First, I want to pick up on Jay’s comment that the decision shows the SEC “is an agency with too many lawyers and not enough economists.”  Indeed, the court emphasized that

the Commission inconsistently and opportunistically framed the costs and benefits of the rule; failed adequately to quantify the certain costs or to explain why those costs could not be quantified; neglected to support its predictive judgments; contradicted itself; and failed to respond to substantial problems raised by commenters. * * *

The court condemned the SEC’s disregard of rigorous empirical evidence, noting its failure to utilize “readily available,” evidence of expenditures in proxy contests, and to appropriately weigh the Buckberg-Macey study of the negative effects of electing dissident shareholder nominees.

The court also criticized the SEC’s dismissal of the possible effect of 14a-11 in distracting management by noting that managers already need to incur such costs because of shareholders’ exercise of their state law rights.  The court said: “As we have said before, this type of reasoning, which fails to view a cost at the margin, is illogical and, in an economic analysis, unacceptable” (citation omitted).

Second, the opinion highlights the importance of comments and dissents given rising judicial distrust of the SEC (here’s more on that). This is indicated by the court’s citation of the Buckberg-Macey report noted above, and its reference to the Paredes and Casey dissents to 14a-11. Even if the Commission’s decision might seem to be a foregone conclusion, the fact that the SEC is now essentially in judicial receivership means that these expressions of views will be heard in another venue. There’s also the (possibly slim) hope that the SEC majority will get the message and start listening to such views.

Third, it is worth noting the court’s holding “that the Commission failed adequately to address whether the regulatory requirements of the ICA reduce the need for, and hence the benefit to be had from, proxy access for shareholders of investment companies, and whether the rule would impose greater costs upon investment companies by disrupting the structure of their governance.”  I have shown why it is a mistake for federal regulators to treat investment companies like ordinary state-created business associations instead of the misshapen creatures of statute that they are.

Fourth, and perhaps most important, is the court’s concluding remark that its holding striking down the rule on other grounds left it “no occasion to address the petitioners’ First Amendment challenge to the rule.”

I have previously discussed the First Amendment argument in this case. My recently published article, The First Amendment and Corporate Governance, covers the potential implications of Citizens United for regulation of corporate governance and commercial speech generally.  Suffice it to say for present purposes that regulation of speech under rules like 14a-11 is vulnerable to a First Amendment challenge.  After CU, it is no longer possible to dismiss this speech as merely “corporate” or internal corporate governance speech.  It may be, at least in some cases, part of the political debate that must be heard regardless of the identity of the speaker and the direct audience.

Indeed, I suspect that the court’s strong language about the arbitrariness of 14a-11 may have had something to do with its desire to rest its holding solely on that ground.  This court got to avoid the First Amendment can of worms, with its uncertain implications for the validity of regulation of truthful speech under securities and other laws (lawyer regulation?).  But after CU courts will not be able to avoid this argument forever.

Chung, Sensoy, Stern and Weisbach have some important evidence of this in their Pay for Performance from Future Fund Flows: The Case of Private Equity.  Here’s the abstract:

Lifetime incomes of private equity general partners are affected by their current funds’ performance through both carried interest profit sharing provisions, and also by the effect of the current fund’s performance on general partners’ abilities to raise capital for future funds. We present a learning-based framework for estimating the market-based pay for performance arising from future fundraising. For the typical first-time private equity fund, we estimate that implicit pay for performance from expected future fundraising is approximately the same order of magnitude as the explicit pay for performance general partners receive from carried interest in their current fund, implying that the performance-sensitive component of general partner revenue is about twice as large as commonly discussed. Consistent with the learning framework, we find that implicit pay for performance is stronger when managerial abilities are more scalable and weaker when current performance contains less new information about ability. Specifically, implicit pay for performance is stronger for buyout funds compared to venture capital funds, and declines in the sequence of a partnership’s funds. Our framework can be adapted to estimate implicit pay for performance in other asset management settings in which future fund flows and compensation depend on current performance.

With respect to other possible applications, consider the debate over the compensation of mutual fund managers, which I discuss in my recent article on Jones v. Harris. 

In Jones v. Harris Associates, the Supreme Court interpreted investment advisers’ fiduciary duty regarding compensation for services under Section 36(b) of the Investment Company Act of 1940. The Court endorsed an open-ended Second Circuit standard over a more determinate Seventh Circuit test calling only for full disclosure and no “tricks.” This paper shows that Congress created and must solve the fundamental problem the Court faced in Jones. At one level the problem stems from the existence of an investment adviser fiduciary duty as to compensation and the corporate structure from which it springs. At a deeper level lies the more basic problem of federal interference in firm governance, which lacks state corporate law’s safety valve of interstate competition and experimentation. This discussion is appropriate in light of the increasing federal role evident in the enactment of broad new financial regulation.

And speaking of new financial regulation, here’s a discussion of the latest move toward imposing fiduciary duties on brokers.

Hope to see some of you on Thursday.

In Jones v. Harris Associates, the Supreme Court interpreted investment advisers’ fiduciary duty regarding compensation for services under Section 36(b) of the Investment Company Act of 1940. The Court endorsed an open-ended Second Circuit standard over a more determinate Seventh Circuit test calling only for full disclosure and no “tricks.”  This paper shows that Congress created and must solve the fundamental problem the Court faced in Jones. At one level the problem stems from the existence of an investment adviser fiduciary duty as to compensation and the corporate structure from which it springs. At a deeper level lies the more basic problem of federal interference in firm governance, which lacks state corporate law’s safety valve of interstate competition and experimentation.  This discussion is appropriate in light of the increasing federal role evident in the enactment of broad new financial regulation.

Here’s an earlier pre-decision post laying out some of the issues, which I concluded by noting:

I suspect that in this day and age the Supreme Court will side with Posner. Such a decision would be a symptom and signal of our sharp turn toward paternalism in everything from complex finance to corporate governance to the simplest products.

Although the Court’s result was consistent with Posner’s position, as noted here it left the deeper issues to Congress. These include questions not only about markets, but also about the appropriate federal role in structuring investment vehicles. My article suggests that, whatever the flaws in markets and state regulation, federal regulation may be worse.

Here’s the description:

As the founder of the Center for Law and Economics at George Mason University and dean emeritus of the George Mason School of Law, Henry G. Manne is one of the founding scholars of law and economics as a discipline. This three-volume collection includes articles, reviews, and books from more than four decades, featuring Wall Street in Transition, which redefined the commonly held view of the corporate firm.

Volume 1, The Economics of Corporations and Corporate Law, includes Manne’s seminal writings on corporate law and his landmark blend of economics and law that is today accepted as a standard discipline, showing how Manne developed a comprehensive theory of the modern corporation that has provided a framework for legal, economic, and financial analysis of the corporate firm.

Volume 2, Insider Trading, uses Manne’s ground-breaking Insider Trading and the Stock Market as a framework for many of Manne’s innovative contributions to the field, as well as a fresh context for understanding the complex world of corporate law and securities regulation.

Volume 3, Liberty and Freedom in the Economic Ordering of Society, includes selections exploring Manne’s thoughts on corporate social responsibility, on the regulation of capital markets and securities offerings, especially as examined in Wall Street in Transition, on the role of the modern university, and on the relationship among law, regulation, and the free market.

Manne’s most auspicious work in corporate law began with the two pieces from the Columbia Law Review that appear in volume 1, says general editor Fred S. McChesney. Editor Henry Butler adds: “Henry Manne was an innovator challenging the very foundations of the current learning.” “The ‘Higher Criticism’ of the Modern Corporation” was Manne’s first attempt at refuting the all too common notion that corporations were merely devices that allowed managers to plunder shareholders. Manne saw that such a view of corporations was inconsistent with the basic economic assumption that individuals either understand or soon will understand the costs and benefits of their own situations and that they respond according to rational self-interest.

My dad tells me the sample copies have arrived at his house, and I expect my review copy any day now.  But I can already tell you that the content is excellent.  Now-under-cited-but-essential-nonetheless corporate law classics like Some Theoretical Aspects of Share Voting and Our Two Corporation Systems: Law and Economics (two of his best, IMHO) should get some new life.  Among his non-corporations works, the classic and fun Parable of the Parking Lots (showing a humorous side of Henry that unfortunately rarely comes through in the innumerable joke emails he passes along to those of us lucky enough to be on “the list”) and the truly-excellent The Political Economy of Modern Universities (an updating of which forms a large part of a long-unfinished manuscript by my dad and me) are standouts.  And the content in the third volume from Wall Street in Transition has particular relevance today, and we would all do well to re-learn the lessons of those important contributions.

The full table of contents is below the fold.  Get it while it’s hot!

Table of Contents

VOLUME 1 – The Economics of Corporations and Corporate Law

General Introduction by Fred S. McChesney vii

Biography of Henry G. Manne by Jonathan R. Macey xix

Introduction by Henry N. Butler xxix

Review of Corporation Giving in a Free Society 3

Review of The American Stockholder 13

Current Views on the “Modern Corporation” 22

The “Higher Criticism” of the Modern Corporation;
with a Reply by Professor Adolf A. Berle, Jr., Modern
Functions of the Corporate System 59

Corporate Responsibility, Business Motivation,
and Reality 125

Review of The Calculus of Consent 139

Review of The American Economic Republic 149

Some Theoretical Aspects of Share Voting:
An Essay in Honor of Adolf A. Berle 157

Mergers and the Market for Corporate Control 182

Panel Discussion: The Emergence of “Federal Corporation
Law” and Federal Control of Inside Information 199

Our Two Corporation Systems: Law and Economics 214

Cash Tender Offers for Shares: A Reply to
Chairman Cohen 242

Shareholder Social Proposals Viewed by an Opponent 267

The Social Responsibility of Regulated Utilities:
An Essay Dedicated to Wilber G. Katz 302

The Limits and Rationale of Corporate Altruism:
An Individualistic Model 320

Controlling the Giant Corporation: Myths and Realities 337

Testimony of Dr. Henry G. Manne before the Senate
Commerce Committee Considering Federal Chartering
of Large Corporations 351

Index 365

VOLUME 2 - Insider Trading

Introduction, by Stephen M. Bainbridge vii

INSIDER TRADING AND THE STOCK MARKET

Preface 3

1  Background 9

2  The Traditional Legal Context 26

3  Developments Under SEC Rule 10b-5 44

4  The Market for Valuable Information: An Introduction 59

5  Mechanisms for Marketing Inside Information 69

6  Market Effects of Different Trading Rules 88

7  Effects of Different Legal rules on Non-inside Traders 103

8  The Entrepreneur in the Large Corporation 121

9  Inside Information: The Entrepreneur’s Compensation 141

10 Objections to Information as Compensation 157

11 The Problems of Public and Private Policing 169

12 A Postscript on Government 181

List of Cases 200

Appendix: Selected Cases 202

ARTICLES AND ESSAYS

In Defense of Insider Trading 235

Insider Trading and the Administrative Process 256

Insider Trading and the Law Professors 309

A Rejoinder to Mr. Ferber 359

Definition of “Insider Trading” 364

Bring Back the Hostile Takeover 374

Options? Nah, Try Insider Trading 377

The Case for Insider Trading 380

Citizen Donaldson 384

What Mutual-Fund Scandal? 388

Regulation “In Terrorem” 392

Insider Trading: Hayek, Virtual Markets, and the Dog That Did Not Bark 396

Index 425

VOLUME 3 – Liberty and Freedom in the Economic Ordering of Society

Introduction, by Jonathan R. Macey vii

First Lecture 3

Economic Aspects of Required Disclosure under Federal Securities Laws 28

Reach vs. Grasp: A Legal Authority Analyzes a New Book on Securities Fraud 77

What Price Blue-Sky? State Securities Laws Work against Private and Public Interest Alike (with James S. Mofsky) 84

Prohibition on Wall Street? Congress Should Rewrite the Securities Exchange Act of 1934 94

Accounting and Administrative Law Aspects of Gerstle v. Gamble-Skogmo, Inc. 104

Law by Proxy? In Gerstle v. Gamble-Skogmo, the SEC Has Changed the Rules 136

Unconvincing Case: Mutual Fund “Reforms” Would Do More Harm than Good 143

Corporate Militants: Their Lawsuit Makes a Case for Sounder Securities Regulation 151

The Parable of the Parking Lots 158

The Political Economy of Modern Universities 165

Sins of Commission: A New Study Challenges SEC Disclosure Policies 189

Fighting Back against Controls 196

Preface to The Economics of Legal Relationships 204

The Publicly Held Corporation as a Market Creation 209

A New Perspective for Public Interest Law Firms 215

The Judiciary and Free Markets 239

A Free Market Model of a Large Corporation System 267

How Law and Economics Was Marketed in a Hostile World: A Very Personal History 291

Liberty Fund Conferences Attended by Henry Manne 315

Index 319

Cumulative Index 335

The difference between my pay and that of investment advisors is that there is a statute – section 36(b) of the Investment Company Act of 1940 – that obligates investment advisors under a “fiduciary duty with respect to the receipt of compensation for services.” The justification for the statute was a belief that the corporate structure of mutual funds, where the investment advisor appoints the board of the fund, which in turn is supposed to negotiate with the advisor over its compensation, is insufficient to generate the arm’s length bargaining that I have with our nanny or the University has with me. It is as if I appointed the Trustees of the University, and then they had as their first job deciding how much to pay me.

Unfortunately, the statute’s command is ambiguous – what does having a fiduciary duty mean for the proper judicial role? The prevailing view, until last year, was set forth in a 1982 case from the Second Circuit. The so-called “Gartenberg test” required courts to weigh numerous factors to determine whether the pay of investment advisors was reasonable. Lawyers, of course, love this test. All work-a-day lawyers, regardless of side, love multi-factor tests because they generate uncertainty and therefore fees. Not surprisingly, this generates an agency cost between lawyers and their clients, which may explain in part why no lawyers in the Supreme Court litigation argued to affirm the Seventh-Circuit opinion, which rejected the Gartenberg test.

As I show in a new paper, the Gartenberg standard has generated several hundred cases over the past two decades, costing several billion dollars. Shockingly, plaintiffs have never won once. They are 0 for 150 in cases resulting in reported decisions. Nevertheless, tens of cases are filed each year in an attempt to extract money (up to the costs of defending the litigation) from advisers. This might not be an inefficient result if the litigation is serving a deterrence function, but I show in the paper that the statute’s limit on the damages that can be paid in this litigation and the size of fees relative to the costs of litigation make this an impossibility. There is, in short, absolutely no economic justification for Gartenberg and private litigation about fees.

Perhaps based on this kind of economic analysis, Judge Easterbrook rejected Gartenberg, holding that a fiduciary duty means being transparent and playing no tricks, something not sufficiently alleged by plaintiffs in Jones. This is the approach state courts, for example, in Delaware, take when enforcing the fiduciary duty of corporate managers with respect to the pay they receive. Courts don’t balance factors to determine whether Jeffrey Immelt is paid too much, they look only at the pay-setting process and for unremedied conflicts of interest. This seems like the most sensible reading of the statute, but the simple economic analysis I do in the paper shows that there is another reason for the Court to reject Gartenberg.

A final observation is another reason why no parties before the Court defended Judge Easterbrook’s opinion. As noted above, agency costs is one explanation. Another is fear of change. Although defendants and the mutual fund industry might prefer avoiding the tax imposed on them by Gartenberg, I show that the dollar amounts of the tax are very small relative to the fees advisers earn. Moreover, a decision by the Court affirming Easterbrook might generate a legislative response (note: highly paid Wall Street types aren’t so popular on Capitol Hill these days), and the new statute might be much worse than the prevailing interpretation of section 36(b). In short, better Gartenberg than Barney Frank. The Court therefore did not hear the full story when the parties argued the case. The plaintiffs lawyers had their say, the defense lawyers and the industry had their say, but investors, the ones who ultimately pay the tax or what amounts to a useless wealth transfer to lawyers, did not.

One thing I’ve found puzzling about mutual fund voting is that the SEC requires fund investment advisers to vote the shares in the portfolios they manage. The SEC asserts that “[t]he duty of care requires an adviser with proxy voting authority to monitor corporate events and to vote proxies.” This requirement has more or less spawned the proxy advisory industry and the attendant fees paid by mutual funds to ISS, Glass Lewis and the like for their voting advice. In my mind a specific fiduciary duty to vote is foolish. Certainly, the voting of proxies by mutual fund managers should be subject to the duty of care and loyalty. But a fund manager should be free to decide that it’s in the best interest of a fund for the manager to not to spend the time and money involved in voting. At least a fund manager should be able to disclaim the fiduciary duty to vote by saying as much in the fund prospectus. Personally, I would rather a fund not spend money on proxy advisers or voting thereby reducing fund expenses. I’m in complete agreement with the sentiment expressed in the article–if a fund manager does not agree with a company’s direction, they should either not invest or sell as opposed to attempting to change the direction of the company through voting. As for index funds that don’t have this luxury, I don’t care. I invest in these funds to get the market return. I don’t want to pay higher expenses in the event the index fund manager decides to engage in shareholder activism. Leave it to the hedge funds and keep my expense ratios low.

• Mutual fund investors focus primarily on fees, historical performance, and risk when purchasing funds.
• Recent fund investors make little use of prospectuses or shareholder reports. Around two-thirds of investors did not consult fund prospectuses or shareholder reports in making their purchase decisions.
• Few investors reviewed information about a fund’s portfolio manager (25 percent), proxy voting policies (15 percent) or board of directors (15 percent).

These findings are not surprising to me as I would be in the majority on each one.

The survey also includes several findings that go to internet usage by mutual fund investors, mainly, that they have ready access, are comfortable using it, and use it frequently. It’s obvious that these findings are directed at the SEC. The mutual fund industry wants the SEC to adopt the “access equals delivery model� for mutual fund materials. Under the model, a fund can meet delivery requirements by posting materials on the web and notifying investors of their availability instead of mailing hardcopies. The SEC recently adopted the model for prospectus delivery and has proposed a rule applying it to proxy materials. Investment companies, however, are specifically excluded from coverage.

I’m in favor of extending the model to mutual funds. As I’ve said before, hardcopy distribution requirements are simply inefficient and wasteful in the internet age. Further, as the ICI survey points out, few investors even look at mutual fund prospectuses or shareholder reports. Switching to the model will result in cost savings for the funds.  These savings will presumably be passed on to investors, especially given investor focus on fund fees as demonstrated by the survey.