Archives For IPOs

IPOs going elswhere

Larry Ribstein —  31 March 2011

A couple of months ago I asked “what happened to IPOs.”   I noted then that the decline in US IPOs had something to do with US regulation, including SOX and Dodd-Frank. 

A new paper by Doidge, Karolyi &  Stulz, The U.S. Left Behind: The Rise of IPO Activity Around the World suggests it has something to do with the rest of the world catching up.  Here’s the abstract:  

During the past two decades, there has been a dramatic change in IPO activity around the world. Though vibrant IPO activity, attributed to better institutions and governance, used to be a strength of the U.S., it no longer is. IPO activity in the U.S. has fallen compared to the rest of the world and U.S. firms go public less than expected based on the economic importance of the U.S. In the early 1990s, the declining U.S. IPO share was due to the extraordinary growth of IPOs in foreign countries; in the 2000s, however, it is due to higher IPO activity abroad combined with lower IPO activity in the U.S. Global IPOs, which are IPOs in which some of the proceeds are raised outside the firm’s home country, play a critical role in the increase in IPO activity outside the U.S. The quality of a country’s institutions is positively related to its domestic IPO activity and negatively related to its global IPO activity. However, home country institutions are more important in explaining IPO activity in the 1990s than in the 2000s. The evidence is consistent with the view that access to global markets helps firms overcome the obstacles of poor institutions. Finally, we show that the dynamics of global IPO activity and country-level IPO activity are strongly affected by global factors.

Put the two stories together: the rise of the rest of the world leaves the US less room for regulatory excess.

A couple of months ago I asked, “what happened to IPOs.”  Today’s WSJ asks almost the exact same question and gets the same answer:

The elephant in the room is the 2002 Sarbanes-Oxley law, which triggered billions of dollars in new compliance costs for public companies.

* * * The question for companies now, as ever, is whether the benefits of going public are worth the costs. It’s indisputable that America has raised those costs in recent years. In addition to Sarbox’s Section 404, Congress has made it easier for big labor to get proxy access, increased the opportunities for lawsuits, too often turned reporting mistakes into major fines or potential felonies, and meddled into corporate pay decisions. None of these make going public more attractive.

With America still suffering close to 9% unemployment, it’s time for both parties to bring the cost/benefit calculus for IPOs back into balance.

The so-called “Dodd-Frank Wall Street Reform and Consumer Protection Act” was supposed to fix the problems that led to the financial bust.  Of course, that would require some understanding of what, exactly, those problems were, which Congress lacked.  The Act did little to fix the credit raters or the derivatives market that surely had something to do with the crash.  But it did include countless ill-considered provisions and rules lying in wait behind studies.  I’ve already commented (here and here) on the Act’s unwarranted federal intrusion into aspects of corporate governance that had little to do with the meltdown. And I’ve noted the Act’s contribution to hobbling initial public offerings.

Yale’s Jon Macey comments in today’s WSJ on the potential fallout from one of D-F’s most buried little gems:  Section 929R(a)’s authorization to the SEC to reduce the period for reporting 5% share acquisitions from ten days to “such shorter time as the Commission may establish by rule.”  Marty Lipton’s takeover defense firm, Wachtell, Lipton, Rosen & Katz, has seized on this provision to propose that the SEC reduce that period to one day. 

Alerting the market to a potential impending bid raises share prices and therefore the takeover’s overall cost. This would add to the effects of a long-term trend at both the state and federal level of allocating increasing shares of the potential gains from takeover-induced governance reforms to the incumbent shareholders and away from the bidder. This is fine for the shareholders, given the existence of a bid.  But if you increase the price of bids you’re likely to decrease the supply.  Fewer bids = more power to incumbent managers. 

As Macey notes:

Shareholders benefit from the reforms of corporate governance initiated by these activist investors. So does the economy generally, because the overall economy performs better when companies perform better. But managers are not so fond of this process because activist investors push incumbent senior managers hard to improve their performance. Occasionally they even fire them.

Since incumbent managers sometimes lose to activist investors in fair corporate elections, their preferred strategy for dealing with them is to hire legal talent and team up with friendly regulators to make new rules and to concoct anti-takeover devices like poison pills.

Macey observes that the success of these efforts explains “why the market for corporate control is relatively moribund, particularly when compared to the robust markets of the past.”

One would think that true financial reform would seek to have the opposite effect — to increase the pressure on incumbent managers, whose comfortable entrenchment helped them ignore huge risks that ended up destroying some big companies.

The roots of the W-L initiative lie in two other developments. First, as Macey notes, “changes in technology and other advances have made it possible for investors to buy shares and to file reports with the SEC in less time than before.”  Thus, incumbent managers fear losing some of the edge they’ve accumulated over bidders.  But this just returns to the question of how great that edge should be.

Second, and more important for present purposes, Steve Davidoff notes the role here of yet another formerly obscure Dodd-Frank provision, §766(e), which empowers the SEC to count cash-settled derivatives in their holdings for 13D purposes.  Davidoff suggests the real problem here isn’t reporting, but the fact that bank parties to these transactions hedge their positions by buying target shares. They can then vote those shares although they lacks a real economic interest in the company — i.e., the “empty voting” problem.  Davidoff suggests the solution is simply preventing the hedged parties from voting these shares.  Of course this would open for analysis the large can of “empty voting” worms.  As Kobayashi and I have written, this problem is much less obvious and more complex than meets the eye.  

Davidoff has discussed the interest group battle over the W-L proposal:

Corporate America is divided over the Wachtell petition. According to people close to the firm, an earlier draft of the petition was circulated among seven law firms, a working group of well-known corporate law firms commenting on Dodd-Frank initiatives. But the other law firms begged off signing the petition. * * * Wachtell portrays itself as a firm that favors management. It actively represents companies against hostile takeovers and activist shareholders but appears to have only one large hedge fund activist client* * *

Wachtell appears to have the ear of the S.E.C. Michele M. Anderson, the agency’s chief of mergers and acquisitions, said last month that the S.E.C. staff was planning to recommend that the reporting period be shortened.

The more basic issue here is the battle for control of corporate governance law between the states, who compete for business, and the federal legislators and regulators, who collect rents from powerful interest groups.  On the other side of the takeover argument from Wachtell are those who are pushing increased application of federal law to restrict state law regulation of takeovers.  I’ve argued that these moves are also ill-advised.

And then there is what Davidoff refers to as the “larger war against hedge funds.”  He sees the SEC as

desperately struggling for relevance. Hedge funds are rich but often unpopular. Wachtell, through its focus on protecting shareholders rather than corporate boards, is using the agency’s struggles to push through its agenda.

This might have something to do with a certain insider trading trial going on in NYC.

To make a long story short, rather than solve the problems that led to the financial crisis, Dodd-Frank included myriad buried treasures that are now serving as platforms on which interest groups and federal agencies can battle for control of large corporations.  In the case of 929R and 766(e), “financial reform” may well lead to more federalization of corporate governance law and more power for incumbent managers — exactly what the financial crisis demonstrated we do not need.

The WSJ opines on the impending sale of the NYSE to Deutsche Börse of Frankfurt.  It describes the merger as “a story of inevitable capitalist change and how no country or institution can take its dominance for granted” and a “lesson in how easily capital, both financial and human, can relocate.” It describes the 171 IPOs in the US last year as “dwarfed” by the 1,295 IPOs overseas.

Why did this happen?  As I noted last month:  overregulation of public companies.  As the WSJ says:

The Securities and Exchange Commission’s own exhaustive 2009 survey of U.S. and foreign firms showed that the burden of complying with Sarbox remains a major deterrent to going public in the United States. Yet the agency still hasn’t made a serious effort to pare these burdens. * * *

The Dodd-Frank law requires mountains of new rules that will further burden U.S. financial players, not least in the new derivatives regime emerging from the Commodity Futures Trading Commission. We would not be surprised if the NYSE Euronext managers view the Deutsche Börse merger as a potential refuge for its derivatives business if CFTC Chairman Gary Gensler realizes all of his regulatory ambitions.

See also Butler & Ribstein for a detailed examination of the effect of the burdens under SOX, and my article on the effect of regulation on the cross-listing market.

The WSJ concludes:

If we want the U.S. to be home to the next great financial institution, or even to keep the ones we have, our politicians need to make America a more inviting place to trade and do business.

Attorney Joseph McLaughlin (whose firm represents Goldman) writes in today’s WSJ about the approaching confrontation between the SEC and the First Amendment over the issue of general solicitation: 

Goldman Sachs stated that it wouldn’t offer Facebook shares to U.S. customers because “the level of media attention might not be consistent with the proper completion of a U.S. private placement under U.S. law” * * *

The source of the problem is that the SEC has a built-in bias against private placements. The SEC is in business to impose disclosure requirements on public companies. So when a company avoids the public markets by finding private investors who are satisfied with less disclosure, the SEC takes this as an implied attack on its mission.

 One way the SEC defends its turf is by keeping its rules on private placements vague. The best example of this is its stubborn prohibition of any “general solicitation”—meaning publicity—in connection with a private placement. With the revolution in communications technology, this prohibition is a significant impediment to capital formation. * * *

[T]he SEC never explained how unsophisticated investors could be harmed by the advertising of offerings in which they could not participate.

As McLaughlin notes, “[w]hat really annoys the SEC is that fewer IPOs now take place in U.S. capital markets.”  Of course the reason for that, as I’ve discussed, is escalating securities law requirements that have significantly increased the costs of being publicly traded.

McLaughlin concludes:

Thankfully, the SEC’s ability to stifle truthful communications might soon be tested under the First Amendment. A case pending in Massachusetts challenges whether the state can impose penalties on companies that make general solicitations in connection with private placements. However the state court decides, it will not be long before the issue gets to the U.S. Supreme Court. When that happens, it is hard to imagine the state—or the SEC—being on the winning side.

I wrote last month about that case brought by Bulldog Investors:

The basic problem here is that Bulldog lost its exemption when it generally advertised its fund through its website and followup email.  As a result, it is broadly barred from distributing information about its funds, however truthful, including to people who are accredited investors* * *

[Professor Laurence] Tribe’s participation suggests the constitutionality of the securities laws may finally get the attention the issue has long deserved.  * * * Citizens United suggests this attention may not be favorable to those laws * * * The Massachusetts case threatens the entire scheme for new issues under the Securities Act of 1933 * * *

I have recently blogged here and here about the First Amendment challenge to the SEC’s proxy access rules.  And here’s my recently posted paper, The First Amendment and Corporate Governance, on the implications of Citizens United for such cases.

Securities regulation is about regulating speech.  When the speech is fraudulent, the regulation probably survives.  But when Congress and the SEC start throwing burdensome nets on truthful speech with little effort to justify the regulatory cost, they should be ready for a constitutional battle, particularly after Citizens United. 

A couple of weeks ago I noted regarding the “Sachsbook” deal:

So it seems the increased costs of being public have helped exclude ordinary people from the ability to own the stars of the future.  Back in the 1980s, you could just call your broker and get rich off of the Microsoft IPO.  Now you have to be a wealthy Goldman client to do it. 

I guess I was a bit optimistic.  Now you have to be a foreign investor to invest in Facebook

I love it:  the US securities laws excluding US investors from investing in a US company in the US. What will they think of next?

The real Facebook story

Larry Ribstein —  16 January 2011

I originally wrote about “The Social Network” before having seen it, led by a Gordon Crovitz WSJ story quoting a Larry Lessig TNR review into thinking that Zuckerberg was the villain, and concluding that this was just another movie, like so many others I’ve discussed, in which

Hollywood’s view of business is shaped by the resentment of the artists who make films of the capitalists who make money from their art.  So, Zuckerberg is the capitalist who succeeded by sheer luck or theft or just crawling over the backs of the people who had the ideas. 

I have now seen The Social Network and see I was wrong.  Zuckerberg is not the bad guy, it’s the twins.  Who could like these snooty caricatures of old Harvard privilege? We get all the commentary we need from Larry Summers, who derisively throws them out of his office when they come to complain about getting ripped off, and from Zuckerberg, who likens them to the chair designer who wants credit for the concept of the chair, and says they’re suing because for the first time things didn’t work out for them the way they were supposed to.  The film backs up Zuckerberg’s assessment by adding a whole scene in which they act like spoiled brats for losing a boat race. 

Zuckerberg may have in some sense stolen the twins’ idea, but the film makes clear that it’s better that he did.  And this fits with my artist-centered analysis of business films:  While artists need protection for their ideas, they also need these ideas to be protected from others’ less worthy proprietary claims.

To be sure, the film is complex. Zuckerberg is in some sense Sarnoff in screenwriter Aaron Sorkin’s earlier play, The Farnsworth Invention, using the law and brute force to steal Philo Farnsworth’s idea for the television.  I noted in discussing the play, as in my initial post on the movie, that this was the usual film-artist-complaining-about-moneybags-ripping-off-their-ideas plot.  And Sorkin evidently has a reputation about being particularly prickly and proprietary about his ideas.

Add filmmakers’ sympathy with the socially responsible businessman I discuss in my article linked above: Zuckerberg doesn’t want ads messing up the purity of his product, just as Farnsworth was portrayed in The Farnsworth Invention as wanting to preserve television for the public while Sarnoff commercializes it.  Interestingly, in The Social Network, Sorkin plays an ad man whom Zuckerberg obviously disdains. (But it’s clear even in the film that Zuckerberg isn’t interested in society, but in how to build a billion-dollar business.)   

But what really matters is that both Sarnoff and Zuckerberg were sympathetic characters. In the film, the twins aren’t sympathetic at all, and Zuckerberg is left as the only possible protagonist.  The near-autistic Zuckerberg character does come across as an unlikely hero in a Hollywood movie.  But then there’s a precedent for this sort of movie hero.

This may not be what Sorkin intended.  He’s obviously more interested in getting a good story with snappy dialog.  The film concocts a fake story about Zuckerberg inventing Facebook to get a girl, or get in a club.  It ends with his continued fruitless pursuit of the girl, refreshing his screen to see if she’s noticed.  The lawyer at the mediation gives what’s supposed to be the final pronouncement on his character — that he’s not actually an asshole.  (Who cares?  And why should we care what a lawyer thinks?) The film doesn’t seem to get that he could really have been pursuing the obvious goal of creating a successful business.  Worst of all, the film has the usual movie take on heartless capitalists, including the way they helped ripped off Zuckerberg’s original business partner.

And I wish, as in my Farnsworth post, that the real story about business had come out. How critical it was to get funding, the key role of angel and venture capital, and even the boring role in the Facebook story of LLCs. Also, the roadblocks that the law throws up, including the twins’ continuing opportunistic litigation and Facebook’s having to find ways around regulatory costs of going public

But you can’t really expect that in a film, which needs to tell a story the audience likes and make some money.  The heartening thing about the film is that the real story of the importance of creativity to business and the social wealth business creates does come through.  The film, including its title, is basically about the product Zuckerberg created, and its success.  It also turns out to be about entrepreneurs as rebels fighting the established order.  Just as wealth and privilege couldn’t protect the twins, so established firms aren’t safe from a scruffy and socially awkward Jewish kid in a sweatshirt.  As long as this idea holds sway in our society we can’t be in such bad shape despite the best efforts of politicians and filmmakers.

I’d like to think that it was this story about the romance of the entrepreneur that made the movie so popular and that maybe Hollywood will get the hint.

Last week I noted that Facebook’s big private sale to Goldman was a symptom of how higher disclosure costs have helped make private firms reluctant to take the once-expected step of going public:  “[I]t seems the increased costs of being public have helped exclude ordinary people from the ability to own the stars of the future.”  Gordon Crovitz picked this up yesterday in his WSJ column.

Today comes some evidence that higher disclosure costs, and specifically SOX, in fact have something to do with this phenomenon — Bova, Minutti-Meza, Richardson and Vyas, The Sarbanes-Oxley Act and Exit Strategies of Private Firms.  Here’s an excerpt from the abstract:

[W]e establish three principal findings. First, SOX appears to have shifted the incentive for firms to exit the private market via IPO to exit via acquisition by a public acquirer. Second, * * * [f]or our median-sized private target, the estimated dollar value decrease in deal proceeds when one moves from a high level to a low level of pre-acquisition SOX compliance is $1.3 million. Finally, public target deal multiples are not affected by a public target’s level of pre-acquisition SOX compliance. These findings suggest that SOX-related costs have both restricted the action space of possible exit strategies for private firms and led to lower deal multiples for those private acquisition targets that are less likely to be SOX compliant prior to acquisition.

The study’s basic intuition is that SOX makes it cost less for a public firm to acquire a private target than for a private target to do an IPO because the public firm can apply its existing SOX infrastructure to the newly acquired firm. This is consistent with the basic idea that SOX’s big problem for private firms is that its infrastructure costs are not perfectly scalable.  The effects of variations in target firm SOX compliance support the inference that this is, indeed, a SOX effect and not attributable to some other cause.

This means that in order for an IPO to be preferable to being acquired, a firm has to meet a higher value threshold than it would without SOX.  Thus, the authors conclude, “as a result fewer private firms should choose the IPO option as an exit strategy, post-SOX.”

Moreover, because increased SOX compliance costs are impounded into the price of the acquired firm, SOX compliance affects the price of private, but not public firms. (To be sure, SOX compliance also affects the value of the firms because they are more transparent and hence less risky.)  This could make it harder for private firms to be acquired by public firms post-SOX, although the authors don’t directly measure that effect.

Thus, the authors conclude, “[t]he combined results suggest that the costs to SOX are not restricted solely to public firms, and that an indirect cost of SOX may be its impact on restricting the exit opportunities for owners of private firms.”

To return to the conclusion of my prior blog post, “rules designed to make the markets safe for ordinary investors have ended by excluding them.”

What happened to IPOs?

Larry Ribstein —  4 January 2011

So Facebook finally had its public offering.  But it didn’t look like your father’s IPO.  Instead, Facebook sold $500 million in stock to one person. The stock will be held by a single special purpose vehicle so Facebook avoids going over the 500-investor-limit for avoiding the disclosure obligations of a public company.  Wealthy investors get to trade interests in that interest.  Facebook gets that cash (plus an expectation of another $1.5 billion in stock sales) for growth, a $50 billion market valuation (of which 14 billion belongs to Zuckerberg), stock it can use for acquisitions and hiring — many of the goodies post-IPO companies get. 

According to Steve Davidoff, this won’t work if Facebook is deliberately circumventing the securities laws, and “Goldman’s planned special purpose vehicle and any other vehicles formed certainly appear to be cutting it close.” Facebook therefore may have to start reporting anyway, but not until May 2012, by which time it may be ready to go public, which it may want to do anyway.  The tactic at least enables Facebook to delay an IPO for as long as possible.

Per the VC partner Ben Horowitz, quoted in the WSJ,

the incentive for going public has lowered and the penalty for going public has increased. . . [T]he regulatory environment and the rise of hedge funds has made it “dangerous” for start-ups go to public without a large cushion of cash. In general, we recommend that our companies be very careful about going public.

Meanwhile, Dealbook reports the establishment of another trading system for private firms.

Another Dealbook story adds that “[l]ots of people would stand in line to buy shares in Facebook, but for now, only an exclusive few — wealthy clients of Goldman Sachs — will be able to.”

 “This is a topsy-turvy world,” said Scott Dettmer, a founding partner of Gunderson Dettmer, a law firm that has advised venture capitalists, start-ups and entrepreneurs since the 1980s. He added that even a few years ago, “there were all sorts of business reasons to go public, but for entrepreneurs it was also a badge of honor.”

But now, private market alternatives

have become more attractive for companies, in part because of the increased regulations imposed on public companies but also because of the rise in short-term trading, which leaves some executives feeling they have lost control of their companies. * * *

Ben Horowitz, a partner with Andreessen Horowitz, a venture capital firm, said the cost of being a public company had risen to about $5 million a year, from about $1 million a year. Mr. Horowitz, an early employee of Netscape, said that such costs would have eaten into the meager profits of the pioneering Internet company when it went public in 1995. Additionally, accounting and legal requirements have become distractions for many start-ups, said Mr. Horowitz, whose firm is an investor in Facebook.

So it seems the increased costs of being public have helped exclude ordinary people from the ability to own the stars of the future.  Back in the 1980s, you could just call your broker and get rich off of the Microsoft IPO.  Now you have to be a wealthy Goldman client to do it.  Of course you also got to get poor off of a company that turned out to be a dog.  Now both options are reserved for wealthy people in the name of increasingly onerous disclosure regulation and federal governance requirements such as board structure, proxy access, and whistleblowing rules.

Each of these rules was thought to have some benefit at the time they were enacted.  Nobody really considered how private markets would react (e.g., by establishing alternatives to public markets) or the long-run effects of substituting quasi-private for public markets.  So rules designed to make the markets safe for ordinary investors have ended by excluding them.

Maybe it’s time to start considering whether we got what we wanted.

I had the opportunity to present Treasury Inc.: How the Bailout Reshapes Corporate Theory and Practice at the American Association of Law Schools conference session on Business Associations in January.  It was an engaging experience that I found particularly fun as I am from Louisiana and used to live in New Orleans.  The audience was a veritable who’s who of the corporate law academy, including Bob Clark (former Dean of Harvard Law), Christine Hurt (of Conglomerate fame), Joan Heminway (whose recent Securities Regulation textbook is a must read), Brett McDonnell (whose recent Delaware scholarship offers fascinating insights), and a number of other notable writers in this area.  The opening panel was moderated by Lisa Fairfax (also of Conglomerate fame) and featured Renee Jones (see her blog), Hillary Sale, and Jeff Gordon (great paper on say-on-pay here) among others.  Lots of old friends who have helped me along my career.  Joining me in presenting papers were Bruce Aronson as well as Miriam Cherry and Jared Wong.  It was a professional and well attended panel, and I encourage all business law scholars to attend next year.

A number of the discussants at the panel focused their attention on Delaware.  This is certainly appropriate, as Delaware is the corporate home of nearly 70% of the Fortune 500 and half of the 14,000 publicly traded companies in the United States.  Most of the academy has a contentious relationship with the Delaware courts and an inordinate number of academics dedicate their time to attacking the Delaware model of corporate law.  (For the Don Quixote of anti-Delaware scholarship, see Jay Brown at U. Denver)  The AALS panel discussion on Business Associations this year mirrored that tendency in the corporate law scholarship.

As the only member of the academy, to my knowledge, who has clerked in the Delaware Court of Chancery (or any Delaware court for that matter) I often find myself on the less populated side of the debate.  (Side note: Constitutional law scholarship seems to be overrun with former Supreme Court clerks, one would imagine more Delaware expertise would be required in corporation law?).  Some may assert this as evidence of bias in my remarks, in much the same way that scholars who respond to a pro-regulatory herd mentality may also exhibit bias.  I’ll let readers judge that question.  I will, however, offer that my viewpoint is far more informed than most of Delaware’s critics.  I’ll also note as counterpoint that I remain a proud student and acolyte of Professor Bebchuk, a noted critic of Delaware.  I’m proud to say that Lucian has forgotten more about corporate governance than most of the anti-Delaware critics who have followed in his footsteps.  Though we disagree on a great many issues, I judge other critiques of Delaware against Lucian’s robust methodology, which is in part why I find much of the surplus anti-Delaware scholarship ultimately unconvincing.

The theme of the AALS panel on Business Associations was “The Financial Collapse and Recovery Effort: What Does it Mean for Corporate Governance?”   A summary of Lisa Fairfax’s excellent discussion on clawbacks for executive compensation can be found here.  Erik Gerding has also compiled a great summary of the full discussion here and here.  The portion of the discussion relating to Delaware was focused around the question of: “Can we rely on Delaware to solve the crisis?”  and “Can Delaware serve as a regulator of systemic risk?”  The specifics of that discussion focused on the outcome of the Citigroup case.  I will save my response to the panel’s particular comments on the Citigroup case for a moment, and first take issue with the broader question presented by the panel.  Is Delaware the appropriate forum for regulating systemic risk?  Absolutely, definitively, no.  Delaware is not designed to deal with that question, and it does not assert such jurisdiction.

The confusion is easily explained: the Delaware Courts are designed to deal with large scale business transactions, and rarely does a week go by without a Delaware Court of Chancery case appearing in the Wall Street Journal.  Issues of systemic risk relating to large publicly traded investment banks have also tended to make the front pages of the Wall Street Journal during the crisis.  This is however merely a matter of coincidence.  Delaware adjudicates conflicts between shareholders, companies, their boards of directors, and their executives.  These conflicts are decided on a case-by-case basis.  The Delaware judiciary does not have the constitutional authority, nor does it possess a policy advantage, to serve as a nation-wide regulator of systemic risk.  For that matter, neither does the SEC (which is often described by Delaware critics as Delaware’s antipode).  The SEC has a mandate to protect investors and encourage capital formation under the 33 and 34 Acts, but it possesses neither a mandate nor sufficient expertise to regulate the investment community to police leverage.  This is particularly true in light of the Department of Housing and Urban Development’s superseding authority over the leading source of systemic risk (to the tune of a recent $400 billion dollar backstop from the Treasury Department), namely Fannie Mae and Freddie Mac.

The AALS panel also focused on the Citigroup case as its shining example of Delaware corporate law gone astray.  I feel compelled to respond accordingly.  In that case, the plaintiff sought to evade Section 102(b)7 of the Delaware General Corporation Law, which permits Boards to opt out of liability for good faith violations of the duty of care, by arguing that the Board of Citigroup “failed to act” in its oversight of risk management.  The subject of the Citigroup plaintiff’s challenge was essentially subprime mortgage bets by Citigroup.  Chancellor Chandler noted that the plaintiff’s reading would have eviscerated the Delaware legislature’s intent in enacting 102(b)7 by allowing plaintiffs to allege that, despite an initial good faith and well considered decision to undertake an investment opportunity, a board could be found liable after the fact for its failure to “oversee” the progress of that opportunity.

First, the AALS panel’s view seems to encourage judicial activism on the part of the Delaware Court of Chancery to ignore the Delaware General Corporation Law.  Even more surprisingly, they begin from a clearly hindsight-biased view of Citigroup’s risks.  The tenor of the discussion was in the order of “well, clearly, Citigroup’s board made bad decisions, because they lost lots of money.”  This is precisely the sort of thinking that the DGCL, in particular Section 102(b)7, is designed to avoid.  Hindsight bias built into corporation law would cripple the ability of boards to invest resources in risky propositions, because boards would fear ex ante the potential liability of good faith but uncertain investments that subsequently lost money.

And if you don’t think the AALS panel’s view on Citigroup’s investments is overwhelmingly colored by hindsight bias, consider remarks by Chairman Ben Bernanke, who in 2006 said that the housing market “will most likely experience a gradual cooling rather than a sharp slowdown” and who in 2007 noted that “the impact of subprime loans on the broader economy and financial markets are likely to be contained.”  Readers should certainly not take my quotes of Bernanke as a critique of him.  Though I personally feel the Fed is overly lax in monetary policy these days, that’s another issue.  My point is that one of the smartest, most informed, and least conflicted financial regulators felt in 2006 and 2007, at the height of the events of the Citigroup case, that subprime was a relatively riskless bet.  As such, I take severe issue with the “conventional wisdom” at the AALS that the Citigroup case was a slam dunk against Chancellor Chandler’s decision.

Let’s also not forget that the Delaware Court of Chancery decided to permit the waste claim to survive at that stage in the litigation, and it survives to this day.  I realize that waste claims rarely result in ultimate judgment against the defendants, but then again most all claims in civil court rarely result in ultimate judgment against the defendants.  If Delaware was such a rigged game in favor of defendants, as the AALS panel seemed to suggest, why would Chancellor Chandler have permitted the waste claim to survive, knowing it would give the plaintiffs continued leverage to demand some form of award in settlement negotiations?

I will close with two general critiques of Delaware’s critics that applies both to some of the recent commentators at the AALS panel and also to the anti-Delaware vein of scholarship generally.  Don’t get me wrong… I won’t argue that Delaware is perfect, but I will take issue with a lack of sophistication in much of the criticism.  My first point is that the anti-Delaware crowd lumps the various institutions of Delaware together as though it were a single entity.  This could not be more inaccurate.  In the interest of brevity in this blog post, I will only note 10 relevant institutional players in Delaware, although to respond justly I should dedicate a summer to an article that atomizes the players in more depth.  There are significant conflicts of interest among the Delaware Court of Chancery, the Delaware Supreme Court, the Delaware litigation defendant’s bar, the Delaware litigation plaintiff’s bar, the Delaware deal advisory bar, the out of state (particularly NY) deal advisory bar, the Delaware Committee on Corporate Laws, the Delaware Legislature, the Delaware Governor’s office, and the Delaware Secretary of State (responsible for incorporating entities).

My second broad critique of the anti-Delaware crowd is that they seem to ignore that if Delaware were such an anti-shareholder jurisdiction, we would expect to see a share price discount for Delaware publicly traded entities against shares in other companies.  As such, we should also expect to see new IPOs featuring non-Delaware corporations in the hopes of obtaining a premium.  We see neither.  In fact, 70% of all IPOs in 2005 were Delaware corporations.  Furthermore, the only empirical evidence on point is in precisely the opposite direction… empirical evidence suggests that Delaware firms trade at a substantial premium to other firms (see Roberta Romano’s work here and Robert Daines’ work  here).

My colleague Tom Hazlett (George Mason University) has a characteristically thoughtful and provocative column in the Financial Times on the recent Clearwire joint venture and what it tells us about the “innovation commons” and current public policy debates such as network neutrality, spectrum property rights, and municipal wi-fi. Here’s an excerpt:

Clearwire-Sprint-Intel-Google-Comcast-TimeWarner-McCaw blasts away barriers to broadband and a flock of public policy myths. Stories about the coming era of municipal wi-fi, the obsolescence of property rights to radio spectrum and the desperate need for “net neutrality” fall to pieces. For years these tales were spun from the triumphal assertion that the “innovation commons” of the post-internet economy changed everything. The “Chicago School” tools to prosperity – establish property rights, deregulate, let market competition rip – were dusty relics of a bygone era.

So broadband was a crummy cable-DSL duopoly, and local governments’ wireless networks would fix that. Mobile telephony was a crummy oligopoly, and more unlicensed spectrum – as used for wi-fi and cordless phones – would fix that. And to protect it all, the internet’s “open end-to-end” environment needed some regulatory muscle: rules prohibiting discrimination by internet service providers, control freaks who, left to their grabby impulses, would increasingly squeeze customer choices. Network neutrality rules would fix that.

But here’s “New Clearwire”. The chief advocates of muni networks are shelling out to build private networks, instead; the lobbyists for more unlicensed spectrum are paying to purchase licensed spectrum; the champions of net neutrality are getting preferential non-neutral customer access by buying the internet service provider…. New Clearwire tells us that a “fully-open, third pipe” has arrived in the broadband market – and their corporate network, crafted with exclusive spectrum and preferential access, and gobs of private capital — will deliver it. That, truly, is a great leap forward. Thank goodness for the “innovation commons”. The Chicago School could not have said it better.

I thought I would be safe in church. I thought I could avoid her there. But no, the minister had to mention Britney Spears during the sermon Sunday morning. I think the reference had something to do with keeping perspective and the ridiculousness of a motorcade escort to UCLA medical center. I’m not really sure. My mind immediately began to wander.

The question I was pondering was: Why is everyone so obsessed with her??? In case you haven’t noticed, her latest work sucks, and (much more importantly for purposes of media coverage) she’s looking pretty plain these days. Now, I don’t mean to be rude. She’s not hideous or anything. She looks, well, sort of average. But she’s just not hot, or even interesting. So why do gazillions of paparazzi follow her every move?

I was still mulling over The Britney Obsession as I continued reading William Page and John Lopatka’s fantastic new book, The Microsoft Case: Antitrust, High Technology, and Consumer Welfare. As many TOTM readers will recall, a primary theory underlying the government’s high-profile monopolization case against Microsoft was that the company had achieved its success because of “network effects” and was making efforts to protect the “applications barrier to entry” that preserved those effects and precluded the emergence of a serious rival (in particular, the Netscape Navigator/Java combination). Page and Lopatka explain network effects as follows (pp. 24-25):

[N]etwork effects are scale economies on the demand side. They arise when the user of the product receives not only the product’s inherent benefit, but also a network benefit that increases with the number of other users of the product. A telephone network, for example, is more attractive if it is larger and thus allows a member of the network to communicate with more people. … [A] computer operating system is used with various complementary goods, especially applications. Software vendors tend to write applications for the most popular operating system to reach the largest market, and the greater availability of applications in turn induces new users to choose that operating system. This positive feedback loop may cause the market to standardize on the product that gets the early lead in competition among incompatible standards. The theory even suggests that consumers may be locked in to a durable good with inferior qualities, simply because of its enormous network benefits.

Does this explain The Britney Obsession, at least in part? People follow Britney not because she’s that interesting but because they know tons of other people follow Britney, and they’ll therefore have lots of good fodder for the water-cooler. The media follow Britney because they know she has this “installed base” of followers. The abundance of media reports and photos makes Britney that much more interesting to follow. After all, everyone loves an unflattering candid shot, and when there are paparazzi everywhere, there are bound to be many such shots. We therefore end up with a positive feedback loop: Britney’s crazy because the paparazzi have essentially turned her into a caged animal, and she’s become a caged animal because she’s crazy.

Do you see what’s happening here? We’ve settled on a “standard” that, judged by its intrinsic merits alone, is probably not the best thing out there. But when we take account of how many people use that standard, it becomes most desirable. It’s like the QWERTY keyboard or VHS tape.

So is there any hope for Britney? In The Antitrust Enterprise, Herbert Hovenkamp explains that “when equipment based on a particular network standard is marketed and acquires a significant installed base, resistance to change becomes considerable and only a very large technological improvement will succeed in displacing the existing format.” The DVD standard, for example, was so superior that it eventually dethroned VHS.

Here’s hoping that a new pop idol emerges as the standard before Britney destroys herself.

UPDATE: Over at Organizations and Markets, my colleague Peter Klein analyzes this a bit further. Some nice points. (Be sure to check out the link to Paul David on Path Dependence.) Peter also notes that there’s a Wikipedia entry, Famous for Bring Famous, that gets at the phenomenon I’m discussing. The list of people falling into that category is pretty amusing.