Archives For fiduciary duty

Problems With the Theory of Anticompetitive Harm from Common Ownership

Thom Lambert — 25 May 2018

Mike Sykuta and I have been blogging about our recent paper on so-called “common ownership” by institutional investors like Vanguard, BlackRock, Fidelity, and State Street. Following my initial post, Mike described the purported problem with institutional investors’ common ownership of small stakes in competing firms.

As Mike explained, the theory of anticompetitive harm holds that small-stakes common ownership causes firms in concentrated industries to compete less vigorously, since each firm’s top shareholders are also invested in that firm’s rivals. Proponents of restrictions on common ownership (e.g., Einer Elhauge and Eric Posner, et al.) say that empirical studies from the airline and commercial banking industries support this theory of anticompetitive harm. The cited studies correlate price changes with changes in “MHHI∆,” a complicated index designed to measure the degree to which common ownership encourages competition-softening.

We’ll soon have more to say about MHHI∆ (admirably described by Mike!) and the shortcomings of the airline and banking studies. (Look for a “Problems With the Evidence” post.) First, though, a few words on why the theory of anticompetitive harm from small-stakes common ownership is implausible.

Common ownership critics’ theoretical argument proceeds as follows:

Premise 1: Because institutional investors are intra-industry diversified, they benefit if their portfolio firms seek to maximize industry, rather than own-firm, profits.
Premise 2: Corporate managers seek to maximize the returns of their corporations’ largest shareholders—intra-industry diversified institutional investors—and will thus pursue maximization of industry profits.
Premise 3: Industry profits, unlike own-firm profits, are maximized when producers refrain from underpricing their rivals to win business.

Ergo:

Conclusion: Intra-industry diversification by institutional investors reduces price competition and should be restricted.

The first two premises of this argument are, at best, questionable.

With respect to Premise 1, it is unlikely that intra-industry diversified institutional investors benefit from, and thus prefer, maximization of industry rather than own-firm profits. That is because intra-industry diversified mutual funds tend also to be inter-industry diversified. Maximizing one industry’s profits requires supracompetitive pricing that tends to reduce the profits of firms in complementary industries.

Vanguard’s Value Index Fund, for example, holds around 2% of each major airline (1.85% of United, 2.07% of American, 2.15% of Southwest, and 1.99% of Delta) but also holds:

1.88% of Expedia Inc. (a major retailer of airline tickets),
2.20% of Boeing Co. (a manufacturer of commercial jets),
2.02% of United Technologies Corp. (a jet engine producer),
3.14% of AAR Corp. (the largest domestic provider of commercial aircraft maintenance and repair),
1.43% of Hertz Global Holdings Inc. (a major automobile rental company), and
2.17% of Accenture (a consulting firm for which air travel is a significant cost component).

Each of those companies—and many others—perform worse when airlines engage in the sort of supracompetitive pricing (and corresponding reduction in output) that maximizes profits in the airline industry. The very logic suggesting that intra-industry diversification causes investors to prefer less competition necessarily suggests that inter-industry diversification would counteract that incentive.

Of course, whether any particular investment fund will experience enhanced returns from reduced price competition in the industries in which it is intra-industry diversified ultimately depends on the composition of its portfolio. For widely diversified funds, however, it is unlikely that fund returns will be maximized by rampant competition-softening. As the well-known monopoly pricing model depicts, every instance of supracompetitive pricing entails a deadweight loss—i.e., an allocative inefficiency stemming from the failure to produce units that create greater value than they cost to produce. To the extent an index fund is designed to reflect gains in the economy generally, it will perform best if such allocative inefficiencies are minimized. It seems, then, that Premise 1—the claim that intra-industry diversified institutional investors prefer competition-softening so as to maximize industry profits—is dubious.

So is Premise 2, the claim that corporate managers will pursue industry rather than own-firm profits when their largest shareholders prefer that outcome. For nearly all companies in which intra-industry diversified institutional investors collectively hold a significant proportion of outstanding shares, a majority of the stock is still held by shareholders who are not intra-industry diversified. Those shareholders would prefer that managers seek to maximize own-firm profits, an objective that would encourage the sort of aggressive competition that grows market share.

There are several reasons to doubt that corporate managers would routinely disregard the interests of shareholders owning the bulk of the company’s stock. For one thing, favoring intra-industry diversified investors holding a minority interest could subject managers to legal liability. The fiduciary duties of corporate managers require that they attempt to maximize firm profits for the benefit of shareholders as a whole; favoring even a controlling shareholder (much less a minority shareholder) at the expense of other shareholders can result in liability.

More importantly, managers’ personal interests usually align with those of the majority when it comes to the question of whether to maximize own-firm or industry profits. As sellers in the market for managerial talent, corporate managers benefit from reputations for business success, and they can best burnish such reputations by beating—i.e., winning business from—their industry rivals. In addition, most corporate managers receive some compensation in the form of company stock. They maximize the value of that stock by maximizing own-firm, not industry, profits. It thus seems unlikely that corporate managers would ignore the interests of stockholders owning a majority of shares and cause their corporations to refrain from business-usurping competition.

In the end, then, two key premises of common ownership critics’ theoretical argument are suspect. And if either is false, the argument is unsound.

When confronted with criticisms of their theory of anticompetitive harm, proponents of common ownership restrictions generally point to the empirical evidence described above. We’ll soon have some thoughts on that. Stay tuned!

In Antitrust & Competition, Banking, Corporate & Securities Law, Financial Regulation common ownership, fiduciary duty, institutional investors, mutual funds

The Essential Facility of Obama’s Competition Policy

Kristian Stout — 19 April 2016

It appears that White House’s zeal for progressive-era legal theory has … progressed (or regressed?) further. Late last week President Obama signed an Executive Order that nominally claims to direct executive agencies (and “strongly encourages” independent agencies) to adopt “pro-competitive” policies. It’s called Steps to Increase Competition and Better Inform Consumers and Workers to Support Continued Growth of the American Economy, and was produced alongside an issue brief from the Council of Economic Advisors titled Benefits of Competition and Indicators of Market Power.

TL;DR version: the Order and its brief do not appear so much aimed at protecting consumers or competition, as they are at providing justification for favored regulatory adventures.

In truth, it’s not exactly clear what problem the President is trying to solve. And there is language in both the Order and the brief that could be interpreted in a positive light, and, likewise, language that could be more of a shot across the bow of “unruly” corporate citizens who have not gotten in line with the President’s agenda. Most of the Order and the corresponding CEA brief read as a rote recital of basic antitrust principles: price fixing bad, collusion bad, competition good. That said, there were two items in the Order that particularly stood out.

The (Maybe) Good

Section 2 of the Order states that

Executive departments … with authorities that could be used to enhance competition (agencies) shall … use those authorities to promote competition, arm consumers and workers with the information they need to make informed choices, and eliminate regulations that restrict competition without corresponding benefits to the American public. (emphasis added)

Obviously this is music to the ears of anyone who has thought that agencies should be required to do a basic economic analysis before undertaking brave voyages of regulatory adventure. And this is what the Supreme Court was getting at in Michigan v. EPA when it examined the meaning of the phrase “appropriate” in connection with environmental regulations:

One would not say that it is even rational, never mind “appropriate,” to impose billions of dollars in economic costs in return for a few dollars in health or environmental benefits.

Thus, if this Order follows the direction of Michigan v. EPA, and it becomes the standard for agencies to conduct cost-benefit analyses before issuing regulation (and to review old regulations through such an analysis), then wonderful! Moreover, this mandate to agencies to reduce regulations that restrict competition could lead to an unexpected reformation of a variety of regulations – even outside of the agencies themselves. For instance, the FTC is laudable in its ongoing efforts both to correct anticompetitive state licensing laws as well as to resist state-protected incumbents, such as taxi-cab companies.

Still, I have trouble believing that the President — and this goes for any president, really, regardless of party — would truly intend for agencies under his control to actually cede regulatory ground when a little thing like economic reality points in a different direction than official policy. After all, there was ample information available that the Title II requirements on broadband providers would be both costly and result in reduced capital expenditures, and the White House nonetheless encouraged the FCC to go ahead with reclassification.

And this isn’t the first time that the President has directed agencies to perform retrospective review of regulation (see the Identifying and Reducing Regulatory Burdens Order of 2012). To date, however, there appears to be little evidence that the burdens of the regulatory state have lessened. Last year set a record for the page count of the Federal Register (80k+ pages), and the data suggest that the cost of the regulatory state is only increasing. Thus, despite the pleasant noises the Order makes with regard to imposing economic discipline on agencies – and despite the good example Canada has set for us in this regard – I am not optimistic of the actual result.

And the (maybe) good builds an important bridge to the (probably) bad of the Order. It is well and good to direct agencies to engage in economic calculation when they write and administer regulations, but such calculation must be in earnest, and must be directed by the learning that was hard earned over the course of the development of antitrust jurisprudence in the US. As Geoffrey Manne and Josh Wright have noted:

Without a serious methodological commitment to economic science, the incorporation of economics into antitrust is merely a façade, allowing regulators and judges to select whichever economic model fits their earlier beliefs or policy preferences rather than the model that best fits the real‐world data. Still, economic theory remains essential to antitrust law. Economic analysis constrains and harnesses antitrust law so that it protects consumers rather than competitors.

Unfortunately, the brief does not indicate that it is interested in more than a façade of economic rigor. For instance, it relies on the outmoded 50 firm revenue concentration numbers gathered by the Census Bureau to support the proposition that the industries themselves are highly concentrated and, therefore, are anticompetitive. But, it’s been fairly well understood since the 1970s that concentration says nothing directly about monopoly power and its exercise. In fact, concentration can often be seen as an indicator of superior efficiency that results in better outcomes for consumers (depending on the industry).

The (Probably) Bad

Apart from general concerns (such as having a host of federal agencies with no antitrust expertise now engaging in competition turf wars) there is one specific area that could have a dramatically bad result for long term policy, and that moreover reflects either ignorance or willful blindness of antitrust jurisprudence. Specifically, the Order directs agencies to

identify specific actions that they can take in their areas of responsibility to build upon efforts to detect abuses such as price fixing, anticompetitive behavior in labor and other input markets, exclusionary conduct, and blocking access to critical resources that are needed for competitive entry. (emphasis added).

It then goes on to say that

agencies shall submit … an initial list of … any specific practices, such as blocking access to critical resources, that potentially restrict meaningful consumer or worker choice or unduly stifle new market entrants (emphasis added)

The generally uncontroversial language regarding price fixing and exclusionary conduct are bromides – after all, as the Order notes, we already have the FTC and DOJ very actively policing this sort of conduct. What’s novel here, however, is that the highlighted language above seems to amount to a mandate to executive agencies (and a strong suggestion to independent agencies) that they begin to seek out “essential facilities” within their regulated industries.

But “critical resources … needed for competitive entry” could mean nearly anything, depending on how you define competition and relevant markets. And asking non-antitrust agencies to integrate one of the more esoteric (and controversial) parts of antitrust law into their mission is going to be a recipe for disaster.

In fact, this may be one of the reasons why the Supreme Court declined to recognize the essential facilities doctrine as a distinct rule in Trinko, where it instead characterized the exclusionary conduct in Aspen Skiing as ‘at or near the outer boundary’ of Sherman Act § 2 liability.

In short, the essential facilities doctrine is widely criticized, by pretty much everyone. In their respected treatise, Antitrust Law, Herbert Hovenkamp and Philip Areeda have said that “the essential facility doctrine is both harmful and unnecessary and should be abandoned”; Michael Boudin has noted that the doctrine is full of “embarrassing weaknesses”; and Gregory Werden has opined that “Courts should reject the doctrine.” One important reason for the broad criticism is because

At bottom, a plaintiff … is saying that the defendant has a valuable facility that it would be difficult to reproduce … But … the fact that the defendant has a highly valued facility is a reason to reject sharing, not to require it, since forced sharing “may lessen the incentive for the monopolist, the rival, or both to invest in those economically beneficial facilities.” (quoting Trinko)

Further, it’s really hard to say when one business is so critical to a particular market that its own internal functions need to be exposed for competitors’ advantage. For instance, is Big Data – which the CEA brief specifically notes as a potential “critical resource” — an essential facility when one company serves so many consumers that it has effectively developed an entire market that it dominates? ( In case you are wondering, it’s actually not). When exactly does a firm so outcompete its rivals that access to its business infrastructure can be seen by regulators as “essential” to competition? And is this just a set-up for punishing success — which hardly promotes competition, innovation or consumer welfare?

And, let’s be honest here, when the CEA is considering Big Data as an essential facility they are at least partially focused on Google and its various search properties. Google is frequently the target for “essentialist” critics who argue, among other things, that Google’s prioritization of its own properties in its own search results violates antitrust rules. The story goes that Google search is so valuable that when Google publishes its own shopping results ahead of its various competitors, it is engaging in anticompetitive conduct. But this is a terribly myopic view of what the choices are for search services because, as Geoffrey Manne has so ably noted before, “competitors denied access to the top few search results at Google’s site are still able to advertise their existence and attract users through a wide range of other advertising outlets[.]”

Moreover, as more and more users migrate to specialized apps on their mobile devices for a variety of content, Google’s desktop search becomes just one choice among many for finding information. All of this leaves to one side, of course, the fact that for some categories, Google has incredibly stiff competition.

Thus it is that

to the extent that inclusion in Google search results is about “Stiglerian” search-cost reduction for websites (and it can hardly be anything else), the range of alternate facilities for this function is nearly limitless.

The troubling thing here is that, given the breezy analysis of the Order and the CEA brief, I don’t think the White House is really considering the long-term legal and economic implications of its command; the Order appears to be much more about political support for favored agency actions already under way.

Indeed, despite the length of the CEA brief and the variety of antitrust principles recited in the Order itself, an accompanying release points to what is really going on (at least in part). The White House, along with the FCC, seems to think that the embedded streams in a cable or satellite broadcast should be considered a form of essential facility that is an indispensable component of video consumers’ choice (which is laughable given the magnitude of choice in video consumption options that consumers enjoy today).

And, to the extent that courts might apply the (controversial) essential facilities doctrine, an “indispensable requirement … is the unavailability of access to the ‘essential facilities’[.]” This is clearly not the case with much of what the CEA brief points to as examples of ostensibly laudable pro-competitive regulation.

The doctrine wouldn’t apply, for instance, to the FCC’s Open Internet Order since edge providers have access to customers over networks, even where network providers want to zero-rate, employ usage-based billing or otherwise negotiate connection fees and prioritization. And it also doesn’t apply to the set-top box kerfuffle; while third-parties aren’t able to access the video streams that make-up a cable broadcast, the market for consuming those streams is a single part of the entire video ecosystem. What really matters there is access to viewers, and the ability to provide services to consumers and compete for their business.

Yet, according to the White House, “the set-top box is the mascot” for the administration’s competition Order, because, apparently, cable boxes represent “what happens when you don’t have the choice to go elsewhere.” ( “Elsewhere” to the White House, I assume, cannot include Roku, Apple TV, Hulu, Netflix, and a myriad of other video options that consumers can currently choose among.)

The set-top box is, according to the White House, a prime example of the problem that

[a]cross our economy, too many consumers are dealing with inferior or overpriced products, too many workers aren’t getting the wage increases they deserve, too many entrepreneurs and small businesses are getting squeezed out unfairly by their bigger competitors, and overall we are not seeing the level of innovative growth we would like to see.

This is, of course, nonsense. Consumers enjoy an incredible amount of low-cost, high quality goods (including video options) – far more than at any point in history. After all:

From cable to Netflix to Roku boxes to Apple TV to Amazon FireStick, we have more ways to find and watch TV than ever — and we can do so in our living rooms, on our phones and tablets, and on seat-back screens at 30,000 feet. Oddly enough, FCC Chairman Tom Wheeler … agrees: “American consumers enjoy unprecedented choice in how they view entertainment, news and sports programming. You can pretty much watch what you want, where you want, when you want.”

Thus, I suspect that the White House has its eye on a broader regulatory agenda.

For instance, the Department of Labor recently announced that it would be extending its reach in the financial services industry by changing the standard for when financial advice might give rise to a fiduciary relationship under ERISA. It seems obvious that the SEC or FINRA could have taken up the slack for any financial services regulatory issues – it’s certainly within their respective wheelhouses. But that’s not the direction the administration took, possibly because SEC and FINRA are independent agencies. Thus, the DOL – an agency with substantially less financial and consumer protection experience than either the SEC or FINRA — has expansive new authority.

And that’s where more of the language in the Order comes into focus. It directs agencies to “ensur[e] that consumers and workers have access to the information needed to make informed choices[.]” The text of the DOL rule develops for itself a basis in competition law as well:

The current proposal’s defined boundaries between fiduciary advice, education, and sales activity directed at large plans, may bring greater clarity to the IRA and plan services markets. Innovation in new advice business models, including technology-driven models, may be accelerated, and nudged away from conflicts and toward transparency, thereby promoting healthy competition in the fiduciary advice market.

Thus, it’s hard to see what the White House is doing in the Order, other than laying the groundwork for expansive authority of non-independent executive agencies under the thin guise of promoting competition. Perhaps the President believes that couching this expansion in free market terms ( i.e. that its “pro-competition”) will somehow help the initiatives go through with minimal friction. But there is nothing in the Order or the CEA brief to provide any confidence that competition will, in fact, be promoted. And in the end I have trouble seeing how this sort of regulatory adventurism does not run afoul of separation of powers issues, as well as assorted other legal challenges.

Finally, conjuring up a regulatory version of the essential facilities doctrine as a support for this expansion is simply a terrible idea — one that smacks much more of industrial policy than of sound regulatory reform or consumer protection.

GMU Law & Economics Center Presents “Unlocking the Law: Building on the Work of Professor Larry Ribstein”

Josh Wright — 25 July 2012

I’m very pleased to announce the George Mason Law & Economics Center is hosting a program focusing on our friend and colleague Larry Ribstein’s scholarship on the market for law. Henry Butler and Bruce Kobayashi have put together a really wonderful program of folks coming together not to celebrate Larry’s work — but to use it as a platform for further discussion and for legal scholars to engage in these important issues.

Interested readers might want to check out the TOTM Unlocking the Law Symposium.

The announcement follows and I hope to see some of you there on Friday, November 9, 2012 at GMU Law.
The Henry G. Manne Program in Law and Regulatory Studies presents Unlocking the Law: Building on the Work of Professor Larry Ribstein to be held at George Mason University School of Law, Friday, November 9th, 2012. The conference will run from 8:00 A.M. to 4:00 P.M.

OVERVIEW: In a series of influential and provocative articles, Professor Larry Ribstein examined the forces behind the recent upheaval in the market for legal services. These forces included increased global competition, changes in the demand for legal services resulting from the expanded role of the in-house counsel, and the expanded use of technology. His analysis showed that changes in the market for legal services were not just the result of a cyclical downturn in the economy. Rather, the profound changes in the market reflected building competitive pressures that exposed the flaws in the business model used by large firms to provide legal services. His recent writings also examined the broader implications of this upheaval for legal education, the private production of law, and whether legal innovation will be hindered by or hasten the demise of the current system of professional regulation of lawyers.

Professor Ribstein passed away suddenly on December 24, 2011. In the wake of the terrible loss of their close friend and colleague, Professors Henry Butler and Bruce Kobayashi (along with several other colleagues at Mason Law) have decided to honor Larry through a conference designed to capture and expand on the spirit of Larry’s recent work. The Unlocking the Law Conference seeks to advance these goals by inviting legal scholars to present their views and engage in a vibrant discussion about the present and future of the market for legal services. The panels at this conference will showcase 14 papers written specifically for this occasion and presented to the public for the first time.

This conference is organized by Henry N. Butler, Executive Director of the Law & Economics Center and George Mason Foundation Professor of Law, and Bruce H. Kobayashi, Professor of Law, George Mason University School of Law through a new Project on Legal Services Reform – under the auspices of the Mason Law & Economics Center. The Project on Legal Services Reform seeks to continue and extend the important work on legal innovation, legal education, law firms, and legal regulation produced by Larry. We hope to encourage scholars who have not worked in these areas to read Larry’s work, critique it in the same manner in which Larry famously commented on papers, and expand (or even restrict or redirect) the thrust of Larry’s work. In essence, this project is about “Larry as Catalyst.”

For background information, you might want to visit TRUTH ON THE MARKET (http://www.truthonthemarket.com), which held an online symposium on this topic on September 19 and 20, 2011.

REGISTRATION: You must pre-register for this event. To register, please send a message with your name, affiliation, and full contact information to: Jeff Smith, Coordinator, Henry G. Manne Program in Law and Regulatory Studies, jsmithQ@gmu.edu

AGENDA:

Friday, November 9, 2012:

Panel I. The Future of Legal Services and Legal Education

How the Structure of Universities Determined the Fate of American Law Schools
– Henry G. Manne, Distinguished Visiting Professor, Ave Maria School of Law; Dean Emeritus, George Mason University School of Law

The Undergraduate Option for Legal Education
– John O. McGinnis, George C. Dix Professor in Constitutional Law, Northwestern University School of Law

Panel II. Deregulating Legal Services

The Deprofessionalization of Profession Services: What Law and Medicine Have in Common and How They Differ
– Richard A. Epstein, Laurence A. Tisch Professor of Law, New York University School of Law

The Future of Licensing Lawyers
– M. Todd Henderson, Professor of Law, University of Chicago Law School

Failing the Legal System: Why Lawyers and Judges Need to Act to Authorize the Organizational Practice of Law
– Gillian K. Hadfield, Richard L. and Antoinette Schamoi Kirtland Professor of Law and Professor of Economics, University of Southern California Gould School of Law

Globalization and Deregulation of Legal Services
– Nuno Garoupa, Professor and H. Ross and Helen Workman Research Scholar, University of Illinois College of Law; Co-Director, Illinois Program on Law, Behavior, and Social Science

Panel III. Law Firms and Competition Between Lawyers

From Big Law to Lean Law
– William D. Henderson, Professor of Law and Van Nolan Faculty Fellow, Indiana University Maurer School of Law; Director, Center on the Global Legal Profession

Glass Half Full: The Significant Upsides to the Changes in the American Legal Market
– Benjamin H. Barton, Professor of Law, University of Tennessee College of Law

An Exploration of Price Competition Among Lawyers
– Clifford Winston, Senior Fellow, Economics Studies, Brooking Institution

Panel IV. Reputation, Fiduciary Duties, and Agency Costs

Lawyers as Reputational Intermediaries: Sovereign Bond Issuances (1820-2012)
– Michael H. Bradley, F.M. Kirby Professor of Investment Banking Emeritus, Fuqua School of Business, Duke University; Professor of Law, Duke University School of Law
– Mitu Gulati, Professor of Law, Duke University School of Law
– Irving A. De Lira Salvatierra, Graduate Student, Department of Economics, Duke University

The Fiduciary Society
– Jason Scott Johnston, Henry L. and Grace Doherty Charitable Foundation Professor of Law and Nicholas E. Chimicles Research Professor in Business Law and Regulation, University of Virginia School of Law

Class Action Lawmakers and the Agency Problem
– Barry E. Adler, Bernard Petrie Professor of Law and Business and Associate Dean for Information Systems and Technology, New York University School of Law

Panel V. Private Lawmaking and Adjudication

Decentralizing the Lawmaking Function: Should There Be Intellectual Property Rights in Law?
– Robert G. Bone, G. Rollie White Teaching Excellence Chair in Law, University of Texas at Austin School of Law

Arbitration, the Law Market, and the Law of Lawyering
– Erin O’Hara O’Connor, Milton R. Underwood Chair in Law, Vanderbilt University Law School
– Peter B. Rutledge, Herman E. Talmadge Chair of Law, University of Georgia Law School

VENUE:
George Mason University School of Law
3301 Fairfax Drive
Arlington, VA 22201

FURTHER INFORMATION: For more information regarding this conference or other initiatives of the Law & Economics Center, please visit: http://www.MasonLEC.org

Call or send an email to: Tel: (703) 993-8040, Email: lec@gmu.edu

The Henry G. Manne Program in Law & Economics honors the legacy of Henry G. Manne, Dean Emeritus of George Mason Law School and founder of the Law & Economics Center. Manne was a trailblazer in the development of law and economics, not only as a prominent and influential scholar, but also as an academic entrepreneur. He spurred the development of law and economics into the most influential area of legal scholarship through his Economics Institutes for Law Professors and Law Institutes for Economics Professors. The Manne Program promotes law-and-economics scholarship by funding faculty research and hosting research roundtables and academic conferences.

http://www.MasonManne.org

In Banking, Constitutional Law, Corporate & Securities Law, Financial Regulation, Intellectual Property, Jurisdictional Competition, Law & Economics, Legal Profession, Regulation, Unlocking the Law Symposium Agency Costs, fiduciary duty, larry ribstein rip, Law school, lawyering, lawyers, licensing

A Decision-Theoretic Approach to Insider Trading Regulation

Thom Lambert — 19 January 2012

Regular readers will know that several of us TOTM bloggers are fans of the “decision-theoretic” approach to antitrust law. Such an approach, which Josh and Geoff often call an “error cost” approach, recognizes that antitrust liability rules may misfire in two directions: they may wrongly acquit harmful practices, and they may wrongly convict beneficial (or benign) behavior. Accordingly, liability rules should be structured to minimize total error costs (welfare losses from condemning good stuff and acquitting bad stuff), while keeping in check the costs of administering the rules (e.g., the costs courts and business planners incur in applying the rules). The goal, in other words, should be to minimize the sum of decision and error costs. As I have elsewhere demonstrated, the Roberts Court’s antitrust jurisprudence seems to embrace this sort of approach.

One of my long-term projects (once I jettison some administrative responsibilities, like co-chairing my school’s dean search committee!) will be to apply the decision-theoretic approach to regulation generally. I hope to build upon some classic regulatory scholarship, like Alfred Kahn’s Economics of Regulation (1970) and Justice Breyer’s Regulation and Its Reform (1984), to craft a systematic regulatory model that both avoids “regulatory mismatch” (applying the wrong regulatory fix to a particular type of market failure) and incorporates the decision-theoretic perspective.

In the meantime, I’ve been thinking about insider trading regulation. Our friend Professor Bainbridge recently invited me to contribute to a volume he’s editing on insider trading. I’m planning to conduct a decision-theoretic analysis of actual and proposed insider trading regulation.

Such regulation is a terrific candidate for decision-theoretic analysis because stock trading on the basis of material, nonpublic information itself is a “mixed bag” practice: Some instances of insider trading are, on net, socially beneficial; others create net welfare losses. Contrast, for example, two famous insider trading cases:

In SEC v. Texas Gulf Sulphur, mining company insiders who knew of an unannounced ore discovery purchased stock in their company, knowing that the stock price would rise when the discovery was announced. Their trading activity caused the stock price to rise over time. Such price movement might have tipped off landowners in the vicinity of the deposit and caused them not to sell their property to the company (or to do so only at a high price), in which case the traders’ activity would have thwarted a valuable corporate opportunity. If corporations cannot exploit their discoveries of hidden value (because of insider trading), they’ll be less likely to seek out hidden value in the first place, and social welfare will be reduced. TGS thus represents “bad” insider trading.
Dirks v. SEC, by contrast, illustrates “good” insider trading. In that case, an insider tipped a securities analyst that a company was grossly overvalued because of rampant fraud. The analyst recommended that his clients sell (or buy puts on) the stock of the fraud-ridden corporation. That trading helped expose the fraud, creating social value in the form of more accurate stock prices.

These are just two examples of how insider trading may reduce or enhance social welfare. In general, instances of insider trading may reduce social welfare by preventing firms from exploiting and thus creating valuable information (as in TGS), by creating incentives for deliberate mismanagement (because insiders can benefit from “bad news” and might therefore be encouraged to “create” it), and perhaps by limiting stock market liquidity or reducing market efficiency by increasing bid-ask spreads. On the other hand, instances of insider trading may enhance social welfare by making stock markets more efficient (so that prices better reflect firms’ expected profitability and capital is more appropriately channeled), by reducing firms’ compensation costs (as the right to engage in insider trading replaces managers’ cash compensation—on this point, see the excellent work by our former blog colleague, Todd Henderson), and by reducing the corporate mismanagement and subsequent wealth destruction that comes from stock mispricing (mainly overvaluation of equity—see work by Michael Jensen and yours truly).

Because insider trading is sometimes good and sometimes bad, rules restricting it may err in two directions: they may acquit/encourage bad instances, or they may condemn/prevent good instances. In either case, social welfare suffers. Accordingly, the optimal regulatory regime would seek to minimize the sum of losses from improper condemnations and improper acquittals (total error costs), while keeping administrative costs in check.

My contribution to Prof. Bainbridge’s insider trading book will employ decision theory to evaluate three actual or proposed approaches to regulating insider trading: (1) the “level playing field” paradigm, apparently favored by many prosecutors and securities regulators, which would condemn any stock trading on the basis of material, nonpublic information; (2) the legal status quo, which deems “fraudulent” any insider trading where the trader owes either a fiduciary duty to his trading partner or a duty of trust or confidence to the source of his nonpublic information; and (3) a laissez-faire, “contractarian” approach, which would permit corporations and sources of nonpublic information to posit their own rules about when insiders and informed outsiders may trade on the basis of material, nonpublic information. I’ll then propose a fourth disclosure-based alternative aimed at maximizing social welfare by enhancing the social benefits and reducing the social costs of insider trading, while keeping decision costs in check.

Stay tuned…I’ll be trying out a few of the paper’s ideas on TOTM. I look forward to hearing our informed readers’ thoughts.

In Antitrust & Competition, Corporate & Securities Law, Economic Theory, Error Costs, Law & Economics, Regulation, Securities 10b-5, decision theory, fiduciary duty, insider trading

An academic’s day in court

Larry Ribstein — 20 December 2011

About a month ago I discussed a case in which I had written an amicus brief:

Last year I wrote here about Roni LLC v Arfa, which I cited as an example of the ”troubling lawlessness of NY LLC law.” In brief, the court sustained a non-disclosure claim based on “plaintiffs’ allegations that the promoter defendants planned the business venture, organized the LLCs, and solicited plaintiffs to invest in them” despite holding that the parties’ arms-length pre-formation business relationship did not support a fiduciary relationship. I argued that this new pre-formation duty to disclose

promises to make a mess out of NY LLC law. It also creates significant problems for business people who now have a fiduciary duty, with uncertain disclosure duties, imposed on what the court itself recognized is basically an arms’ length market relationship. It’s not even clear how parties can contract out of this duty, since the whole problem is that they do not yet have a contract.

I later noted that my blog post was cited in the appellants’ brief on appeal, which triggered a response in the respondents’ brief (see n. 25) and then my amicus brief in connection with the appeal, which the NY Court of Appeals accepted for filing.

Now the NY Court of Appeals has decided the case. In its brief opinion the Court said “we conclude that plaintiffs’ allegations of a fiduciary relationship survive the dismissal motion.” The Court added (footnote 2):

2 Based on the foregoing analysis, we need not decide the question of whether the promoter defendants’ status as organizers of the limited liability companies, standing alone, was sufficient to allege a fiduciary relationship.

In other words, the Court of Appeals, without saying so directly, effectively rejected the lower court’s determination that the complaint had not alleged a fiduciary relationship. The Court did so in order to avoid a holding in favor of promoter liability that would, I argued, “make a mess out of NY LLC law.”

The Court elsewhere in its brief opinion alluded to another aspect of my amicus brief. My brief pointed out (p. 6) that there was no authority for a pre-formation disclosure duty in LLCs, and that analogies from other business entities

should be drawn carefully because * * * the LLC has evolved as a unique entity, sharing some features of but ultimately distinct from all other business entities. See generally, Larry E. Ribstein, Rise of the Uncorporation ch. 6 (2010).

In its opinion, the Court recognized (n. 1) that “[c]ertainly, there are differences between limited liability companies and traditional corporations, but the distinctions are not relevant to the allegations in this case.” They were not relevant because the Court strained to accept the alternative basis for a fiduciary duty the lower court had rejected.

In short, I invited the Court not to wreck NY LLC law by imposing open-ended pre-formation promoter liability. The Court accepted my invitation although this forced it to weave a circuitous course around the lower court’s opinion.

Now, I must avoid taking too much credit for the result in the case. The NY court might have reached the same conclusion without my brief. The case was very well argued by the defendant-appellant’s lawyer, David Katz, who raised all the relevant issues.

All I can say for sure is that my brief made it harder for the Court of Appeals to accept the lower court’s promoter liability theory, and the Court did, in fact, reject that theory. I think it’s plausible my brief affected some of the language in the opinion, and thereby the course of NY LLC law.

I make these points not solely out of pure ego (not that I’m totally devoid of same) but because they relate to the many words that have been spilled over the uselessness of legal academics. You see, we academics do have some credibility because we devote ourselves to the study of underlying theory and policy rather than to achieving particular results in cases. This is a quality that could be lost if legal academic is restructured so as to reduce the time and resources available for such work.

In Corporate & Securities Law, Legal Profession fiduciary duty, Law school, LLCs

Should there be default fiduciary duties in Delaware LLCs and LPs?

Larry Ribstein — 9 December 2011

A recently published on-line symposium calls needed attention to Delaware Chief Justice Myron Steele’s remarkable article, Freedom of Contract and Default Contractual Duties in the Delaware Limited Partnerships and Limited Liability Companies, 46 Am. Bus. L.J. 221 (2009) (no free link available).

The Chief Justice makes an argument that is guaranteed to shock traditional business association scholars: that there should be no default fiduciary duty in Delaware LLCs or limited partnerships. According to the CJ, this would effectuate “Delaware’s strong policy favoring freedom of contract.”

CJ Steele notes that there are no fiduciary duties currently in the LLC statute, providing no basis for implying duties from the standard form. This argument is less clear for limited partnerships, which link to the general partnership act’s duty of loyalty in §15-404. The Chief Justice argues that the freedom of contract provision in §17-1101 effectively negates this duty. Although default duties arguably are preserved by reference in this provision, freedom of contract may trumps a nebulous default.

The ambiguity about default duties calls for application of policy considerations. The Chief Justice relies significantly on my writing, particularly Are Partners Fiduciaries? (for a more recent version of my theory see Fencing Fiduciary Duties). I argue for narrowly construing default fiduciary duties because of the extra transaction and other costs associated with broad duties. In other articles [see, e.g., Larry E. Ribstein, Fiduciary Duty Contracts in Unincorporated Firms, 54 WASH. & LEE L. REV. 537 (1997) also cited by the Chief Justice] I have argued that the parties ought to be able to narrow default duties by contract.

The Chief Justice builds on these policies to take the extra step of leaving it to the parties to contractually define fiduciary duties from scratch. Here’s his reasoning in a nutshell (46 Am. Bus. L. J. 239-40) (footnotes omitted):

Professor Larry Ribstein has written extensively on the economic costs and benefits of fiduciary duties. Professor Ribstein explains that “the existence of default fiduciary duties depends solely on the structure of the parties’ relationship that is, on the terms of their express or implied contract — and not on any vulnerability arising other than from this structure.” Specifically, for LLCs, Ribstein sets forth three economic rationales to narrowly define fiduciary duties.

First, according to Ribstein, even where fiduciary duties have some benefits, those benefits are outweighed by costs such as “effect on the purported fiduciary’s incentives and the reduction of trust or reciprocity from substituting legal duties for extralegal constraints.” In particular, Ribstein notes, “courts often ignore the costs of fiduciary duties perhaps because these costs matter most in the cases that do not get to court, and therefore seem insignificant compared to the unfairness in the case being litigated.” Second, Ribstein argues that “there are benefits to clearly delineating the situations in which fiduciary duties apply, including minimizing litigation and contracting costs and effecting extralegal conduct norms.” Third, and finally, Ribstein concludes that “a narrow approach to fiduciary duties inheres in the contractual nature of such duties.” Ribstein warns that “[a]pplying fiduciary duties broadly threatens to undermine parties’ contracts by imposing obligations the parties do not want or expect.”

Professor Ribstein’s thoughtful analysis also applies to default fiduciary duties. In particular, the cost of applying any default fiduciary duty is outweighed by its benefit. First, default fiduciary duties add unnecessary costs to contracting. Second, default fiduciary duties also add unexpected litigation costs. Finally, any benefit to default fiduciary duties is limited because the LLC, by its nature, is designed to be a highly customized vehicle, determined primarily by contract. A critic to my cost-benefit analysis will invariably argue: (1) there is no cost to default fiduciary duties because the LLC statute provides that parties may eliminate any default duties and (2) parties benefit from fiduciary duties because they expect them and need not contract for them. However, I will demonstrate why those criticisms are misplaced.

First, default fiduciary duties add unnecessary contracting costs. The nebulous nature of default fiduciary duties makes it difficult for parties to eliminate some, but not all, potential fiduciary duties. * * * If we assume no default fiduciary duties, the parties need only explicitly provide for a self-dealing proscription. The contract is much easier to draft, and the parties have more confidence that they adequately provided for that ban without also introducing other unwanted fiduciary duties.

A question remains: how often will parties want to remove the default fiduciary duties? If, for the most part, parties simply intend to keep the default fiduciary duties, then it would be less costly for parties to contract. However, if we proceed from the baseline of no default fiduciary duty, adding in a wholesale provision adopting Delaware’s fiduciary duty principles could also be easily achieved — without much cost. As I described in the last paragraph, this will benefit the parties who intend to adopt a discrete number of those duties because it will be less costly to contract for those limited duties. Moreover, by adopting an LLC, the parties have consciously chosen to use a highly customizable vehicle–in so choosing, we naturally infer that the parties intend customization.

Second, default fiduciary duties introduce unexpected litigation expenses. Without default fiduciary duties, the parties’ litigation will focus solely on the agreement between them–and not on fiduciary duty principles outside of the contract. * * *

In light of those potential costs, the courts must also weigh them against any benefits to applying default fiduciary duties. Professor Ribstein explains that “[i]n general, this is a matter of articulating standard form terms to minimize contracting costs. It is difficult and expensive for parties to enter into customized contracts covering all of the details of a long-term agency-type relationship.” However, it is important to remember that in the context of an LLC that the parties have specifically chosen to use an LLC agreement, which provides contractual flexibility, and have bargained for the relevant provisions in this agreement. Thus, it does not necessarily follow that default fiduciary duty principles will more accurately reflect the parties’ intent rather than principles of contract interpretation. Instead, because the parties chose a Delaware LLC and because the Delaware judiciary is skilled in resolving difficult issues of contract interpretation, the opposite conclusion is likely true, that is, parties would prefer Delaware courts to determine their rights and duties in accordance with the terms of the contract and not an unbargained-for default fiduciary principle. Moreover, if the parties intended to apply traditional fiduciary duties to their relationship, they could easily add a provision stating precisely that in the agreement.

The Chief Justice has a point. I grappled with the problem of contracting around default duties in my Uncorporation and Corporate Indeterminacy (at 165, footnotes omitted):

Vice Chancellor Strine’s admonition to lawyers not to address fiduciary duties “coyly” could require such careful and costly drafting that it makes fiduciary duties in effect mandatory. Even a moderate insistence on careful drafting could put fiduciary duty waivers out of the reach of smaller firms. In other words, by making very skilled drafting the price of avoiding indeterminacy, Delaware’s uncorporate law may be trading lower litigation costs for higher fees to transactional lawyers. This may reserve the benefits of the uncorporate approach only for the largest and most sophisticated uncorporations.

In other words, the current Delaware approach achieves free contracting at significant cost. Chief Justice Steele’s approach may be the best way to deal with that problem.

The important question is whether there will be many parties who (1) fail to contract fully regarding fiduciary duties; and (2) expect a certain level of fiduciary duties to apply. If both apply, then eliminating default fiduciary duties could defeat expectations and increase litigation by frustrated LLC members. The Chief Justice’s response is that parties to Delaware LLCs know they’re getting a contractual regime and therefore are getting what they expect. In other words, the market for LLC law offers a potential opportunity to contract not only out of default duties, but also away from the existence of default rules.

The brief articles in the symposium by Ann Conaway, Bill Callison & Allan Vestal, Carter Bishop, Dan Kleinberger, and Louis Hering take both sides of the issue, but do not, in my opinion, fully grapple with CJ Steele’s (and my) policy arguments. Unfortunately I didn’t have an opportunity to participate in this symposium (not sure why, since after all the Chief Justice does rely on me!) so I haven’t had a chance to insert a full-fledged version of my thinking into the debate. I plan to write at more length on this, but wanted to take this opportunity to opine on the important issues raised by the Chief Justice while the iron was hot.

In Apple, Corporate & Securities Law, Platforms cost-benefit analysis, fiduciary duty, partnerships, unincorporated business entities

TOTM goes to court

Larry Ribstein — 15 November 2011

Last year I wrote here about Roni LLC v Arfa, which I cited as an example of the ”troubling lawlessness of NY LLC law.” In brief, the court sustained a non-disclosure claim based on “plaintiffs’ allegations that the promoter defendants planned the business venture, organized the LLCs, and solicited plaintiffs to invest in them” despite holding that the parties’ arms-length pre-formation business relationship did not support a fiduciary relationship. I argued that this new pre-formation duty to disclose

The case is being argued today at about 1:30 EST. Tune in (click the blue “oral arguments webcast” link on the right in the middle) for this latest chapter in the saga of the blog post that went to court.

Update: Peter Mahler provides a very helpful and complete summary of the oral argument.

In Corporate & Securities Law fiduciary duty, LLCs

A questionable criticism of “alternative” entities

Larry Ribstein — 20 October 2011

Steve Bainbridge invites my opinion of Delaware lawyer Edward McNally’s view that alternative entities “may not protect investors.” By “alternative entities” he is referring to limited liability companies and limited partnerships, despite his own recognition that they “have become the preferred form of entity for new businesses” (so why aren’t corporations “alternative entities”)? He uses as the text for his sermon VC Noble’s recent opinion in Brinckerhoff v. Enbridge Energy Co. involving the interpretation of a broad fiduciary duty waiver.

McNally says that “the lack of a uniform governance structure in these alternative entities may cause problems” when there are outside investors. He argues that broad fiduciary waivers may result in investors not being adequately paid for the risks they’re taking because “it seems doubtful that those risks can ever be adequately anticipated.” By contrast

corporate entities with much more standardized governance norms with greater investor protection have long flourished and raised capital. The corporate governance form benefits from its predictability and presumably raised capital effectively without the added risk of unpredictable governance provisions. Thus, the theoretical justification for letting alternative entities be governed loosely [that investors are paid for the risks they take] may not be valid.

Moreover, he says, the parties may not know for sure whether the waiver is effective. He cites the following example:

Years ago, we had a case where a master limited partnership’s 60-page operating agreement attempted in great detail to spell out how to handle conflict of interest transactions involving its general partner. After consulting a national legal expert on limited partnerships, the general partner bought limited partnership interests following what it thought was the correct process. It was promptly sued, lost and paid millions of dollars in damages. The court held it followed the wrong process, and in doing so had breached its duty to the partnership. Complexity has its own risks.

He concludes that this is why “few alternative entities have been used as a vehicle to issue publicly traded securities, such as limited partnerships or membership interests.”

McNally repeatedly refers to the entity involved in Brinckerhoff as an “LLP.” These are the initials for a “limited liability partnership,” which is a form of general partnership. However, the entity in the case is a limited partnership, or “LP.” He also confuses the “good faith” duty, a fiduciary duty which the agreement in Brinckerhoff added, with the “implied contractual covenant of good faith and fair dealing,” a non-waivable rule of contractual interpretation under Delaware law.

Apart from these technical glitches, I question McNally’s reasoning. As to his claim of unpredictability, as I have discussed at some length, Delaware alternative entities are actually a way to avoid the more serious indeterminacy problem in corporate law. McNally’s illustration of uncorporate unpredictability is unpersuasive. Maybe the general partner’s legal advisor was wrong, or the court erred. Both can also happen in corporate practice. Anyway, he says this happened “years ago.” Delaware uncorporate jurisprudence has developed rapidly in recent years, as the Brinckerhoff case itself illustrates.

Now let’s examine the case. A pipeline partnership found itself mid-project at the nadir of the finaical crisis. Its controller offered to invest. A special committee negotiated a deal and hired legal and financial advisors to evaluate it. They determined that it met the agreement’s “arms length” value standard for deals with affiliates. The court held this was not bad faith. The court noted (n. 39):

Although on some level the [agreement] may appear problematic for the simple reason that the controller of a limited partnership’s general partner is engaging in a transaction with the limited partnership, the LPA anticipates such transactions. Moreover, if the Court were to determine that [plaintiff] could state a claim that Enbridge [the defendant controlling party] acted in bad faith even though Enbridge negotiated the JVA with an independent special committee, then what would Enbridge have to do to be able to dispose of bad faith claims on a motion to dismiss? Would Enbridge be required, in analogy to In re John Q. Hammons Hotels Inc. S’holder Litig., 2009 WL 3165613 (Del. Ch. Oct. 2, 2009), to negotiate a transaction with an independent committee and have the transaction approved by a majority of the public unit holders? Requiring Enbridge to put in place those “robust procedural protections,” in order to be able to dispose of a bad faith claim on a motion to dismiss, would seem to rewrite the LPA when the Delaware General Assembly has explicitly stated that “[i]t is the policy of [Delaware’s Limited Partnership Act] … to give maximum effect to the principle of freedom of contract and to the enforceability of partnership agreements.” 6 Del. C. § 17–1101(c).

The court interestingly compares the determinacy of the partnership agreement with the indeterminacy the parties avoided by not being a corporation.

As I have discussed elsewhere (e.g., here and here) the parties to uncorporations may quite reasonably trade off exit and managerial incentives for control and fiduciary duties. The courts should enforce these contracts and the Delaware courts do. It follows that McNally’s broader point that uncorporate entities are generally unsuitable for outside investors is flat wrong.

McNally raises the separate question of why there are only a relative few publicly held alternative entities. One reason may be that the exit tradeoff I referred to may not work in publicly held firms. Most such firms need the corporate feature of “capital lock in” which precludes buyout and dissolution provisions.

Bottom line: Lawyers need to understand that “alternative” entities are an important transactional tool for clients. Protestations that uncorporate law is too new or unpredictable, which were common 20 years ago, simply don’t wash today.

In Corporate & Securities Law conflict of interest, fiduciary duty, partnerships, Steve Bainbridge, uncorporations, unincorporated business entities

The cash hoarding problem and some solutions

Larry Ribstein — 5 October 2011

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.

In Amazon, Corporate & Securities Law, Platforms, Taxes Agency Costs, executive compensation, fiduciary duty, uncorporations, unincorporated business entities

Debating the business judgment rule

Larry Ribstein — 5 October 2011

Alison Frankel gripes about a NJ judge’s ruling throwing out a shareholders’ derivative suit seeking to hold the J & J board accountable for problems concerning the company’s Rispardal drug. Frankel thinks the bad faith standard the court applied is not high enough.

Ted Frank responds that the fact that the company had settled criminal allegations doesn’t mean the board was irresponsible given big companies’ exposure to prosecutorial overreaching (here’s my thoughts on the problems with prosecutors). He notes that given huge potential penalties and legal costs “even a risk-neutral set of executives would refuse to go to trial on criminal charges that they had a 95% chance of winning.” As Ted says:

The issue is this: first, any corporate law is going to have to balance false negatives (valid suits against directors being thrown out prematurely) and false positives (invalid suits against directors costing tens of millions of dollars in time and money to resolve). Any opening up of the courtroom doors to challenge directors will reduce false negatives at the expense of more false positives; any increase in the burden to bring suit will reduce false positives at the expense of more false negatives.

Anyway, Ted continues, shareholders of NJ corporations can decide to invest in firms incorporated elsewhere if they think NJ law is too lenient on directors, aptly citing my and O’Hara’s The Law Market.

Of course Frankel might argue that the business judgment rule that the court used to decide the case is ubiquitous, leaving plaintiffs with little choice. Indeed, the only significant dissent is Nevada which is, if anything, even easier on directors than NJ. Frankel might also argue that this indicates state corporation law is rigged for managers and that we would do better under federal law. Perhaps what we need is a super Dodd-Frank/SOX on steroids that preempts state law and exposes managers to suits like the one NJ dismissed.

I would respond that the universal acceptance of the business judgment rule represents the market’s rejection of Frankel’s position. If Frankel wants to complain that the market for corporate law is imperfect, she would need to persuade me that shareholders are better off in the clutches of Congress.

In Amazon, Corporate & Securities Law, Federalism, Jurisdictional Competition, Platforms corporate governance, corporate law, fiduciary duty

The Law and Economics Revolution in Securities Law, Part V

J.W. Verret — 29 September 2011

Law Review Editors…take note. You may get an opportunity to catch this one in February if you play your cards right.

I’ve been blogging updates of my research for a new article developing what the economic analysis provisions of the National Securities Markets Improvement Act of 1996 requires of new SEC rulemaking. Blog colleague Prof. Wright has a great title suggestion: “The Law and Economics Revolution in Securities Law.” I like it. I would add: “Constructing the Four Pillars.”

This project is inspired by the DC Circuit’s opinion in Business Roundtable v. SEC, which revives the four principles in a tremendous way, and the project forms the heart of my research plan as a fellow at the Hoover Institution this semester studying economic analysis of law and my syllabus for a seminar in the law and economics of financial regulation I am teaching at Stanford Law School this semester. Prior posts are referenced here.

In prior posts I described the first portion of this article, which will use legislative and judicial history to elaborate on the SEC’s mandate to consider the impact of new rules on what I am calling the “four pillars” or “four principles” of securities regulation: investor protection, efficiency, competition, and capital formation. The second portion of the article will seek to link the various relevant literatures to prospective rulemaking.

The second portion of the article will start with a broad view of various strains of the economic literature and move to a more particular focus on individual articles. Along the way I’ll be calling balls and strikes for the relevance of entire strains of the securities regulation, economics, and financial economics literature generally, and individual articles in particular. I will do so using the hurdles presented by the legislative and judicial history of the NSMIA that, like Prometheus stealing flame from Olympus, brought us the four principles as a light by which to interpret the means and ends of securities regulation more clearly.

This article will be controversial (at least I hope).

The legislative and judicial history from the first half of this article will describe a lot of nuance, but the dominant theme taking shape is that the drafters of the NSMIA were inspired by the benefits of cost-benefit analysis (CBA) and economic analysis as a guiding principle in securities regulation. The legislation was largely authored by Congressman Jack Fields who was appointed to chair the subcommittee overseeing the securities laws. The law was promulgated pursuant to the Contract With America. On the Senate side the legislation was sponsored by Senator Phil Gramm. The legislative history, as described in a prior post, clearly envisioned in part some version of the regulatory analysis conducted by the SBA for small businesses and by the White House Office of Management and Budget (OMB) Office of Information and Regulatory Affairs (OIRA) more generally. In the three judicial cases interpreting the NSMIA (all of which ruled against the SEC) the court demonstrated a premier focus on the empirical economic literature as well as a focus on indirect costs. The four principles take cost-benefit analysis to a new level by considering impact on institutional incentives, capital market efficiency, and competition.

Logistical problems that should be considered:

1) What is the significance of what I would call the patchwork problem? So many SEC regulations reference other regulations, and presume the existence of a number of other levers in the system of SEC regulation, and in some rule proposals also assume the existence of regulatory regimes administered by other agencies. Must new regulations be measured against the alternative of not only the status quo, but of actually amending or eliminating prior regulations?

2) What about looking back? Is a sunset requirement in SEC regulations generally, or in some specific areas, advisable? Does it speak toward a heightened scrutiny from the DC Circuit for regulations that do not have a sunset requirement? Does it require the SEC conduct a CBA at some point (5 or 10 years) after the rule is adopted? What are the corresponding uncertainty or transition costs associated with firm compliance flowing from such a requirement?

3) What about the issue of potential implicit NSMIA repeal as Congress issues mandates that would otherwise fail a proper cost-benefit analysis? The SEC has taken the position that it is not required to perform CBA where Congress explicitly mandates that it promulgate a rule. But the SEC certainly has discretion at multiple decision points in adopting a rule. Consider all the discretionary decisions that must be made by the SEC staff as they write a multi-hundred page rule proposal implementing a rule required by a paragraph long amendment in the authorizing legislation. Shouldn’t the SEC be held to a requirement that it meet CBA requirements whenever it actually exercises discretion? Conversely, if the SEC’s position is that Congress implicitly pre-empted the NSMIA with an affirmative requirement to adopt a rule, shouldn’t the SEC be required during judicial review to demonstrate that position by showing that there is no way to implement the rule in a way that would survive review under the four pillars of the NSMIA?

4) Position consistency is a principle that must be part of this calculus. Should the SEC be allowed to take mutually inconsistent positions in different rules? Note that the SEC cited a couple of studies in the final draft of Reg FD (which inhibited selective provision of information to analysts and required industry-wide announcements if any information is publicly provided) arguing that issuers had plenty of incentive, in spite of Reg FD, to share information with the market to facilitate new offerings and to maintain long term customer and supplier relationships. That position directly contradicts the agency’s position in a number of other rules mandating affirmative disclosure of various items. How does this play into judicial review for agency consideration of the four principles?

Thoughts taking shape about the various economic literatures:

A) Public Choice/Public Finance Economics—–I am not aware of a single instance where Henry Manne or Jon Macey’s work in the public choice problems of securities regulation have ever been cited in the cost-benefit analysis section of an SEC rule. The Commission should be held to some consideration of the effect of new rules on this problem. New rules alter the relationships between market participants in ways that accrue rents to I-bankers, lawyers, and accountants, particularly those with prior SEC experience. I see no reason why this impact shouldn’t be relevant. Deadweight losses are quite costly when rules are adopted. With respect to analysis post-rule, one would need to ask to what extent rent seeking effects are dynamic, and to what extent they are static and thus capitalized into stock price as of the rule’s adoption.

B) Austrian Economics—–I think Austrian thought will be most useful in this project in offering some broad insights for regulatory architecture. For instance, the role of the entrepreneur in discovering information and the pervasive uncertainty of the future demonstrated by the Austrian literature seem to argue against the SEC’s obsessive focus on uniformity. This is true in accounting rules, in market structure, in the broker fiduciary duty debate, in mandatory private equity and hedge fund registration, and in the “dark pool” controversy. There seems to be a marked hesitation at the SEC for diverse paths that develop for forming capital or institutions that develop idiosyncratic methods for valuing assets, structuring their board, deploying capital, etc. This literature’s influence will be subtle, it won’t help to measure a compliance cost dollar figure for instance, but I think I can certainly incorporate the literature in a broad way to inform how the regulatory adoption process must be structured. Reading Rizzo and Kirzner on the economics of time and information, I am convinced of the necessity to require that SEC rules be considered not only at the point of adoption, but that they must also be subject to an economic analysis requirement post-implementation.

C) Behavioral Economics—–Given the disclosure-based system, and the fraud on the market presumption, and the use of event studies in determining damages, the legislative history and judicial interpretations of the ’33, ’34 and ’40 Acts seem to presume semi-strong market rationality. I think the four principles must be read in light of that presumption. Thus behavioral economics has little relevance for new SEC rule-making with respect to arguments about the rationality of investors. If we look to rationality arguments with respect to the biases of regulated actors, like directors or managers, in the vein of Don Langevoort’s work (see e.g. here), there are relevant issues to consider. Although, once that door is opened, you also have to consider the behavioral biases exhibited by regulators along the lines of Professor, and current SEC Commissioner, Troy Paredes’ work here.

D) Financial/Empirical Economics—–The DC Circuit has demonstrated a particular focus for this type of work to demonstrate either the cost or the benefit side of the equation. What types of studies count? In corporate governance many writers have used event studies, but for the purpose of considering new rules event studies require an unanticipated event which will rarely be true for new rule proposals unless significant elements of the rule are unanticipated. Most of the corporate governance empirical literature has also tried to compare different governance characteristics across firms to make a case for which governance methods should become mandatory, but that type of inquiry often suffers from quite severe endogeneity problems.

The real interesting question is what variables matter and which don’t, because I can see a potential for gamesmanship in selecting the variables impacted based on the what a writer wanted to accomplish. SEC rules have at times cited to studies looking at impact on abnormal stock price returns, the bid-ask spread, Tobin’s q, trading volume, trading volatility, and brokerage costs, among a variety of other variables. But how does one choose between these variables as superior indicators of the two “pillars” of efficiency and capital formation? And what about considering a new SEC rule’s impact on bond yields or on the price of derivatives linked to common equity? Surely the “capital formation” pillar should include the impact of a new rule on debt and derivatives instruments as well as equity? What about impacts of rules on the debt/equity tradeoff? The Miller/Modigliano Theorem of financing irrelevance envisions taxes and bankruptcy as primarily driving the debt/equity financing tradeoff, but shouldn’t we also consider the impact of mandatory disclosure on securities class action risk as well (in other words, the more onerous the risk of securities class action risk, the more attractive debt financing becomes)?

E) Direct Compliance Costs—–The SEC has often made use of direct industry compliance costs in its economic analysis of new rules. This is a particularly limited measure and is frequently underestimated. Not much in the way of applicable economic literature here, this estimate mostly relies on conflicted best guesses by SEC staff and likely conflicted estimates from industry comment letters. The ridiculousness of the SEC staff estimates when viewed post-adoption argues in favor of a mandatory look-back requirement for economic analysis. (When I say ridiculous, I am thinking of the SEC’s estimate in the rule implementing Sarbox Section 404 that implementation costs would average $90,000 per firm. An SEC study five years later admits it was more like $2 million per firm.)

In a subsequent post, I will consider how to make more use of the transaction cost or New Institutional Economics literature, particularly with respect to rulemaking under the SEC Division of Corporation Finance and Division of Investment Management jurisdictions, as well as how economic game-theory can prove more useful to inform rulemaking in SEC oversight of the exchanges and SROs through the SEC Division of Trading and Markets.

In Corporate & Securities Law, Taxes, Truth on the Market bankruptcy, behavioral economics, cost-benefit analysis, fiduciary duty, rent seeking

The tangled duty to tell the whole truth

Larry Ribstein — 18 September 2011

A recent NY App. Div case, Pappas v. Tzolis, presents a tangled web that illustrates the current state of the LLC contracting architecture in the U.S. I previously discussed the lower court opinion in this case, concluding that ” any appeal of this judgment should be interesting.” (See also Peter Mahler.) I was right about that.

The complaint alleges that Tzolis and plaintiffs formed an LLC (Vrahos) for the sole purpose of entering into a long-term lease. Tzolis got a sublease on the property in exchange for advancing the LLC’s $1.2 million security deposit and additional payments. Tzolis later took over the lease so he could extinguish the sublease. The plaintiff members assigned him their interests, receiving a payment that was 20 times what they invested about a year earlier. Six months thereafter Tzolis assigned the lease to a third party for $17.5 million. The complaint alleges he was negotiating this sale at the time of buying out the plaintiffs. Plaintiffs sue on various theories essentially based Tzolis’s breach of fiduciary duty in failing to disclose these negotiations.

At this point the case gets complicated.

To begin with, the LLC operating agreement, in a section titled “Other Activities of Members,” provided that “[a]ny Member may engage in business ventures and investments of any nature whatsoever, whether or not in competition with the LLC, without obligation of any kind to the LLC or to the other Members.” The title of this section was “other activities.”

Given the title and the reference to “competition with the LLC, this section seems to refer only to dealings outside the LLC rather than a buyout of co-members’ interest without disclosing negotiations to sell the LLC’s only property. The title’s reference to “other activities” clarifies this intent. Except that the agreement elsewhere says that “headings. . . shall be given no effect in the interpretation of this Agreement.” If the heading has no effect, should the section be limited to outside dealings as it implies, or extended to “investments of any nature whatsoever,” including an “investment” in another member’s interest, as it says?

Confused yet? Ok, let’s add another layer. At the time of the assignment the parties signed a handwritten “certificate,” which included the following language:

[E]ach of the undersigned Sellers, in connection with their respective assignments to Steve Tzolis of their membership interests in Vrahos LLC, has performed their own due diligence in connection with such assignments. Each of the undersigned Sellers has engaged its own legal counsel, and is not relying on any representation by Steve Tzolis or any of his agents or representatives, except as set forth in the assignments & other documents delivered to the undersigned Sellers today. Further, each of the undersigned Sellers agrees that Steve Tzolis has no fiduciary duty to the undersigned Sellers in connection with such assignments.

Still not confused? The LLC was formed in Delaware, which normally means Delaware law applies. But the operating agreement provided that it was governed by NY law.

How should a court untangle this mess? Let’s start with what law applies. As I discussed regarding the lower court opinion in this case, referring to the choice-of-law analysis in The Law Market, incorporating in Delaware indicates the parties’ intent to apply Delaware law notwithstanding a contrary choice of law clause. This intent is supported by Kobayashi and my paper presenting data indicating that LLCs choose Delaware in order to get the advantages of Delaware’s legal infrastructure. On the other hand, the parties arguably were focusing on choice of law more in the choice of law clause (NY) than in the state of organization (Delaware).

Both courts in this case concluded that a choice between the two states was unnecessary because both states reached the same result. The problem is that that same result was different in the two opinions — dismissal of the complaint below, reversed above.

The lower court relied on Delaware’s freedom-of-contract provision, and said that “under New York law, parties are free to contract as they wish, so long as the terms of their contract are neither unlawful, nor in violation of public policy.” But as I noted in my post on the lower court opinion, NY has no equivalent to Delaware’s freedom of contract provision.

If the only relevant contract provision here were the operating agreement, the defendant should lose. As discussed in my earlier post, even Delaware requires fiduciary opt-outs to be clear, which this was not. The Appellate Division appropriately cited Kelly v. Blum on that point (which I discussed here).

But does the handwritten certificate have the requisite clarity? There the plaintiffs explicitly disclaimed they were owed any fiduciary duty in connection with the specific transaction at issue. The lower court didn’t make much of this, saying that the defendant didn’t claim it was a waiver, but that it just evidenced and certified the non-existence of any fiduciary duties defendant might have owed. This strategy may have been intended to head off the argument that any release of duties in the certificate was invalid because of defendant’s preexisting fiduciary duty.

The Appellate Division didn’t buy this strategy. Having held that Tzolis owed a duty under the agreement, the court held that the certificate couldn’t override it.

The court relied on Blue Chip Emerald v Allied Partners 299 A.D.2d 278, 750 N.Y.S.2d 291 (1st Dep’t 2002). This is part of a line of cases discussed in Ribstein & Keatinge, §9:5, n.51 involving non-enforcement of seemingly clear fraud waivers. For other cases along the same lines see Kronenberg v. Katz, 872 A.2d 568 (Del. Ch. 2004); Salm v. Feldstein, 20 A.D.3d 469, 799 N.Y.S.2d 104, 106 (2d Dep’t 2005). Also, a non-LLC case, Abry Partners V, L.P. v. F & W Acquisition LLC, 891 A.2d 1032 (Del. Ch. 2006) (criticized here) refused to insulate a seller from liability for intentional misrepresentations despite a clear and comprehensive contract that covered precisely these claims because “the public policy of this State will not permit” a contract that would insulate a seller who deliberately lied or knew that the company had made false representations.

But there are cases upholding fraud waivers. See DIRECTV Group, Inc. v. Darlene Investments, LLC, 2006 WL 2773024 (S.D. N.Y. 2006), applying Delaware law, and two recent NY Court of Appeals cases: Centro Empresarial Cempresa S.A. v. America Movil and Arfa v. Zamir. Centro emphasized that the release was broad, the fiduciary relationship was “no longer one of unquestioning trust,” and the plaintiff understood that the fiduciary was acting in its own interest. Arfa relied on the facts that plaintiffs were sophisticated and there was distrust between the parties. In these circumstances the courts held that plaintiff could not simply rely on defendant, but had a duty to investigate further. See Peter Mahler’s excellent discussion of these NY cases.

A vigorous dissent in Pappas by Justice Freedman, joined by Justice Friedman, relied on Centros. The dissent acknowledged that while the operating agreement did not eliminate Tzolis’s fiduciary duties, the certificate notified plaintiffs that they shouldn’t place “unquestioning trust” in Tzolis, and therefore “was tantamount to a release” of fiduciary duty claims. Moreover,

Tzolis’s substantial offer to plaintiffs should have alerted them to the fact that some deal was in the offing. Pappas and Ifantapoulos did not ask Tzolis why he was offering them 20 times more than what they had invested in Vrahos one year earlier; their lack of due diligence is unreasonable as a matter of law and fatal to plaintiffs’ claim.

Obviously this tangled mess in a substantial deal where the parties clearly could afford sophisticated advice suggests that something is amiss somewhere in the system.

Does the problem lie in the statute? The parties easily could have taken advantage of Delaware’s broad freedom of contract provision and entered into a clear fiduciary opt-out, which would seem appropriate in the sort of limited joint venture involved in this case. Instead they deliberately complicated their choice of law to use NY law which lacks such a provision.

But Abry indicates that Delaware law is no panacea. Is NY clearer, given Centros? The problem is that it is one thing to say that the parties’ relationship has broken down into clear distrust, as in Centros, and another to derive that distrust from the certificate alone, which is itself subject to the incomplete waiver of fiduciary duties in the initial agreements.

Abry suggests that once the parties agree to fiduciary duties because they failed to opt out, these duties may preclude them from ever opting out. At that point the best they can hope for is a judicial determination that the fiduciary duty did not result in liability for particular conduct. That could be based on actual distrust (Centros) or other circumstantial evidence (the high buyout price in a rapidly rising market).

Which raises a final question: was there even a breach of fiduciary duty in this case? What difference should it make whether defendant had an offer in hand? The plaintiffs had reason to know the lease value was rising rapidly.

The basic problem is that this case has been decided on a motion to dismiss, and therefore on the complaint’s allegations. Issues about what plaintiffs knew, when did they know it, and what did defendant have to tell them are for trial.

The answer here is to let the parties, via a clear agreement, opt out of liability for intentional nondisclosures. A clear opt out should prevent the need for a trial. Why can’t at least sophisticated parties agree to fend for themselves in determining what price they should get for their property? Under such a rule it would be up to the lawyers to help the parties clarify their intentions, as the lawyers arguably did here. But given the incomplete statutory protection in NY and the unclear cases in both NY and Delaware there was an inadequate legal framework for such an agreement.

Update: Read Peter Mahler’s through analysis of the case.

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