Archives For executive compensation

I’ve argued, e.g., in Rise of the Uncorporation, that a reason why the uncorporation beats the corporation for some types of firms is the high-powered incentives these firms offer their managers.  Sometimes the incentives may not be obvious because percentages, e.g., for “carried interest,” seem not to vary much across firms.  But that can be deceiving because it overlooks an important form of compensation – future fund flows to successful managers. 

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

I’ve written about the Apple rule. Here’s another version:

“License plates? I don’t need no stinkin license plates.”

The Dell rule

Larry Ribstein —  23 July 2010

More than three years ago I provided this “corporate crime primer”:

The Apple Rule provides for an exception from corporate criminal liability when a popular business executive is accused of, or presides over a company that is accused of, misconduct. “Popular” is defined as “liked by journalists.” * * * By contrast, when an “unpopular” business executive (i.e., unliked by business journalists) is associated with criminal misconduct, the “Enron rule” applies. This means that the executive becomes the target of the criminal investigation. * * * Tom Kirkendall asks whether the Apple Rule or the Enron Rule will be applied to Michael Dell.

In the linked post, Tom described charges against Dell based on years of bogus earnings inflated by undisclosed suspect payments from Intel.

Dell has now settled those charges with the SEC for $100 million, plus $4 million from Michael Dell and fines against other executives.

The SEC alleged:

Dell’s increasing profitability was largely attributable to an unusual source of funds: payments from Intel, a microprocessor manufacturer that was one of Dell’s largest vendors. During this period, Intel effectively paid Dell not to use processors manufactured by Advanced Micro Devices, Inc. (“AMD”), Intel’s arch-rival. Intel’s payments to Dell, which were the subject of various antitrust investigations and claims, grew significantly. When measured as a percentage of Dell’s operating income, these payments grew from about 10% in fiscal year 2003 (“FY03”) to 38% in FY06, peaking at 76% in the first quarter of fiscal 2007 (“QIFY07”). While almost all of the Intel funds were incorporated into Dell’s component costs, Dell did not disclose the existence, much less the magnitude, of the Intel exclusivity payments. * * *

Dell would often seek additional rebates from Intel in order to close a gap between its forecasted results and its earnings targets. Dell was quite open with Intel about the reasons it was requesting additional money. * * *

In Q4 FY04, Dell sought a $25 million lump sum payment from the Tactical and Strategic Fund after forecasting that its results would fall short of analysts’ consensus. In a January30, 2004 string of emails to the SVP, Schneider wrote “I think we will barely make the quarter because of the Intel money.” Dell would have missed analysts’ consensus in this quarter without the additional Intel funds; Rollins however, stated to investors that it was Dell’s business model that allowed the company to continue its streak of meeting or exceeding Wall Street earnings targets. Rollins stated during the company’s Q4FY04 earnings call that Dell’s record of “twelve consecutive quarters of meeting or exceeding guidance to investors, is driven by our tightly controlled supply chain, highly efficient infrastructure and direct relationships with customers.” These statements by Rollins were contained in a script that was circulated in advance of the earnings call to Michael Dell, Schneider, and other Dell personnel.

And so on, for 61 pages. One wonders how high-flying Dell would have been between 2002 and 2006 without those payments. Seems like 100 million was a pretty good investment.

Meanwhile, Goldman pays $550 million for one alleged questionably material misrepresentation to one sophisticated investor, and Greg Reyes goes to jail for an even more questionable backdating violation.

Persuade me that this is about securities fraud rather than politics.

Clawbacks

Larry Ribstein —  23 June 2010

Dennis Berman, writing in yesterday’s WSJ, discussed the SEC’s case against Maynard Jenkins, former ceo of CSK, to return $4.1 million in stock option grants because accounting fraud, in which
Jenkins was not involved, allegedly inflated the returns the grants were based on.

This is the SEC’s first attempt to enforce SOX Section 304 against an innocent executive. That section provides for return of incentive-based compensation and profits from stock sales following accounting restatements resulting from “the material noncompliance of the issuer, as a result of misconduct, with any financial reporting requirement under the securities laws.”

Berman notes that Jenkins is protesting that he

must pay (literally and figuratively) for [accounting] misconduct because he was literally the “captain of the ship,” despite the fact that under its own view of the evidence the crew was mutinous—deceiving him and secretly circumventing the ship’s controls.”

Also, an outside audit of the company “found that his bonus payments were tied to other financial goals—such as refinancing company debt—and had virtually no link to CSK’s earnings statements.” But the SEC argues that board members now say they wouldn’t have awarded Jenkins the compensation had they known that the company had a loss rather than the reported profit.

Berman rightly refers to this as a new frontier in SEC enforcement efforts. He notes that this case’s importance is increased by the fact that the current version of the financial reform bill has a three-year claw-back provision which does not require any misconduct at all. Specifically, Section 954 requires the SEC to order national securities exchanges and associations to prohibit the listing of a security whose issuer does not adopt the following rule:

(b)(2) [I]n the event that the issuer is required to prepare an accounting restatement due to the material noncompliance of the issuer with any financial reporting requirement under the securities laws, the issuer will recover from any current or former executive officer of the issuer who received incentive-based compensation (including stock options awarded as compensation) during the 3-year period preceding the date on which the issuer is required to prepare an accounting restatement, based on the erroneous data, in excess of what would have been paid to the executive officer under the accounting restatement.

Both the SOX and financial reform clawback provisions are terribly misguided.

To be sure, firms may reasonably decide that clawback provisions in employment contracts make sense on a prospective basis, as argued here. A retrospective clawback provision like the one proposed in the wake of the AIG bonuses obviously cannot be justified on incentive grounds.

A mandatory provision that operates prospectively is at least better than one inserted ex post. But firms might rationally decide against including such provisions in employment agreements. While the accounting restatement might be said to have undercut the basis for the bonus, any incentive pay based on short-term financial results might similarly seem unfounded in the fullness of time. For example, a business strategy or product that seemed great at the time could misfire. Moreover, a clawback is essentially the same thing as holding the executive strictly liable for the restatement up to the amount of the executive’s incentive compensation. If strict liability is not warranted on incentive grounds, it is not clear why the fact of incentive compensation should make it so.

The real question concerns the appropriate allocation of the risk of accounting mistakes or fraud between the company and the executive. This is and should be left to firm-specific contracts. Firms might or might not decide to subject executives’ compensation to this risk to motivate them to monitor for misconduct. But even if the firm decides this is a good idea in general, it also needs to decide such questions as (1) which types of compensation should be subject to clawback; (2) whether the clawback should be triggered by any restatement, or only a restatement resulting from misconduct; and (3) whether the trigger be of a type that the executive might have been expected to guard against.

Indeed, contracts will continue to apply in this setting whatever the law says. If the law subjects “incentive-based” compensation to a potential penalty for bad accounting, the parties can always contract for non-incentive-based pay, or increase the non-incentive component of pay to reflect the risk. It is not clear how shareholders or society benefit from messing with incentive compensation in this way.

Finally, writing this provision into a federal law sets in stone a novel approach to disclosure penalties and executive pay despite the lack of a clear idea what its consequences will be. The need for flexibility and experimentation is a good reason for leaving compensation arrangements to contracts and the market for state law.

The clawback provision is just one little aspect of the mammoth federalization of corporate law. Watch this space for further updates as the morass of financial reform takes shape and effect.

[Post bumped to the top, and cross-posted at Organizations & Markets, in light of our technical difficulties last week and in the hopes of eliciting a response — Eds]

Dear Gene and Ken:

I must say that I was totally flabbergasted when I read your recent blog posting on insider trading.  I know that your usual posts on investments, which I often cite to friends, are well-informed and empirically-supported; your work over the years on these topics is important and influential—and rightly so.  Unfortunately, in this post, you have deviated from your usual high quality.  Anyone current on the topic of insider trading will recognize that you have been careless in your selection of anti-insider-trading arguments and that you omitted from your brief note the major part of the argument about insider trading: whether and how much it contributes to market efficiency.  To say this is a strange omission coming from Fama and French would be an understatement.

Your first error is to assume that the insider trading debate is about informed trading only by “top management”.  I suspect that this error may flow from my original argument for using insider trading to compensate for entrepreneurial services in a publicly held company, a matter you do not mention and which I will not pursue here except to note that “entrepreneurial services” does not equate to top management.  Strangely no one seems to notice that most of the celebrated cases on the subject have not involved corporate personnel at all (a printer, a financial analyst, a lawyer and Martha Stewart).

I was more surprised, however, to see you repeating the oldest myth in the whole field, one that even the SEC gave up on as wrong many years ago and which frankly is no longer a part of the respectable debate on this topic: that a trade by an insider “disadvantages” the party on the other side.  (I will let pass the peculiar mistake of relating this by inference to a duty owed to existing shareholders when insiders are selling—how about insider sales to perfect strangers to the corporation?  Is there an inchoate fiduciary duty?).  I challenge you to show me any way in which the anonymous buyer or seller in an exchange transaction is harmed because that transaction just happens to involve an insider on the other side.  In fact, you cannot.  The specialist might be assumed to be vulnerable to losses from insiders’ being in the market, but careful research has shown that even they are totally unconcerned about the presence of insiders (other than as usurpers of their rents, and disclosure laws from the ’33 Act to Regulation FD have ensured that the specialists’ sphere of operation is well-protected) and that this so-called “moral hazard” argument is simply insignificant in the real world

Then you repeat another of the old myths surrounding the topic of insider trading:  that allowing it will create a further managerial moral hazard since it will give an incentive to top managers (who I presume are supposed to be able to manage this mischief without anyone else knowing about it—weird) to produce bad news rather than good news.  There is not, in the entire enormous literature on the topic, one iota of evidence for this statement, although some law professors, who are generally better at making arguments for a legal brief than they are at doing rigorous economics, may still mouth it. True, there could indeed be a small end-period problem with trading on bad news.  But, even if there is, it must be of little significance compared to the benefits to shareholders and other investors of allowing insider trading.  There are many forces, including reputation and market competition, operating to induce managers to produce good news, and there is no limit on the amount of this the market will continue to reward them for.  But there are no incentives other than this highly theoretical one encouraging managers to produce bad news.  A bit too much of this and the manager is ruined, while the possibility of making a gigantic killing to justify some once-in-a-lifetime malfeasance with inside information is all but non-existent.  This would be a very foolish bet for any corporate manager to make, and not surprisingly there is no evidence that they do so.

As for the idea that they will delay disclosure (a special form of the bad news/moral hazard argument), as Harold Demsetz pointed out over 40 years ago, the insider will have every incentive not to delay but to speed up disclosure so he can get the highest rate of return on his transaction.  Again there is not one bit of evidence suggesting that this delay ever occurs in the real world and some very strong evidence (the best is by Lisa Meulbroek) that insider trading of the illegal variety quickly moves stock price in the appropriate direction.

On this point, I can’t help but ask what is your theory of how stock market pricing came to be so efficient?  Surely it is not a result of the SEC and disclosure laws—a joke if it were not all so expensive (on which see, among other things, my son’s Hydraulic Theory of Disclosure article).  The studies that have looked have found a mixed result, at best, and the best of these (starting with Stigler’s in 1964 and Benston’s in 1973) find that the market was just as efficient before the SEC and the ’33 and ’34 Acts as it was after.  Gilson and Kraakman certainly did not supply a satisfactory answer to this question that they addressed many years ago, even though they were trying desperately to prove that something besides insider trading was making the market so efficient.

Obviously this is a much larger topic than I can address here, but I must admit to being most dismayed by your implication that the goal of instantaneous communication of new information to all market participants is a worthy ideal that in some way might be aided by disclosure regulation or a ban on insider trading.  We know very well who was pushing all along for a ban on insider trading: the market professionals who stood next in line for new information if they could just get those pesky insiders out of the picture.  They certainly were not interested in universal, equal access to information, nor was the SEC who aided and abetted them in this project.  Given this well-known history, do you really mean to stand with those rent seekers?

I have greatly admired your work for many years, as you know, and I hope I may have missed something in your short blog post.  But precisely because I admire your work—and because many others do, too—I felt an obligation to respond to your problematic comments on this point.  I look forward to your thoughts in response.

Yours cordially,

Henry Manne

The expansive executive compensation literature has two camps: one camp believes markets generally work; the other that they don’t. I am in the former camp, but believe markets and individuals that comprise them make mistakes and that those with power can sometimes use that power to serve their own, selfish ends. The only difference between my views and those of, say, Lucian Bebchuk, is how pervasive we think those mistakes and abuses are. Prof. Bebchuk thinks managers are systematically overpaid and game the compensation setting process to constantly turn out in their favor. He cites, for instance, the fact that managers earn “secret” profits on trades in company shares that do not show up in disclosure about pay, and believes this is consistent only with a managerial power theory of CEO compensation.

In a paper just posted to SSRN, I examine Bebchuk’s claim empirically by looking at what happens to CEO pay when firms liberalize opportunities for insiders to trade their shares. If markets work reasonably well, the explicit pay of these insiders should fall, since their implicit pay is rising. This is what I find. Markets work. Not always. Not perfectly. But they work.

And, if I’m right, this evidence makes a strong case for the laissez-faire view of insider trading most closely associated with the work of Henry Manne. If boards bargain with insiders about the profits they earn from informed trading, it is hard to see who is harmed by this conduct.

Dear Gene and Ken:

I must say that I was totally flabbergasted when I read your recent blog posting on insider trading.  I know that your usual posts on investments, which I often cite to friends, are well-informed and empirically-supported; your work over the years on these topics is important and influential—and rightly so.  Unfortunately, in this post, you have deviated from your usual high quality.  Anyone current on the topic of insider trading will recognize that you have been careless in your selection of anti-insider-trading arguments and that you omitted from your brief note the major part of the argument about insider trading: whether and how much it contributes to market efficiency.  To say this is a strange omission coming from Fama and French would be an understatement.

Your first error is to assume that the insider trading debate is about informed trading only by “top management”.  I suspect that this error may flow from my original argument for using insider trading to compensate for entrepreneurial services in a publicly held company, a matter you do not mention and which I will not pursue here except to note that “entrepreneurial services” does not equate to top management.  Strangely no one seems to notice that most of the celebrated cases on the subject have not involved corporate personnel at all (a printer, a financial analyst, a lawyer and Martha Stewart).

I was more surprised, however, to see you repeating the oldest myth in the whole field, one that even the SEC gave up on as wrong many years ago and which frankly is no longer a part of the respectable debate on this topic: that a trade by an insider “disadvantages” the party on the other side.  (I will let pass the peculiar mistake of relating this by inference to a duty owed to existing shareholders when insiders are selling—how about insider sales to perfect strangers to the corporation?  Is there an inchoate fiduciary duty?).  I challenge you to show me any way in which the anonymous buyer or seller in an exchange transaction is harmed because that transaction just happens to involve an insider on the other side.  In fact, you cannot.  The specialist might be assumed to be vulnerable to losses from insiders’ being in the market, but careful research has shown that even they are totally unconcerned about the presence of insiders (other than as usurpers of their rents, and disclosure laws from the ’33 Act to Regulation FD have ensured that the specialists’ sphere of operation is well-protected) and that this so-called “moral hazard” argument is simply insignificant in the real world

Then you repeat another of the old myths surrounding the topic of insider trading:  that allowing it will create a further managerial moral hazard since it will give an incentive to top managers (who I presume are supposed to be able to manage this mischief without anyone else knowing about it—weird) to produce bad news rather than good news.  There is not, in the entire enormous literature on the topic, one iota of evidence for this statement, although some law professors, who are generally better at making arguments for a legal brief than they are at doing rigorous economics, may still mouth it. True, there could indeed be a small end-period problem with trading on bad news.  But, even if there is, it must be of little significance compared to the benefits to shareholders and other investors of allowing insider trading.  There are many forces, including reputation and market competition, operating to induce managers to produce good news, and there is no limit on the amount of this the market will continue to reward them for.  But there are no incentives other than this highly theoretical one encouraging managers to produce bad news.  A bit too much of this and the manager is ruined, while the possibility of making a gigantic killing to justify some once-in-a-lifetime malfeasance with inside information is all but non-existent.  This would be a very foolish bet for any corporate manager to make, and not surprisingly there is no evidence that they do so.

As for the idea that they will delay disclosure (a special form of the bad news/moral hazard argument), as Harold Demsetz pointed out over 40 years ago, the insider will have every incentive not to delay but to speed up disclosure so he can get the highest rate of return on his transaction.  Again there is not one bit of evidence suggesting that this delay ever occurs in the real world and some very strong evidence (the best is by Lisa Meulbroek) that insider trading of the illegal variety quickly moves stock price in the appropriate direction.

On this point, I can’t help but ask what is your theory of how stock market pricing came to be so efficient?  Surely it is not a result of the SEC and disclosure laws—a joke if it were not all so expensive (on which see, among other things, my son’s Hydraulic Theory of Disclosure article).  The studies that have looked have found a mixed result, at best, and the best of these (starting with Stigler’s in 1964 and Benston’s in 1973) find that the market was just as efficient before the SEC and the ’33 and ’34 Acts as it was after.  Gilson and Kraakman certainly did not supply a satisfactory answer to this question that they addressed many years ago, even though they were trying desperately to prove that something besides insider trading was making the market so efficient.

Obviously this is a much larger topic than I can address here, but I must admit to being most dismayed by your implication that the goal of instantaneous communication of new information to all market participants is a worthy ideal that in some way might be aided by disclosure regulation or a ban on insider trading.  We know very well who was pushing all along for a ban on insider trading: the market professionals who stood next in line for new information if they could just get those pesky insiders out of the picture.  They certainly were not interested in universal, equal access to information, nor was the SEC who aided and abetted them in this project.  Given this well-known history, do you really mean to stand with those rent seekers?

I have greatly admired your work for many years, as you know, and I hope I may have missed something in your short blog post.  But precisely because I admire your work—and because many others do, too—I felt an obligation to respond to your problematic comments on this point.  I look forward to your thoughts in response.

Yours cordially,

Henry Manne

Usha Rodrigues and Mike Stegemoller have penned an interesting article, “Placebo Ethics,” assessing the effect of one of SOX’s disclosure provisions: The required immediate disclosure of waivers from a company’s code of ethics, found in Section 406 of the law.  The article is concrete, informative, empirical and well-written.

The article’s abstract summarizes the heart of the paper:

Out of 200 randomly selected firms, we found only one waiver over 4 years disclosed pursuant to Section 406. However, by exploiting an overlap in disclosure regulations [between SOX 406 and Item 404 of Regulation S-K requiring disclosure of related-party transactions in year-end proxy statements], we were able to cross check our sample companies’ waiver disclosure. We find 30 instances where companies appear to be violating the law, and another 74 where companies evade illegality by watering down their codes to an arguably impermissible degree – their codes of ethics do not forbid the same Enron-style conflicts of interest that led to the adoption of Section 406 in the first place. Finally we study all waivers filed by all public companies with the SEC in the four years following SOX’s passage – and find only 36 total. Event studies reveal that the market generally does not react to these transactions, suggesting that companies only use waivers to disclose innocuous, immaterial information.

There’s a lot of interesting stuff here, including the conclusions that 15% of the sample firms are apparently violating the law and that the waivers that are disclosed are viewed by the market as irrelevant.  It is also interesting that 37% of the sample “evade illegality by watering down their codes to an arguably impermissible degree.”  It is this latter claim on which I want to focus.

I talked a bit about this issue in my Hydraulic Theory of Disclosure article.  In the article I said this about the waiver disclosure requirement:

The implicit assumption is that disclosure to shareholders will deter inappropriate waivers, inducing better compliance with the underlying code of ethics.  But that assumption must be animated by a further assumption that some conduct will be relatively static—that codes of ethics will not themselves be re-written and relaxed in response to the rule. In fact, however, the more likely outcome is that codes of ethics will be (and have been) re-written in order to minimize the need for waivers, in the event actually stemming rather than improving the flow of information . . . .  In other words, disclosed waivers are (privately) costly, and it may be less (privately) costly to amend codes of ethics than to seek and publicize waivers. Underlying behavior of the sort requiring waivers may not change, or it may even deteriorate. And either way less of it will be disclosed.

Rodrigues’ and Stegemoller’s (R&S’s) concluision seems to be 1) that immediate disclosure of related-party transactions would be a good thing, 2) that SOX 406 intended this but was poorly-executed to achieve the result, and 3) that companies’ failure to disclose waivers of their codes of ethics for related-party transactions is a violation of SOX 406, even where the code does not explicitly prohibit such transactions.

While the abstract quoted above is somewhat circumspect about the illegality of these “in spirit” violations of SOX 406, the article itself is a bit more hard-nosed:

It may be that, by omitting related-party transactions from their codes of ethics, companies are in violation of Section 406(c)(1), because prohibiting related-party transactions is “reasonably necessary” to promote “ethical handling of actual or apparent conflicts of interest between personal and professional relationships.” At the very least, these codes violate the intention, or “spirit” of Section 406’s disclosure requirements. As discussed in Part III, Section 406’s waiver provision was specifically enacted to address Enron’s related-party transactions with its CFO, Andy Fastow. Yet the majority of our sample companies do not forbid related-party transactions in their codes.

Instead, companies tend to have generic “conflicts of interest” provisions. And even when the provisions address related-party transactions, they use “weasel wording” that makes it hard to find an actual violation.

As R&S note, most ethics codes do not prohibit related-party transactions outright, so neither waivers of these codes, nor, therefore, disclosure of waivers, is required.  While seemingly proving my prediction that the effect of SOX 406 would be watered-down codes of ethics and, thus, less disclosure of information (assuming the watering down came in response to SOX 406), R&S focus instead on the illegality point, with which I have some trouble.

Basically, R&S argue that ethics codes that do not prohibit related party transactions are, in fact, impermissible under SOX, but I find their reasoning to be a stretch, and certainly there is no case law or SEC ruling (that I know of or that they cite) supporting the claim.  The R&S argument goes, in essence: a) a firm has an ethics code, waivers of which must be disclosed immediately; b) the code “should” prohibit related-party transactions but it does not on its face; c) there is a related-party transaction; d) there is no disclosure of a waiver; e) 406 is violated because the code of ethics “should” have prohibited this transaction, thus it “should” have required a waiver, and thus the absence of disclosure of a waiver is a violation of 406.  This seems like a pretty big stretch to me.  It might be that firms are interpreting 406 liberally, but it’s a long way from that to saying they are breaking the law.  Rather, I would say that failure to disclose waivers in this case is not an example of a firm flouting its obligation under SOX, it is instead an example of the predictable (and predicted) hydraulic effect of imperfect regulation.

This would still count as a failure of SOX 406, in my book (whether that’s a bad thing or not is another matter), but not because of non-enforcement, as R&S suggest, but rather because of the perverse incentive created by SOX 406 that induces firms to enact less-restrictive ethics codes.

In the end, I see the article as a vindication of my prediction.  My point was to suggest that SOX 406 would have the opposite effect of the one it intended–less internal prohibition (or policing) by firms of “unethical” conduct and less disclosure of such conduct.  I hasten to note that this study doesn’t say anything about whether SOX had anything to do with the watered-down ethics codes; for all I know they were already watered down (and thus the accuracy of my prediction is unconfirmed by the article).  But that would have been the thing to look at, it seems to me:  The role of SOX in inducing firms to engage in disfavored conduct to avoid new disclosure obligations that they would not otherwise have engaged in.

Despite this critique, I think the article is the best sort of empirical legal scholarship.  My conclusion might diverge from R&S’s (I would not suggest, as they do, a rule simply requiring disclosure of all related-party transactions over a certain size), but the evidence they uncover is important and their presentation of it is straightforward, well-written and informative.

I’m delighted to report that the Liberty Fund has produced a three-volume collection of my dad’s oeuvre.  Fred McChesney edits, Jon Macey writes a new biography and Henry Butler, Steve Bainbridge and Jon Macey write introductions.  The collection can be ordered here.

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! Continue Reading…

Update on backdating

Geoffrey Manne —  20 December 2009

It’s been quite a while since we discussed backdating here at TOTM.  But back when it was all the rage, we were substantial contributors, formulating (we believe) some of the first fundamental explanations of the issues.  Some of the best posts from our backdating archive are here:

I look pretty young but I’m just backdated, yeah (Geoff Manne)

Option Backdating: The Next Big Corporate Scandal? (Bill Sjostrom)

Backdated options and incentives (Bill Sjostrom)

Jenkins channels Manne (Geoff Manne)

Explaining Backdating (and Jenkins Channels Manne Again) (Josh Wright)

No, Matt, executive compensation is not all about norms (Geoff Manne & Josh Wright)

Thoughts on Walker on Backdating (Josh Wright)

Along with Larry Ribstein (of course) we were early critics of the law, economics and reporting of the backdating “scandal.”  One of our posts, “No, Matt, executive compensation is not all about norms,” was made into a short law review essay.  Geoff’s “I look pretty young but I’m just backdated, yeah” post was one of the first substantial criticisms of the claims in the Wall Street Journal article that broke the story.

Although we basically gave up the backdating reporting as the story dragged on, we have been interested to watch the spectacle unfold.  And it has been quite a spectacle.

With the latest”mockery of justice” in the prosecution of these cases upon us, we thought it might be a good time to revive some of our old posts for readers who might have forgotten that there was once a substantive debate over the topic, rather than a series of prosecutorial embarrassments.

Frankly, as Larry notes, the embarrassments stem in part from the fact–as we have discussed in the posts linked above–that these cases never should have been brought in the first place.  Maybe a reminder is in order.

What is the proper role for judges in deciding how much investment advisers to mutual funds should be compensated? This is the question the Supreme Court will answer in Jones v. Harris Associates, argued last month. At first, the question seems silly: courts don’t get a say in how much I get paid or how much (beyond the minimum wage) I pay our nanny, so why would they have any say here.

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.

Back during the days when socialism was all the rage among the intelligentsia, F.A. Hayek predicted that Soviet-style central planning was destined to fail because the central planners lacked access to, and couldn’t process, all the information needed to allocate productive resources efficiently. Optimal resource allocation can occur, Hayek contended, only if resources are allocated according to the prices that emerge as millions of people buy and sell on the information to which they alone are privy. Hayek maintained that market prices dictate the highest and best use of resources and that such prices cannot be produced by a single mind (i.e., the Soviet-style central planner) but can emerge only as millions of folks reveal their needs and desires by trading amongst themselves.

Today, the powers that be seem to think that some czars possess abilities their historical successors, the Soviet central planners, lacked. I’m speaking, of course, of our most esteemed Pay Czar, Kenneth Feinberg. In his near-infinite wisdom, Czar Kenneth has determined how labor resources should be allocated in seven disparate firms (two auto companies, two banks, two auto financing companies, and one insurance company).

Of course, the Czar — whose official title is the less dictatorial sounding (right?) “Special Master of Compensation” — isn’t directly allocating labor resources. (Remember, dear readers, your federal government is not going to run the business of its financial wards!) But, in setting labor prices by fiat, Czar Kenneth is inevitably channeling labor resources away from, toward, and/or within the firms at issue.

Consider, for example, last Saturday’s Wall Street Journal article, GM CFO Search Complicated By Pay Restrictions. According to the Journal, “The company is concerned that [Czar Kenneth’s] salary limit will make it tough to get qualified executives to move to Detroit [really? Detroit?!], especially given the uncertainty facing the company.” The upshot is that GM may end up with a less-than-optimal CFO, and the CFO it does end up with will not be able to work for the firm he or she would likely have gone to had bargaining been unfettered.

No matter, say Czar Kenneth and the Obama administration. The Czar’s salary dictates are necessary because “skewed compensation incentives were one cause of the financial crisis.” (It was, after all, GM’s lavish executive compensation that brought down the company — the company’s woes had nothing to do with improvident union contracts that gave its foreign-owned competitors a cost advantage of over $1000 per vehicle.) Czar Kenneth’s dictates, it seems, are necessary to protect the taxpayers’ equity investment in GM.

I’m just happy the Obama administration was able to find someone with Czar Kenneth’s smarts — someone able to come up with a single policy, applicable to seven companies in disparate industries, that will generate the optimal level of risk-taking (remember, equity investors like us taxpayers generally prefer a bit of risk-taking!) and will not drive talented employees to any of the scads of other firms (domestic and foreign) that are not subject to the Czar’s enlightened policies.

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[More from Geoff here. And please note that the first WSJ article linked above (from today’s paper) quotes our new TOTM colleague, J.W. Verret. Welcome Jay!]