Archives For Agency Costs


Luke Froeb has a great post on the chart above, agency costs, and airline delays.   In particular, Froeb is interested in “on-time” departures, i.e. the plane pushes back from the gate on time, but sits near the gate until it is their turn in the queue.  Read the whole thing, but here is the key paragraph:

The first row (per diem) indicates how much the flight crew earns once it checks into the airport, the second (holding pay) after it loads the plane, and the third (hourly wage) after it pushes back from the gate and turns on the beacon.    By rushing to load the plane, and push back from the gate, the captain earns $164/hour more than he or she does by waiting to load the plane.

It would be relatively easy to solve this problem by taking the decision on when to push back from the gate away from the flight crew and give it to the airline instead.

If you aren’t reading the Management R&D Blog, go check it out.

 

 

 

As I discussed last May, corporations are hoarding cash.  According to today’s WSJ, they’re still hoarding cash.

Mira Ganor writes, in Agency Costs in the Era of Economic Crisis, that it could be about CEO compensation. Here’s the abstract:

This Article reports results of an empirical study that suggests that the current economic crisis has changed managerial behavior in the US in a way that may impede economic recovery. The study finds a strong, statistically significant and economically meaningful, positive correlation between the CEO total annual compensation and corporate cash holdings during the economic crisis, in the years 2008-2010. This correlation did not exist in comparable magnitudes in prior years. The finding supports the criticism against current managerial compensation practices and suggests that high CEO compensation increases managerial risk aversion in times of crisis and contributes to the growing money hoarding practices that worsen an economic slowdown. One possible explanation for the empirical findings is that during the last economic crisis, managerial risk seeking transformed into risk aversion that stalls economic recovery. The study has implications for the discussion on managerial pay arrangements and the implementation of the Dodd-Frank Act concerning say-on-pay

Whatever the cause, as I wrote last May there is a possible solution for cash hoarding (and possibly a better way to deal with agency costs generally), at least for some types of firms:

As I’ve pointed out in numerous articles (e.g.) and in my Rise of the Uncorporation, the uncorporation replaces often-ineffective corporate-type disciplines like fiduciary duties and shareholder voting with financial discipline centered on debt and distributions, which restricts the amount of cash managers have to play with.

And the underuse of the uncorporate form itself comes down to another problem:  the corporate tax.

Yesterday at the Illinois Corporate Colloquium Steve Choi presented his paper (with Pritchard and Weichman), Scandal Enforcement at the SEC: Salience and the Arc of the Option Backdating Investigations.  Here’s the abstract:

We study the impact of scandal-driven media scrutiny on the SEC’s allocation of enforcement resources. We focus on the SEC’s investigations of option backdating in the wake of numerous media articles on the practice of backdating. We find that as the level of media scrutiny of option backdating increased, the SEC shifted its mix of investigations significantly toward backdating investigations and away from investigations involving other accounting issues. We test the hypothesis that SEC pursued more marginal investigations into backdating as the media frenzy surrounding the practice persisted at the expense of pursuing more egregious accounting issues that did not involve backdating. Our event study of stock market reactions to the initial disclosure of backdating investigations shows that those reactions declined over our sample period. We also find that later backdating investigations are less likely to target individuals and less likely to accompanied by a parallel criminal investigation. Looking at the consequences of the SEC’s backdating investigations, later investigations were more likely to be terminated or produce no monetary penalties. We find that the magnitude of the option backdating accounting errors diminished over time relative to other accounting errors that attracted SEC investigations.

As readers of this blog, and Ideoblog before it, will appreciate, this paper particularly resonated with me.  As I wrote in a large number of posts (e.g.) backdating was a molehill the media blew up into a mountain.  Now come Choi et al with evidence that while the SEC was spending its scarce resources on this overblown molehill it was ignoring real mountains (e.g., Madoff).

I found the paper overall quite persuasive.  I wasn’t entirely convinced by the evidence that the backdating cases were getting weaker.  In particular, stock price reactions may just indicate the market was learning about the which companies were involved before the investigations were brought, and was gradually figuring out that backdating was not such a big deal.  But I was convinced of the evidence of the opportunity costs of the SEC’s backdating obsession — the otherwise inexplicable decline in investigations of serious non-backdating accounting problems.

As we discussed in the Colloquium, the paper reveals that there are agency costs not just in the backdating companies that were investigated but also in the agency that was doing the investigating.  Although it’s not clear exactly what moved the SEC to follow the media, there is at least some doubt about whether the SEC’s resource allocation decisions were in the public interest.

This calls attention to another set of agents — the ones in the media.  Why did the media love backdating so much?  As discussed in my Public Face of Scholarship, there are “demand” and “supply” explanations:  the public demands stories about cheating executives and/or journalists like to supply these stories.  David Baron, Persistent Media Bias, presents a supply theory emphasizing journalists’ anti-market bias.

Whatever the cause of media bias, when the media is influential its bias can result in bad public policy. SEC enforcement isn’t the only example. As I discuss in my article (at 1210-11, footnotes omitted):

Where interest groups are closely divided, the outcome of political battles may depend on how much voter support each side can enlist. This may depend on how journalists have portrayed the issue to the public. For example, the press is an important influence on corporate governance. One factor in the rapid passage of the Sarbanes-Oxley Act, the strongest federal financial regulation in seventy years, may have been the overwhelmingly negative coverage of business in the first half of 2002: seventy-seven percent of the 613 major network evening news stories on business concerned corporate scandals.

It’s not clear what can be done to better align SEC enforcement policy with the public interest.  Incentive compensation for SEC investigators?  Perhaps the only thing we can do (as with corporate crime) is to try to keep in mind when creating regulation that even if corporate agents may sometimes do the wrong thing, people don’t stop being people when they go to work for the government.

My paper, Energy Infrastructure Investment and the Rise of the Uncorporation has been published in the current issue of the Journal of Applied Corporate Finance.  It includes a useful summary of my views of uncorporations applied to larger firms.  As of now it’s behind a pay wall.  Here’s the abstract:

While most large U.S. businesses have long been organized as corporations, a significant portion of our economy, including major parts of our energy infrastructure, are organized as other types of legal entities. These “uncorporations” include such business forms as Master Limited Partnerships (MLPs) and Limited Liability Companies (LLCs). Many practitioners have dismissed these alternative entities as merely tax devices and only peripherally important to mainstream business. But this view misses important features of the uncorporation that make it an important alternative in dealing with the “agency” costs that arise in public companies from separating managerial control from equity ownership. Corporate governance relies heavily on agents such as auditors, class action lawyers, judges, and independent directors to protect shareholders from managerial self‐interest. The obvious costs and defects of relying on these governance mechanisms have generally been seen as a reasonable price to pay for the benefits of the corporate form. But this conclusion depends on the availability and effectiveness of the alternative mechanisms for addressing agency costs. Uncorporations provide such an alternative by tying managers’ economic well‐being so closely to that of their firms that corporate monitoring devices become less necessary. Uncorporate governance mechanisms include managerial compensation that is based largely (if not entirely) on the firm’s profits or cash distributions, and restrictions on managers’ control of corporate cash through liquidation rights and requirements for cash distributions. Business people and policy makers should evaluate the potential benefits of uncorporations before concluding that the costs of corporate governance are an inevitable price of separating ownership and control in modern firms

John Steele Gordon, writing in the WSJ, peels the corporate veil away from Warren Buffett’s tax situation:

Warren Buffett recently claimed that he had paid only $6.9 million in taxes last year. But Berkshire Hathaway, of which Mr. Buffett owns 30%, paid $5.6 billion in corporate income taxes. Were Berkshire Hathaway a Subchapter S corporation and exempt from corporate income taxes, Mr. Buffett’s personal tax bill would have been 231 times higher, at $1.6 billion.

Gordon describes our two tax systems — corporate and personal tax — as an “original sin.” According to Gordon, the system lets the rich play tax games by arbitraging differences between corporate and personal rates. It also creates a “field day for demagogues and the misguided to claim that the rich are not paying their ‘fair share'” by ignoring the effect of the so-called “corporate” tax on the real people who own corporations.

Actually, the mischief goes deeper than Gordon suggests.  First, the corporate tax has helped entrench in the popular mind the idea that the merely legal creation of the corporation is actually flesh and blood.  This fuels the post-Citizens-United rhetoric on the evils of “corporate” speech as being somehow magically different from all other political activity by associations.

Second, the corporate tax has been a great engine of agency costs.  As discussed in my Rise of the Uncorporation, business associations such as LLCs and partnerships can mitigate corporate managers’ misuse of the owners’ money by replacing cumbersome corporate-type monitoring with obligations to distribute excess cash.  If more firms were uncorporations, we would not see the enormous cash hordes of today’s firms.  Lacking investment opportunities, they (e.g. Berkshire Hathaway?) would return the cash to their owners. But the “second” tax on distributions gives managers (Warren Buffett?) a powerful argument against distributing cash.  In fact, Steven Bank has adduced strong evidence that the corporate tax originated in 1936 as part of a deal promoted not by populists but by corporate managers (Bank, Corporate Managers, Agency Costs, and the Rise of Double Taxation, 44 Wm. & Mary L. Rev. 167 (2002)).

Third, the tax manipulations run deeper than Gordon suggests.  The difference between corporate and personal taxation helps maintain the sharp separation in the U.S. between the corporation and the uncorporation.  Only certain types of firms — those engaging in “passive” types of business such as resource management — can be both publicly held and free of corporate taxation.  Yet many other types of firms could benefit from uncorporate governance.  As a result, as discussed in my book, “uncorporate” governance must operate indirectly, through entities such as hedge and private equity funds.  Abolition of the “corporate” tax would encourage the use of more direct mechanisms for loosening managers’ reins over firms’ cash in a wide variety of firms.

In short, the corporate tax obfuscates analysis of business forms and helps inflate agency costs.  It’s not just unfair, as Gordon suggests.  It’s stupid.

Innovation and entry by entrepreneurs is a powerful force for change. Joseph Schumpeter saw these forces as the primary engine for long-term growth, even as the process of creative destruction destroyed existing wealth, including monopoly rents associated with established regulatory regimes.  The forces of creative destruction seemingly have their sights squarely on the legal profession, promising greater access to legal services while simultaneously threatening licensed lawyers’ monopoly over legal services.

The traditional market for legal services is breaking down in the face of increased competition from numerous sources.  One of the biggest threats comes from new technologies that enable clients to perform many tasks formerly performed by lawyers.  For example, large clients now use of sophisticated search algorithms to substitute for hours of manual document search and selection formerly performed in large law firms.  As technology improves, it is not hard to imagine the expansion of tasks performed by computers rather than lawyers.  At the low end, legal software products allow unsophisticated consumers competently to perform a wide variety of legal tasks with little or no additional input from legal professionals.  These and other legal information products allow the seller of such information and services to take advantage of technology as well as economies of scale and scope that were not captured by the traditional market.

The speed and extent to which such legal information products transform the supply of law legal services depends upon the extent to which innovation and entry by entrepreneurs, especially by those outside the traditional legal sector, occurs.  In our forthcoming article, Larry Ribstein and I discuss two important impediments to such entry.  The first is the current system of legal regulations, especially those that forbid non-lawyers from practicing law, which directly suppresses legal innovation.

The current system of legal regulation is based upon the assumption that legal advice is conveyed through one-to-one agency relationships in which an uninformed client depends on her lawyer’s judgment and independence.  This assumption supports the system of attorney ethical rules designed to reduce the agency costs of this one-to one relationship by promoting lawyers’ loyalty to clients.  It also supports licensing laws to ensure lawyer quality.

However, these regulations are costly.  They constrain the supply of legal services by suppressing the use of legal information products and services that would directly compete with traditional legal services.  These rules further inhibit innovation by preventing use of private contractual arrangements that limit organizational flexibility and increase the cost of collaboration between lawyers and non-lawyers.  Moreover, it is far from clear that such rules would serve much of a beneficial purpose outside of the traditional model of legal advice.  For example, if consumers of legal services instead could use legal information products traded in a broad and transparent market, the underlying rationale for ethical rules and licensing would be greatly diminished.  Market competition would reduce consumers’ reliance on the traditional agency relationship and market-based mechanisms could help ensure quality.   Thus, one effect of the current system of legal regulations is to suppress the development of a robust market for legal information products that, left unimpeded, would likely threaten both the viability and underlying rationale of the current regulatory system.

How this struggle comes out in equilibrium will depend upon how much pressure is placed on the existing system by the amount of innovation and entrepreneurial entry that occurs.   This in turn will depend upon the returns to such investments, which will in turn depend upon the ability of the entrepreneur to capture the returns from his investment.   This brings us to the second impediment we identify, a system of relatively weak intellectual property right protection for legal information that reduces the incentives for legal innovation.   I will take up this issue in my second post.

I have written about the problems of criminalizing corporate agency costs and the intersection between these agency costs and the agency costs of the government agents who prosecute the crimes.

Joe Yockey, in his recent paper Solicitation, Extortion, and the FCPA, shows that Foreign Corrupt Practices Act prosecutions provide a particularly acute illustration of these issues.  Here’s the abstract:

The U.S. Foreign Corrupt Practices Act (FCPA) prohibits firms from paying bribes to foreign officials to obtain or retain business. It is one of the most significant and feared statutes for companies operating abroad. FCPA enforcement has never been higher and nine-figure monetary penalties are not uncommon. This makes the implementation of robust FCPA compliance programs of paramount importance. Unfortunately, regardless of whether they have compliance measures in place, many firms report that they face bribe requests and extortionate threats from foreign public officials on a daily basis. The implications of these demand-side pressures have gone largely unexplored in the FCPA context. This Article helps fill that gap. First, I describe the nature and frequency of bribe solicitation and extortion to illustrate the scope of the problem and the costs it imposes on firms and other market participants. I then argue that current FCPA enforcement policy in cases of solicitation and extortion raises several unique corporate governance and compliance challenges, and ultimately poses a risk of overdeterrence. Though these concerns can be partially addressed through enhanced statutory guidance, I conclude by urging regulators to shift some of their focus from bribe-paying firms in order to directly target bribe-seeking public officials. Confronting the market for bribe demands in this way will help reduce corruption in general while also allowing employees and agents to spend less time worrying about how to respond to bribe requests and more time on legitimate, value-enhancing transactions.

I note in my article that “[i]t can be particularly hard to define when corporate agents’ behavior crosses the line into criminal conduct.” These problems seem especially acute in FCPA cases. The inherent difficulty of drawing the line between bribery and extortion is exacerbated by the fact that, as Yockey says, “[i]n many countries, payments made in response to subtle hints by foreign officials do not breach obvious social norms in the same way that behaviors like theft or assault do.”

The FCPA turns the screws by forcing firms to record all payments while increasingly failing to appropriately distinguish bribes from excusable responses to extortionate threats. As Yockey points out, “[t]his dynamic can confuse firms that are legitimately trying to comply with the law and limit their ability to provide instructions that will give agents and employees clear direction.”

Why, you might ask, is FCPA liability escalating?  Yockey suggests one possible explanation is that “[t]he rise in FCPA enforcement has produced a cottage industry of FCPA experts, including lawyers, accountants, and consultants at prestigious firms, which DOJ and SEC personnel often join after leaving their federal jobs for considerably higher compensation.”  Of course more prosecutions mean more jobs.  This nicely illustrates the “revolving door” problem I discuss in my article (which Yockey cites).

The article paints a classic picture of over-criminalization in action and how a poorly designed and over-enforced law is crippling U.S. firms ability to compete internationally.

It’s not easy coming up with scandals all the time.  Some days there just isn’t a new scandal to report.  But that space has to get filled somehow. 

The NYT’s Gretchen Morgenson often finds herself in this position.  Her scandal for yesterday, reported as usual with Louise Story (I’ll just start calling them Morgenstory), was about how prosecutors are letting evil banks off with deferred prosecution agreements.  This, they say, “helps explain the dearth of criminal cases despite a raft of inquiries into the financial crisis.”  And:  “This approach, critics maintain, runs the risk of letting companies off too easily.” And “[t]his “outsourcing” of investigations . . . has led to increased coziness between the government and companies, some critics say.” In other words, the banks are getting away with murder. 

“Critics” here means a law professor and former AUSA, who opines for Morgenstory:

If you do not punish crimes, there’s really no reason they won’t happen again. I worry and so do a lot of economists that we have created no disincentives for committing fraud or white-collar crime, in particular in the financial space. The legal representatives will argue that since recoveries can be had by using civil measures, even private litigations, there’s no need to bring criminal measures. I disagree with that very much.

We don’t get to hear why she “disagree[s] with that.”

This is all very puzzling since we do read some pretty good reasons for the DOJ’s approach.  A DOJ spokesperson tells Morgenstory (“defending” the DOJ’s approach) that dpas collect penalties and restitution and get firms to amend their behavior, and “achieve these results without causing the loss of jobs, the loss of pensions and other significant negative consequences to innocent parties who played no role in the criminal conduct, were unaware of it or were unable to prevent it.” This does sound better than putting them out of business like Arthur Andersen (which was vindicated too late by the Supreme Court).  Indeed, that case helped lead the DOJ to reexamine its policies for prosecuting corporate crime. 

Morgenstory have some supposedly damning details about the development of DOJ’s new approach.  The then deputy attorney general, James Comey, “surprised some attendees” at a 2005 private meeting when “he cautioned colleagues to be responsible.”  Morgenstory quote an anonymous attendee as labeling this shocking call for responsibility “a total retrenchment. It was like we were going backwards.”

Here are some of the horrible results of this new leniency, according to Morgenstory:

  • The companies talk to each other and exchange information.  (Hell, that makes them almost like multiple government agencies pursuing the same crime!).  The terrible consequence, according to Morgenstory, “has often been that banks walk into prosecutors’ offices well-prepared to rebut allegations.”  Yikes, we can’t have that.
  • “One assistant United States attorney, who requested anonymity because he is not allowed to speak with the news media, said many inquiries had been tabled because banks had such good answers.” Nor that either.
  • This AUSA says:  “They’ll hire a counsel who is experienced. They often come in and make a presentation: ‘We’ve looked at this and this is how we see it.’ They’re often persuasive.” OMG. We can’t have the government dealing with well-prepared defendants.

Morgenstory let the reader assume that the dpas are a massive get out of jail free card for firms.  But there’s another way to look at them.  As I discuss in my Agents Prosecuting Agents, they are a way of helping the government put individuals in jail whether or not they belong there:

[P]rosecutors can pressure corporate agents through their firms.  Like individual defendants, firms face strong incentives to plead guilty to avoid even worse penalties at trial.  These penalties could include fatal sanctions for firms that must stay clean to continue in business, like those imposed on Arthur Andersen.  Unlike individuals, firms can negotiate for deferred prosecution agreements (DPAs) in which the firm agrees to governance arrangements in order to avoid prosecution.

[FN: See James R. Copland, Regulation by Prosecution: The Problem with Treating Corporations as Criminals, Civ. Just. Rep. No. 13 (December, 2010); Richard A. Epstein, The Deferred Prosecution Racket, WALL St. J., Nov. 28, 2006, at A14.] 

The firm’s ability to get a DPA depends on its cooperation with the prosecution which, in turn, may require the firm to induce its agents to cooperate with investigators.  Accordingly, firms seeking DPAs have strong incentives to deny agents advancement or indemnification of expenses and to waive the attorney–client privilege.

[FN: With respect to privilege waivers, see Michael Seigel, Corporate America Fights Back: The Battle Over Waiver of the Attorney-Client Privilege, Social Science Research Network (March 3, 2010), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1564270.]  

Employees may find themselves having to talk to corporate attorneys without the protection of an attorney–client privilege.  Given the high defense costs discussed above, indemnification and advancement can mean the difference between a defendant’s ability to mount a defense and having to plead guilty.  These issues surfaced in the KPMG case, in which the government pressured the defendant accounting firm, which faced the possibility of following Arthur Andersen to extinction, to deny its employees advancement and indemnification.

[FN: See Harvey A. Silverglate, Three Felonies a Day:  How the Feds Target the Innocent, 138-52 (Encounter Books, 2009); Sarah Ribstein, A Question of Costs:  Considering Pressure on White-Collar Criminal Defendants, 58 Duke L. J. 857, 870-73 (2009); United States v. Stein, 495 F. Supp. 2d 390 (S.D.N.Y. 2007), aff’d United States v. Stein, 541 F.3d 130 (2d Cir. 2008) (The trial court ruled that the government’s pressure violated defendants’ Fifth and Sixth Amendment rights and dismissed several of the indictments).]

All of this is not to say that Morgenstory don’t report some problems.  One of them is the nice way these very costly proceedings dovetail with the interests of white collar defense bar — one of the more lucrative preserves remaining to Big Law. 

The other is the DOJ’s secrecy about its decision-making.  Morgenstory make it look like DOJ is cloaking a pro-corporate conspiracy.  But DOJ secrecy also hid DOJ’s process of deciding which corporate executives to send up the river in its prosecution spree of in the early 2000s. I discussed a few years ago some questions raised by those decisions.

The “scandal” in the Morgenstory story is, at most, the DOJ cleaning up after the real scandal of excessive criminalization of agency costs, and maybe not even that.  Nevertheless, watch for the followup hearings on the “dpa scandal,” followed by a return to the good old days of excessive prosecutorial behavior.

So how is Ralph Nader, the former scourge of GM and all things corporate, doing with his retirement fund?  The WSJ takes a peak:

In 2000, his Cisco stake was valued at $1 million, about one-third of his $3 million portfolio. As Cisco’s share price swooned in the years that followed, it has represented a smaller slice of his overall investment portfolio, which he said still is valued at about $3 million. At Thursday’s closing price, his stake is valued at $278,460.

I guess Nader is learning about diversification the hard way.

Like Frank Easterbrook, Michael Jensen and Mike Milken, among others, Nader seems to understand the agency costs of cash retention:

In a private letter to Cisco Chief Executive John Chambers sent June 13, Mr. Nader blasted the CEO for not doing enough to lift shares of the technology company and said “it is time for a long overdue Cisco shareholder revolt against a management that is oblivious to building or even maintaining shareholder value,” according to the letter. * * * Among the specific actions Mr. Nader suggested in the letter are the distribution of a one-time dividend of $1 a share and an increase in Cisco’s annual dividend to 50 cents from 24 cents. “If they can’t give shareholders value, then they have to give cash,” Mr. Nader said in an interview this week. . .

Nader does have cause for complaint:

Cisco’s shares  * * * are down nearly a third in the past year and are off 75% from their all-time, tech-bubble high. * * * Cisco, like many big tech companies, has been accumulating cash despite its weak growth. It holds $43 billion in cash, nearly half of its market value.

So Cisco is basically a very expensive money market fund.  Or possibly tax shelter, since it says most of the cash is “foreign earnings, which would be subject to taxes if the funds were brought back to the U.S.”

Nader says he’s an “adversary of corporate capitalism” but a “believer in capitalism.” True to form, Nader is thinking about organizing a shareholder revolt. 

But corporate accountability measures don’t necessarily work with cash cows that resist reform.  Nader seems to recognize this in trying to enlist hedge funder Carl Icahn to his cause. 

Yes, what Nader really wants is an uncorporation.

Steve Bainbridge responds to my post about insider trading as compensation with a suggestion that rules against insider trading are an example of a case “where mandatory rules are appropriate.”

I was about to sputter about laws against insider trading are really about property rights, and surely property should be alienable — right?  And about how this is really about fiduciary duties, and behind that agency costs, which is the heart of corporate law.  So how much of the rest of corporate law should be made mandatory and federal?

Then I realized Steve was really talking about lawyers trading on clients’ information.  Well, that’s different. Clients rarely authorize this, so it’s usually theft and therefore bad.  But I still wonder why clients shouldn’t be allowed to authorize it.  And who knows whether that might happen as lawyers’ roles evolve?  (You knew I was going to stick that one in again, didn’t you?)

But after calming down I got riled up by the last line: “If investors have a taste for prohibiting insider trading, it thus does no good to say that the world would be a more efficient place if insider trading were allowed.”

Um, well, where does that sort of reasoning stop?  People ought to be able to indulge a lot of seemingly goofy tastes.  But that’s a long way from a normative argument that these tastes should be imposed on society.

I’m just catching up with this Board Member article about Delaware’s new competitor, Nevada. It notes that Nevada’s share of the out-of-state incorporation market rose from 4.6% in 2000 to 6% in 2007.  Part of this may be due to lower fees than Delaware. But that can’t be the full explanation because all states are cheaper than Delaware.  More interestingly, the article suggests Nevada may be succeeding by offering a haven for shady operators with low fiduciary standards and high barriers to takeovers. 

The article features a discussion of Michal Barzuza’s article with David Smith, What Happens in Nevada? Self-Selecting into a Lax Law, which as the title indicates supports the competition-for-laxity position.  This paper, as the Board Member article notes, shows that “Nevada corporations posted accounting restatements twice as often as the national average from 2000-2008.”  Barzuza tells Board Member:  “It should be a cause for concern if the companies that need regulation most are allowed to choose a lax legal regime.”

I get a chance to respond in the Board Member article.  Here’s my quote:  “The data show that riskier firms are going to Nevada, but risky firms need capital, too. What Delaware has to offer is its legal infrastructure. But it’s reasonable to ask what that is worth to me as a business.” This is along the lines of my comment on Barzuza-Smith at last year’s Conference on Empirical Legal Studies. 

Barzuza also has a sole-authored paper that focuses on the normative aspects of the Barzuza-Smith empirical study.  That paper doesn’t yet have a public link, but I’ve read it and saw it presented at ALEA last week. 

Barzuza and I agree that Delaware and Nevada appeal to different segments of the incorporation market.  We disagree on whether this is a problem.  In a nutshell:

  • Barzuza thinks the relatively high level of accounting restatements by Nevada corporations indicates Nevada offers an escape from regulation for firms that most need to be regulated.  As Barzuza-Smith say in their abstract:  “Our findings indicate that firms may self-select a legal system that matches their desirable level of private-benefit consumption, and that Nevada competes to attract firms with higher agency costs.”
  • But I see an efficient contracting story, with Nevada offering smaller firms an opportunity to economize on monitoring and litigation costs. (Note: the more recent unposted Barzuza paper also discusses the efficient contracting story.)

The implications of this debate are important because it carries the threat of more federal regulation of corporate governance.

Here’s some support for my efficient contracting hypothesis:

  • Nevada isn’t, in fact, a haven for defrauders.  Its law provides for liability for fraud as well as intentional misconduct or a knowing violation of law. It couldn’t if it wanted to offer escape from federal securities law liability. Although B-S (Table 4) show a higher fraud percentage in Nevada restatements, the total percentage is tiny in Nevada as elsewhere.  More importantly, B-S found no evidence that increased restatements followed incorporation under Nevada’s lax (post-2000) provisions.  In other words, although Nevada may attract dishonest managers, there’s no indication these firms were reincorporating in Nevada in order to commit fraud.
  • The value of Nevada corporations doesn’t suffer from any evident “fraud discount” as measured by Tobin’s q (B-S Table 5) (although it’s not clear how these values might be affected by pre- or post-restatement accounting). 
  • There are benign explanations for the larger number of Nevada accounting restatements.  Nevada public firms are smaller than those in Delaware, increasing the per capitalization cost of setting up controls that could catch accounting errors.  Small size is one of the factors associated with weaker controls (see Doyle, Ge and McVay).  B-S show that Nevada has a relatively high percentage of mining firms, and Barzuza’s ALEA paper shows that Nevada has a relatively high percentage of family firms.  Both of these characteristics relate to the amount and type of monitoring required, and therefore to the efficient contracting story.

In short, the article’s data is consistent with the hypothesis that firms choose Nevada for its better balance of costs and benefits of monitoring than they could get in Delaware. Its strict default standards for suing managers may tolerate some managerial misconduct, but they also reduce firms’ exposure to opportunistic strike litigation.  Nevada removes from its statute the sources of legal indeterminacy that Delaware has been criticized for.  This enables Nevada to offer a legal package that is attractive to some firms without the costly legal infrastructure required to apply Delaware’s open-ended good-faith and loyalty standards.

In other words, in contrast to the B-S claim that Nevada “competes to attract firms with higher agency costs,” in fact Nevada may be attracting firms seeking lower agency costs defined by Jensen & Meckling to include monitoring and bonding costs as well as agent misconduct (Jensen & Meckling, Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure, 3 J. Fin. Econ. 305 (1976).  This recognizes that the costs of hiring an agent, and thereby separating ownership and control, are never zero.  Attempting to reduce agent misconduct to zero could actually increase total agency costs as compared with cheaper monitoring that tolerates a reasonable level of agent misconduct.

None of this is to say that Nevada law offers an optimal set of terms.  We could probably benefit from additional standard forms to match firms’ diverse governance needs.  (Watch for my forthcoming paper with Kobayashi on the production of private law.)   But Nevada law doesn’t have to be optimal to be welfare-increasing. The question is whether the Nevada package of terms offers a better match for some firms than a Nevada-less market for corporations in which only Delaware competes for out-of-state incorporations.

Aside from substantively evaluating Nevada law, it is worth asking whether the Nevada story suggests market failure in the corporate law market.  B-S show that Nevada is not pretending to be something it isn’t.  It clearly advertises its “laxity,” so both shareholders and managers know what they’re getting.  Moreover, the Board Member article indicates there’s inherent resistance to any state that departs from the Delaware standard.  Investors may over-discount Nevada corporate shares out of distrust or fear of the unknown so Nevada laxity is, if anything, over-reflected, in the price of Nevada IPOs.  If Nevada shareholders don’t get an adequate voice on Nevada reincorporations (as where an existing firm merges with a Nevada shell) this is a problem with the law of the non-Nevada states where the firms originate.

So more work needs to be done to flesh out the Nevada story.  This might include

  • More specific comparisons of the firms that are and aren’t choosing Nevada to get a clearer picture of the effect of Nevada incorporation. 
  • As somebody suggested at ALEA, perhaps California-based firms incorporating in Nevada may not really be choosing Nevada governance law because of California’s “quasi-foreign” provisions. 
  • Is there an “out of Nevada” effect analogous to the “out of Delaware” effect documented by Armour, Black and Cheffins, in which Nevada corporate cases, particularly those involving fraud, are being litigated in, say, California or federal court?  This would negate any effort by Nevada to attract managers seeking to escape fraud liability.
  • Is Nevada using a similar strategy to compete in the market for LLCs?  Kobayashi and my data on the market for LLCs suggest not, and that the overall market for LLCs differs from that for corporations.  So why don’t firms opt out of Delaware corporate law by opting into uncorporate law?  I show that this strategy could produce a Nevada-like reduction of indeterminacy.

In short, Barzuza & Smith are right and clever to focus on this evidence of segmentation in the incorporation market.  This contradicts those who contend that the so-called market for out-of-state incorporations is really a Delaware monopoly. 

But it’s a mistake without much more data to jump to the conclusion that this is a “cause for concern.” This sort of argument could feed building pressures to federalize corporate law.  So far the Nevada story shows that there’s a significant demand for rules that reduce governance costs even in the face of strong pressures toward Delaware standardization. This cuts against rather than for increasing federalization, particularly as we are learning that even federal law competes in a global market for corporate law.

A few days ago Paul Caron summarized moves toward corporate taxation of pass-through entities with more than $50 million gross receipts, adding links to prior posts on this subject.

Today’s WSJ echoes this story, quoting Sen. Max Baucus, Senate Finance Chair: “We’re talking about business income here. Why not have the large pass-throughs … pay a corporate rate?”

Well, here’s “why not”:  Changing the tax on pass-throughs could significantly reduce governance efficiency and may not produce that much more revenue.

As detailed in my Rise of the Uncorporation, an important uncorporate feature is their emphasis on owner “exit,” in the form of distributions and buyouts, over corporate-type monitoring such as boards of directors, shareholder voting and fiduciary duties.  Recent financial crises have shown the problems with corporate-type management, even after decades of reform.  This should encourage openness to alternatives, including uncorporate management. But corporate taxation, by taxing income both when earned by the corporation and when distributed to owners, effectively penalizes the distributions and buyouts that are so important to uncorporate governance. 

Instead of increasing the application of the corporate tax we should be asking how expanding the domain of tax pass-throughs could increase efficient uncorporate governance.   As discussed in Rise of the Uncorporation (243-44, footnotes omitted):

Taxing distributions burdens an important aspect of the uncorporate approach to governance. Yet the only way large firms can be publicly held is to fit into a small exception from the rule treating publicly traded firms as corporations. Large firms that want the discipline provided by owner access to the cash need to end-run the tax on distributions by using tax-deductible debt, thereby increasing the risk of costly bankruptcy. This encourages firms to continue to use the corporate form even as the costs of this form increase. * * *

The factors discussed above in this chapter pointing to more use of the uncorporation for publicly held firms eventually might encourage a change in tax policy. As discussed above, the current exception from the corporate tax on publicly traded firms is limited essentially to passive rent collectors such as natural resource and real estate firms. This is probably narrower than the class of firms that could benefit from flow-through partnership taxation and that would seek this taxation under a more flexible rule. For example, mature, slowgrowth firms that get fairly predictable earnings from established brands might derive comparable benefits from a tax rule that encouraged regular distributions to owners.

Congress might accommodate this need for flexibility by drawing the corporate-partnership tax border with a view to encouraging governance structures that mitigate agency costs. Firms arguably should be able to balance the costs and benefits of the tax as they do with other governance devices. In other words, firms’ governance choices should determine the application of the tax rather than vice versa. At the same time, as long as the corporate tax remains, Congress has to restrict firms’ ability to opt out of it. Lawmakers could let firms choose to be taxed as partnerships on the condition that they have substantially adopted partnership-type governance, including committing to making distributions. This would be analogous to the tax code’s approach to REITs in which the application of partnership-type tax turns to some extent on the firms’ distribution of earnings. It also would be consistent with the goal of making statutory standard forms coherent because it would enable firms to mesh tax consequences with their choice of business association.

A full analysis of proposals to tax pass-throughs should look closely at claims about potential revenue gains given likely increased reliance on debt, as well as the efficiency costs of undermining the uncorporate form and increasing bankruptcy costs.