative efforts towards deregulation largely fell by the wayside in the wake of the financial crisis of 2007-2008. Instead, massive new regulations came into being, especially in the Dodd Frank Act. The competitive position of U.S. capital markets, however, continues to decline.

This essay argues that litigation and regulatory reform remain essential if U.S. capital markets are to retain their leadership position. Unfortunately, the article concludes that federal corporate governance regulation follows a ratchet effect, in which the regulatory scheme becomes more complex with each financial crisis. If so, significant reform may be difficult to achieve.

Bill de Blasio's costly carbon pension fund divestment grandstanding

The NYC Mayor Bill de Blasio puts progressive theater ahead of sound public policy is by now one of the basic truisms of American politics. Latest case in point comes from a NY Times report that de Blasio is trying to strong-arm trustees of NYC employee pension funds--who are supposed to be fiduciaries of their beneficiaries, not mayoral rubber stamps--into divesting from oil stocks:

Seeking to position himself as a national leader against climate change, Mayor Bill de Blasio on Wednesday announced a two-pronged attack against the fossil-fuel industry, including a vow that city pension funds would divest about $5 billion from companies involved in the fossil fuel business. ...

Mr. de Blasio said that a majority of the trustees on two of the funds — one for teachers and another for many employees not including police officers or firefighters — were ready to support divestment.

... The total amount managed by the funds is about $189 billion.

At least NYC comptroller Scott M. Stringer is sounding some cautionary notes, but since when has de Blasio put fiscal stewardship ahead of grandstanding?

As we have discussed on these pages many times before, social divestment is almost always bad news for fund beneficiaries:

A London Business School Institute of Finance and Accounting working paper called "The Effect Of Socially Activist Investment Policies On The Financial Markets: Evidence From The South African Boycott concluded: 

"We find that the announcement of legislative/shareholder pressure of voluntary divestment from South Africa had little discernible effect either on the valuation of banks and corporations with South African operations or on the South African financial markets. There is weak evidence that institutional shareholdings increased when corporations divested. In sum, despite the public significance of the boycott and the multitude of divesting companies, financial markets seem to have perceived the boycott to be merely a 'sideshow.'"

Another paper, "The Stock Market Impact of Social Pressure: The South African Divestment Case," from the Quarterly Review of Economics and Finance in fact found:

 "Using the South African divestment case, this study tests the hypothesis that social pressure affects stock returns. Both short-run (3-, 11-, and 77-day periods) and long-run (13-month periods) tests of stock returns surrounding U.S. corporate announcements of decisions to stay or leave South Africa were performed. Tests of the impact of institutional portfolio managers to divest stocks of U.S. firms staying in South Africa were also performed. Results indicate there was a negative wealth impact of social pressure: stock prices of firms announcing plans to stay in South Africa fared better relative to stock prices of firms announcing plans to leave."

In sum, divestment may make activists feel all warm and fuzzy, but the evidence is that (1) it has no significant effect on the target of the divestment campaign but (2) likely does harm the activists' portfolios.

As the Manhattan Institute's James Copeland explained in reference to an anti-semitic effort by the Presbyterian Chiurch (USA) to embrace the BDS movement, these results are entirely consistent with financial theory:

"Unlike a boycott in a traditional goods market, the sale of a stock or bond in a financial market in sufficient volume to affect its price makes it more attractive to a buyer who doesn't care about the divester's social cause. These buyers will bid the price back up to its equilibrium level, the risk-adjusted net present value of expected free cash flows from the instrument. So whereas a goods boycott can be effective under certain conditions, a stock divestiture never can unless there is insufficient liquidity on the other side, a highly dubious condition in our financial market. The Presbyterian Church may have $7 billion in financial assets, but that's hardly a sufficient sum to control financial market pricing."

In the NYC case, it's especially appalling because NYC's pension funds are so badly underfunded:

Mayor de Blasio presented a fiscal 2018 Executive Budget that called for pension contributions totaling $9.6 billion — another all-time high . Yet city pension plans remain significantly underfunded even by lenient government accounting standards, posing a big risk to New York’s fiscal future. ...

The city’s unfunded pension liabilities (i.e., pension debt) ballooned to an officially reported total of nearly $65 billion as of fiscal 2016, up from $60 billion just three years earlier. More than half of current pension contributions are required simply to pay down the pension debt instead of for new benefits for current workers.

Is that an environment in which one ought to be putting feel good grand gestures ahead of maximizing return?

The day may well come when NYC retirees have Bill de Blasio to thank for a default on their pensions.

Understanding Dual Class Stock Part I: An Historical Perspective

Dual class stock is back in the news. Institutional investors are seeking ways to delegitimize this governance structure, with some success as reported by the Council of Institutional Investors:

Following the egregious no-vote IPO of Snap Inc. and requests by CII and other concerned investor groups, three major index providers opened public consultations on their treatment of no-vote and multi-class structures. The FTSE Russell consultation resulted in a decision to exclude past and future developed market constituents whose free float constitutes less than 5 percent of total voting power. S&P Dow Jones' consultation resulted in a broader, but only forward-looking exclusion, which bars the addition of multi-class constituents to the S&P Composite 1500 index and its components, covering the S&P 500, MidCap 400 and SmallCap 600 indexes. MSCI's consultation concluded on August 31; a decision remains pending.  

I find this hysteria vastly overblown, as I shall explain in a series of posts. Today, I begin by setting the background through a review of the relevant history. As we shall see, dual class capital structures are not an historical anomaly. Rather, it is prohibitions on them that are the oddities.

Famed oilman and takeover raider T. Boone Pickens once asserted that "equal voting rights and common stock ownership are inextricably linked. Over 200 years of experience have established equal voting rights as a fundamental tenet of American democracy."[1] Pickens' rhetorical powers are considerable, but in this case his grasp of economic history was not. Worse yet, his claim is a common misconception.

In fact, however, one share-one vote is not the historical norm. To the contrary, limitations on shareholder voting rights in fact are as old as the corporate form itself.

Prior to the adoption of general incorporation statutes in the mid-1800s, the best evidence as to corporate voting rights is found in individual corporate charters granted by legislatures. Three distinct systems were used. A few charters adopted a one share-one vote rule.[2] Many charters went to the opposite extreme, providing for one vote per shareholder without regard to the number of shares owned.[3] Most followed a middle path, limiting the voting rights of large shareholders. Some charters in the latter category simply imposed a maximum number of votes to which any individual shareholder was entitled. Others specified a complicated formula decreasing per share voting rights as the size of the investor's holdings increased. These charters also often imposed a cap on the number of votes any one shareholder could cast.[4]

Gradually, however, a trend towards a one share-one vote standard emerged.[5] Maryland's experience was typical of the pattern followed in most states, although the precise dates varied widely.[6] Virtually all charters granted by the Maryland legislature between 1784 and 1818 used a weighted voting system. After 1819, however, most charters provided for one vote per share, although approximately 40 percent of the charters granted between 1819 and 1852 retained a maximum number of votes per shareholder. Finally, in 1852, Maryland's first general incorporation statute adopted the modern one vote per share standard.

Legislative suspicion of the corporate form and fear of the concentrated economic power it represented probably motivated the early efforts to limit shareholder voting rights.[7] A variety of factors, however, combined to drive the legal system towards the one share-one vote standard. Because reform efforts were almost invariably led by corporations, apparently under pressure from large shareholders,[8] it may be assumed that one factor was a desire to encourage large scale capital investment. The ease with which restrictive voting rules could be evaded also undermined the more restrictive rules. Large shareholders simply transferred shares to strawmen, for example, who thereupon voted the shares as the true owner directed.[9] Finally, while other factors also contributed, the most important factor probably was the fading of public prejudice towards corporations.[10]

By 1900, a majority of U.S. corporations had moved to one vote per share.[11] Indeed, contrary to present practice, most preferred shares had voting rights equal to those of the common shares.[12] State corporation statutes of the period, however, merely established the one share-one vote principle as a default rule.[13] Corporations were free to deviate from the statutory standard,[14] and the trend towards one vote per share reversed in the first two decades of the 20^th Century as a growing number of issuers adopted dual class governance structures.

Two distinct deviations from the one share-one vote standard emerged in the years prior to the Great Crash. One involved elimination or substantial limitation of the voting rights of preferred stock. In particular, it became increasingly common to give preferred shares voting rights only in the event of certain contingencies (such as non-payment of dividends). While controversial at the time,[15] this practice is the modern norm.[16]

The more important development for present purposes was the emergence of nonvoting common stock. One of the earliest examples was the International Silver Company, whose common stock (issued in 1898) had no voting rights until 1902 and then only received one vote for every two shares.[17] After 1918, a growing number of corporations issued two classes of common stock: one having full voting rights on a one vote per share basis, the other having no voting rights (but sometimes having greater dividend rights).[18] By issuing the former to insiders and the latter to the public, promoters could raise considerable sums without losing control of the enterprise.[19]

While disparate voting rights plans were gaining popularity with corporate managers in the 1920s, and investors showed a surprising willingness to purchase large amounts of nonvoting common stock, an increasingly vocal opposition also began emerging. William Z. Ripley, a Harvard professor of political economy, was the most prominent (or at least the most outspoken) proponent of equal voting rights. In a series of speeches and articles, eventually collected in a justly famous book, he argued that nonvoting stock was the "crowning infamy" in a series of developments designed to disenfranchise public investors.[20] In essence, this was an early version of the conflict of interest argument made below: promoters were using nonvoting common stock as a way of maintaining voting control for themselves.

The opposition to nonvoting common stock came to a head with the NYSE's 1925 decision to list Dodge Brothers, Inc. for trading. Dodge sold a total of $130 million worth of bonds, preferred stock and nonvoting common shares to the public. Dodge was controlled, however, by an investment banking firm, which had paid only $2.25 million for its voting common stock.[21] In January 1926, the NYSE responded to the resulting public outcry by announcing a new position:

Without at this time attempting to formulate a definite policy, attention should be drawn to the fact that in the future the [listing] committee, in considering applications for the listing of securities, will give careful thought to the matter of voting control.[22]

This policy gradually hardened, until the NYSE in 1940 formally announced a flat rule against listing nonvoting common stock.[23] Although there were occasional exceptions, the most prominent being the 1956 listing of Ford Motor Company despite its dual class capital structure, the basic policy remained in effect until the mid-1980s.[24]

Long before 1940, Ripley had proclaimed the demise of nonvoting common stock.[25] He was somewhat premature: in the years between 1927 and 1932, at least 288 corporations issued nonvoting or limited voting rights shares (almost half the total number of such issuances between 1919 and 1932).[26] But the Great Depression, with an assist from the opposition led by Ripley and the NYSE's growing resistance, killed off many disparate voting rights plans.[27]

Even so, however, dual class governance structures did not disappear. Far from it. Famous firms such as Ford and Hershey retained (as they still do) dual class capital structures. In the period 1988-2007, moreover, dual class firms held more or less steady at approximately seven percent of the total number of public corporations.

In sum, while their popularity has waxed and waned many times, neither dual class stock nor complaints about it are new. Granted, the one share-one vote rule fairly early became the default rule. But it remained only a default rule and departures from it remained common into the 1930s. Today's dual class capital structures thus were almost more of a revival of the historical norm than a departure from it.

Overreacting to dual class stock

Yvan Allaire has a great analysis of Dow Jones' overreaction to Snapchat's IPO and the dual class stock phenomenon in general:

In July 2017, Dow Jones, goaded by the reaction to Snapchat having gone public with a class of shares without voting rights, announced that, after extensive consultation, it had decided to henceforth eliminate companies with dual-class shares from its indices, in particular the S&P 500 Index. ...

The surging popularity of this type of capital structure has agitated institutional investors and other types of shareholders that pretend, with no legal support, to be the owners of the companies. Skirmishes about dual-class shares then turned into an all-out war led by index fund managers, some institutional investors, influential academics, the governance industry, and investment bankers. They allege that dual-class shares result in a discounted value and a poor relative performance. They are prone to claim that the one share-one vote principle is the moral equivalent of the sacrosanct one person-one vote of electoral democracy.

Of course that equivalence between electoral democracy and shareholding is totally bogus.

Precisely, which reminds me I need to do a post on the history that shows just how bogus that equivalence is.

Professor Allaire concludes that Dow Jones' action only helps activists. Kindly go read the whole thing.

 

How dangerous is passive investing

Many things that are useful to individuals prove harmful when viewed from a society-wide perspective. Are passively managed indexed mutual funds one? A friend of the blog sent along a link to this WSJ story:

If investors continue to pile their money into passive index-tracking, at some point markets will stop doing their job of allocating resources efficiently in the economy. Perhaps they already have.

The threat is big enough that the world’s largest pension fund is preparing to put more of its money with active managers—who charge more and on average underperform—in an attempt to keep markets functioning properly. ...

Hiromichi Mizuno, chief investment officer of Japan’s $1.4 trillion Government Pension Investment Fund, worries that market efficiency will be damaged by the rise of passive funds, which rely on trading by active investors to set the price of stocks.

Obviously, passive management is the ideal way for retail investors (like you and me) to invest. Most of my retirement savings are indexed, for example. 

Yet, the WSJ piece is hardly the first time global concerns have been raised about the trend towards passive investing. The New Yorker had a breathless piece back in 2016, for example.

So, are we collectively harming market efficiency? One problem is that a lot of the research on this area has been funded or conducted by people with a dog in the fight. 

Personally, however, I find this analysis pretty persuasive:

But while indexing could be a problem in theory, we are not convinced that indexing poses a problem in practice, for three reasons. First, while the quantity of actively managed assets has been shrinking recently, we believe the quantity of actively managed assets provides an imperfect indication of the amount of active management. Not all active managers are the same. Some are more “active” than others. There is wide variation in investment styles across the population of active managers, from the strength of each manager’s conviction to the size of the coverage universe and the level of trading activity.

Second, a growing number of indexed portfolios reflect “active” views insofar as they pursue goals which are commonly associated with active management. Smart beta strategies that provide exposure to common equity factors are one example. These increasingly popular portfolios may be indexed, but that doesn’t mean that they are “passive” in the same way that market-weight indexing is passive.

Third, many indexed portfolios are used to implement tactical (active) views within asset allocation strategies. Active investing still occurs, but via thematic portfolios and/or at the asset-class level rather than via individual stocks.

So go on feeling good about indexing your investments.

S&P to exclude dual class shares from its indices

Bloomberg reports that:

S&P Dow Jones Indices barred companies from joining its key U.S. stock indexes if they have multiple share classes, taking a stance on an increasingly contentious issue.

Corporations that issue shares conveying different rights to investors will no longer be able to join the S&P 500 Index, one of the most popular ways of tracking the performance of the American stock market. They'll also be banned from S&P's flagship indexes for mid-cap and small-cap stocks, according to a statement released July 31.

This is just moronic. In the first place, S&P is only applying the rule to its US indices. Its global indices will continue to include companies with dual class capital structures. If dual class structures are so evil, why doesn't;t that apply to companies regardless of country.

In the second place, as I have argued for decades, dual class stock capital structures are unobjectionable when adopted--as they must be under current exchange listing standards--before a company goes public:

Public investors who do not want lesser voting rights stock simply will not buy it. Those who are willing to purchase it presumably will be compensated by a lower per share price than full voting rights stock would command and/or by a higher dividend rate. In any event, assuming full disclosure, they become shareholders knowing that they will have lower voting rights than the insiders and having accepted as adequate whatever trade-off the firm offered in recompense.

There simply is no policy basis for this shift.

Active management loses out (again) to passive investment management

The WSJ today reported that:

A growing exodus from hedge funds extended to two of the biggest names in the industry Tuesday, Tudor Investment Corp. and Brevan Howard, as disenchanted investors increasingly shun what was once the hottest place to put money.

The funds’ problem is clear: They just aren’t performing.

Hedge funds and actively managed mutual funds have been underperforming since financial markets began their rebound in early 2009. The average hedge fund is up 3% this year through the end of July, according to researcher HFR Inc., less than half the S&P 500’s rise, including dividends.

This comes as no surprise, of course. It is well-established that you're better off, over the long haul, investing in passively-managed index funds rather than actively-managed mutual or pension funds. Over time, as numerous studies have shown, nobody meets the market once you adjust for risk and the survivor bias. Why? In part, at least, because the managers of active funds are subject to a whole slew of cognitive biases and errors that tend to adversely affect their decisionmaking.

Don't believe me? Fine. But before we talk about it go read Burton Malkiel's magisterial work A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing and then we'll talk. It lays out the evidence in favor of passive investment management "in terms so plain and firm as to command their assent."

Related articles

In 2014, index funds beat hedge funds ... for 6th year running

Active investment fund management is a huge rip-off

Why do activist shareholders favor factionalized boards?

Explaining the cool down in the IPO market

There was an insightful letter to the editor in today's WSJ:

Regarding “IPO Market Cools As Private Deals Rise” (page one, Aug. 1): Is it really hard to understand why a company would prefer to sell shares to a private-equity firm staffed with highly educated professionals who not only will serve on the board but contribute value as opposed to going public and being second guessed by every plaintiffs’ lawyer, SEC staffer and Justice Department enforcer who has never held a job outside of the regulatory quagmire in Washington? 

The IPO is no longer the desired outcome because of litigation and burdensome and expensive regulation. The end result is that affluent investors in private-equity funds continue to hold stakes in promising upstarts while common investors get stuck with their parent’s and grandparent’s portfolio options.

I made a similar argument at length in Corporate Governance and U.S. Capital Market Competitiveness (October 22, 2010). UCLA School of Law, Law-Econ Research Paper No. 10-13. Available at SSRN: http://ssrn.com/abstract=1696303:

During the first half of the last decade, evidence accumulated that the U.S. capital markets were becoming less competitive relative to their major competitors. The evidence reviewed herein confirms that it was not corporate governance as such that was the problem, but rather corporate governance regulation. In particular, attention focused on such issues as the massive growth in corporate and securities litigation risk and the increasing complexity and cost of the U.S. regulatory scheme.

Tentative efforts towards deregulation largely fell by the wayside in the wake of the financial crisis of 2007-2008. Instead, massive new regulations came into being, especially in the Dodd Frank Act. The competitive position of U.S. capital markets, however, continues to decline.

This essay argues that litigation and regulatory reform remain essential if U.S. capital markets are to retain their leadership position. Unfortunately, the article concludes that federal corporate governance regulation follows a ratchet effect, in which the regulatory scheme becomes more complex with each financial crisis. If so, significant reform may be difficult to achieve.

Henderson on the merits of paying for early access to corporate information

My friend and coauthor Todd Henderson (Chicago law) has a really interesting op-ed in today's WSJ, in which he argues for creating a market in early access to corporate disclosures:

The SEC could mandate that corporate information be publicly released at a particular time, say, 2 p.m. Then it would permit companies to offer early peeks—say, starting at 1 p.m.—to anyone willing to pay. Firms could charge a subscription or sell early information a la carte, depending on market demand, and keep the proceeds. ...

If the data does indeed provide an advantage, then some investors, such as hedge funds and high-speed traders, would undoubtedly pay. Those looking for long-term equity returns, such as ordinary retirees and index funds, would not.

In turn, the pricing data that emerges from such a market would help answer one of the most perplexing questions of securities law: What information is material? The law defines materiality as whether there is a substantial likelihood that the reasonable investor would consider it important in making a decision. As Henderson points out, "The SEC may claim to know what shareholders want, but it can do little more than guess."

Once we know whether investors are willing to pay for information or not, SEC disclosure rules could be tailored to provide better tailored disclosures that are actually cost effective.

In addition, we could reduce the uncertainty around securities litigation. At the moment, when cases go to trial, we give jurors the definition of materiality and send them off to make an uniformed decision. It's not a pretty picture. Knowing whether or not investors would be willing to pay for the information would be a huge leap forward.

And don't come crying about ordinary investors. As Henderson points out:

The SEC worries that it would be unfair to ordinary investors to charge for early access. But creating a brief “pros-only” period would actually work to their advantage. Average Americans, who cannot compete with today’s high-speed traders, would know to stay out of the markets during these short periods. So would index funds, which try to avoid being picked off by savvy information traders.

There are also broader advantages: Laying bare the unavoidable fact that ordinary investors cannot beat the pros using corporate news would encourage a long-term perspective among corporate ownership. Making professional investors pay for early access would lower the bill for shareholders by shifting the costs of disclosure to the pros.

I think it's a great idea.

Why are public corporations disappearing and what are the consequences?

Kevin LaCroix explores some reasons why we're seeing a decline in the number of public corporations and then looks at some of the consequences. A very good analysis of a very important issue. Recommended.

Alex Tabarrok: "The Number of Publicly Traded Firms Has Halved"

He observes that:

In the past twenty years [the] U.S. has lost almost 50% of its publicly traded firms [from 6,797 in 1997 to 3,485 in 2013, AT]. This decline has been so dramatic, that the number of firms these days is lower than it has been in the early 1970s, when the real gross domestic product in the U.S. was one third of what it is today. This phenomenon has been a general pattern that has affected over 90% of U.S. industries.

A rather stunning finding from Grullon, Larkin and Michaely.

The total number of firms has dropped far less than the number of publicly traded firms, so in part this is probably due to laws affecting publicly traded firms in particular such as Sarbanes-Oxley. But there has also been a small drop in the total number of firms (depending on year measured) and concentration ratios have increased which suggests that competition might have fallen. (I wish the authors had looked more closely at the entire size distribution). Have international firms risen to offset the decline of publicly-trade firms? The authors discuss but discount the role of globalization. I don’t see, however, how their findings of small effects on output competition are consistent with big labor market effects. Nevertheless the bottom line is that as concentration rates have increased so have profits, as a recent CEA report also argues.

Is this all the after-effects of the Great Recession? I hope so but the decline in the number of publicly traded firms is also consistent with the research on long-run declining dynamism (including my own research on regulation and dynamism) which shows that startup and reallocation rates have been trending down for thirty years.

The drop in publicly held firms reported here is consistent with other reports, so let us take it as given. And I agree with Alex that there are multiple factors at work here:

1. Lingering effects of the Great Recession, during which some estimates claim as many as 170,000 businesses failed. 
2. Consolidation. M&A activity has recovered from its 2008 lows and is resulting in a decline in the number of companies as more are combining than being created.
3. The first two factors meant that in  recent years many startups switched their exit strategy from an IPO to a sale to an established company.
4. Secular stagnation.
5. Regulation.

We all have home field biases, of course, but I tend to think the regulatory aspect has had a crushing effect on public corporations. Firms that were public went dark, while privately held firms decided to remain private or to sell to an acquirer rather than go the IPO route:

During the first half of the last decade, evidence accumulated that the U.S. capital markets were becoming less competitive relative to their major competitors. The evidence reviewed herein confirms that it was not corporate governance as such that was the problem, but rather corporate governance regulation. In particular, attention focused on such issues as the massive growth in corporate and securities litigation risk and the increasing complexity and cost of the U.S. regulatory scheme.

Tentative efforts towards deregulation largely fell by the wayside in the wake of the financial crisis of 2007-2008. Instead, massive new regulations came into being, especially in the Dodd Frank Act. The competitive position of U.S. capital markets, however, continues to decline.

This essay argues that litigation and regulatory reform remain essential if U.S. capital markets are to retain their leadership position. Unfortunately, the article concludes that federal corporate governance regulation follows a ratchet effect, in which the regulatory scheme becomes more complex with each financial crisis. If so, significant reform may be difficult to achieve.

Corporate Governance and U.S. Capital Market Competitiveness (October 22, 2010). UCLA School of Law, Law-Econ Research Paper No. 10-13. Available at SSRN: http://ssrn.com/abstract=1696303

Should TV investment gurus be subject to Labor Department regulation? Not if I were in charge.

There was an important article in today's WSJ about the Labor Department's forthcoming rules under ERISA that will dramatically change how investment advising for IRAs and other retirement vehicles works:

The idea of the regulation, which could be released this month by the Labor Department, seems unobjectionable enough—that brokers would follow a “fiduciary” standard when making investment recommendations. Currently, brokers’ advice only has to be “suitable,” which critics say is a weaker standard that allows the sale of expensive products that eat into returns.

The rule’s opponents, including many in the brokerage industry, say it will increase their costs and make providing investment advice to small-balance retirement accounts less profitable. ...

The rule, provisions of which would be phased in over time, could add costs at industry giants such as Morgan Stanley, which has nearly 16,000 brokers, and Bank of America Corp.’s Merrill Lynch, with more than 14,000. But it is expected to weigh far more heavily on small and midsize firms, which make up the bulk of the industry. ...

Brokerage-industry executives and analysts say the rule is likely to accelerate brokerages’ shift toward fee-based accounts and away from commissions, a trend in which smaller firms generally lag behind their bigger rivals. Smaller firms also tend to have more small accounts that might be uneconomical to serve in a fee model, and they have fewer clients across whom to spread added compliance costs.

This is a classic example of federal government regulation of the stock market and financial services: It screws small business and the middle class, while benefiting the wealthy and the largest firms. (Which leads one to wonder why people like Lucian Bebchuk are so eager for federal regulation of corporate law, but that's an issue for another day.) Because the costs apparently do not scale, the largest brokerage houses will be better able to bear them and wealthy investors will not lose access to professional advice.

But then it gets worse. Forbes reports that:

Popular financial radio show host Dave Ramsey caused a firestorm on Twitter last week when he weighed in against the “fiduciary rule”—the controversial pending Department of Labor regulation that would impose new restrictions on a vast swath of financial professionals who handle IRAs and 401(k) accounts. Yet, Ramsey was only echoing concerns about the costs of the rule already expressed by Members of Congress from both parties. ...

Fittingly, even before Ramsey came out against the rule, one of his critics called for using the rule against Ramsey, supposedly for providing advice said critic deemed harmful to savers. In an October article in LifeHealthPro, an online trade journal for insurance agents and financial advisers, Michael Markey, an insurance agent and owner of Legacy Financial Network, called for Ramsey to “be regulated and to be held accountable” by the government for the opinions he gives to listeners. Markey hailed the Labor Department rule as ushering a new era in which “entertainers like Dave Ramsey can no longer evade the pursuit of regulatory oversight.”

Classic. Markey wants to use regulation to shut down a competitor, which is a primary function of the DC bureaucracy these days.

Experts both for and against the rule I have talked to agree its broad reach could extend to financial media personalities who offer tips to individual audience members, a group that includes not just Ramsey but TV hosts like Suze Orman and Jim Cramer, as well as many other broadcasters who opine on business and investment matters. They would be ensnared by the rule’s broad redefinition of a vast swath of financial professionals as “fiduciaries” and its mandate that these “fiduciaries” only serve the “best interest” of IRA and 401(k) holders.

I admit that I am not an expert on First Amendment law--especially the complexities of commercial speech regulation--but this strikes me as a classic infringement on free speech. But as Forbes notes:

Such limits on financial discussion may seem to violate the First Amendment on its face. But a lawsuit against such restrictions would not be a slam dunk, as this is largely uncharted legal territory. Courts have tread lightly on financial regulation that may harm free speech. In Lowe v. SEC, 472 U.S. 181 (1985), the Supreme Court did strike down a ban by the Securities and Exchange Commission on an investment newsletter published by a convicted felon. But the opinion did not touch upon constitutional issues, as the Court ruled that the law itself – different from the Employee Retirement Income Security Act that governs the Labor Department – applied only to person-to-person, rather than general, advice.

It's these sort of issues that make it so essential to have judges and justices committed to liberty as opposed to being enablers of the nanny state.

The case against divesting from fossil fuel companies

Here at PB.com we oppose divestment campaigns (even in those rare cases when we agree with the proponents about the issue at hand), so we were glad to see our friend Todd Henderson take on the issue in the Chicago student newspaper:

No matter what your views are on the climate change debate, no rational person should support divestment. There is no evidence to demonstrate it will do anything to help the climate, and it will ultimately cost the University hundreds of millions of dollars—Swarthmore estimates it would cost their endowment $200 million over 10 years to divest. This is money that could be spent on research, scholarships, or perhaps best of all for the cause, reducing the University’s carbon footprint.

Here is why divestment won’t work: A central tenet of corporate finance is that demand curves for individual stocks are approximately horizontal. For most things we buy, demand curves slope downward. This means if we demand less, less will be supplied and at lower prices, but stocks are not like other products. The stock price is merely an estimate of the cash flows that ownership of the stock will produce in the future, and therefore is not determined by a “demand” for the stock. Unless the sale of stock conveys information to the market about the future cash flows, no individual sale can move the price.

If the Office of Investments, which manages the University’s nearly $9 billion endowment, sells all of the shares it owns in ExxonMobil, the stock price of ExxonMobil should not change. Others will stand ready to buy the shares at the current market price, meaning supply and demand aren’t helpful ways to think about stock prices. Unless the money that ExxonMobil is expected to earn in the future goes down, the stock price will stay the same. And nothing about the decision of a few university endowments to sell the shares provides the market information about how much oil or coal will be sold at what prices tomorrow. Undervalued shares in the near term will be bought up until their price more or less reflects the expected gain from holding those shares. In an extreme case, ExxonMobil could simply go private, removing any need to rely on public markets for funding or valuation.

The fact that the stock price of divested companies will not fall means that these firms will not experience a higher cost of capital, and therefore nothing about their capital raising activities, project choice, or other decisions will be affected by divestment. Managers with stock-based compensation won’t be affected either nor will other shareholders of these firms. In short, the economic impact of the SJSF demands on the targets of their ire would be nearly zero.

Making matters worse, universities—or rather their employees and students—would bear large costs to achieve no benefits. The endowments already have to spend money defending their investment decisions, and, if it comes to it, will spend more selling shares and accepting lower returns than would otherwise be available. Taking profitable investments off the table also means lower returns for endowments. This means taking money out of the universities’ pockets and putting it into the hands of other people, all without actually imposing any cost on the alleged bad actors.

Indeed.

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