Archives For mutual funds

We recently welcomed Harwell Wells to the Illinois Corporate Colloquium to discuss his and Randall Thomas’s Executive Compensation in the Courts: Board Capture, Optimal Contracting and Officer Fiduciary Duties.  

The paper suggests a new approach to controlling executive compensation:  the courts.  The paper is partly historical, noting that courts have, in fact, been “surprisingly willing to second-guess decisions on executive compensation,” although after doing so they ultimately withdraw from the field to avoid becoming “entangled in setting pay.”  The article says Delaware’s recent Gantler v. Stephens, which recognizes fiduciary duties of corporate officers, “opens the door for courts to monitor executive compensation by scrutinizing rigorously officers’ actions in negotiating their own compensation agreements.” Thomas & Wells also draw on Delaware holdings “that corporate officers are bound by their duty of loyalty to negotiate employment contracts in an arm’s-length, adversarial manner.”

Thomas & Wells suggest their “approach should be welcomed by the courts, which will not be required to determine whether compensation packages are fair or merited, but will instead be asked to engage in a familiar task, examining whether proper procedures were followed in setting compensation.”  The abstract concludes:

This approach . . . promises to break an impasse between the two major academic approaches to executive compensation. Advocates of “Board Capture” theory have long argued that senior executives so dominate their boards that they can effectively set their own pay. “Optimal contracting” theorists doubt this, contending that, given legal and economic constraints, executive compensation agreements are likely to be pretty good and benefit shareholders. The approach advocated here should, surprisingly, please both camps. To Board Capture theorists, it offers to cast light on pay negotiations they believe are largely a sham; to Optimal Contracting theorists, it offers a way to improve the already adequate negotiating environment.

Given the ongoing focus on executive compensation, which shows no sign of abating, this is a timely suggestion.  It’s also an intriguing idea which sparked a lot of discussion in class.  I agree that focus on board procedure offers some benefits over attempting to set pay.  But I also have some skepticism and questions about the proposal.

First, are courts any better suited to determining how pay should be negotiated than what it is? The Delaware Supreme Court thought it knew in Smith v. Van Gorkom when it threw out a seemingly fairly priced transaction solely because it didn’t like the negotiation process.  The post-Van Gorkom fallout in Delaware, including 102(b)(7), and the cases insisting that price be considered with procedure, indicated the problems with the court’s assumption.

Second, I question characterizing the officers’ duty in this situation as fiduciary. As I’ve written, the fiduciary duty is properly conceived of as a duty of unselfishness.  This doesn’t fit with an officer negotiating for what is essentially an exception to the duty – that is, the officer’s compensation.  The officer should have some disclosure duty in this situation, but that’s not the same thing as the hard-core duty of unselfishness. 

Third, what would a fiduciary duty of fair negotiation entail beyond disclosure? There would certainly be a substantial period of unpredictability while courts figure this out, and firms likely would have to tack a premium onto pay packages to reflect the risk of judicial second-guessing. 

Fourth, it’s worth observing that the duty Thomas & Wells describe is similar to the one Judge Easterbrook tried to set in the mutual fund investment adviser context – disclosure and no “tricks.”  See my paper, Federal Misgovernance of Mutual Funds.  The Supreme Court shot the Easterbrook test down in Jones v. Harris. The Court reasoned more or less that the statute says “fiduciary duty” and disclosure-no-tricks isn’t a fiduciary duty.  This is a cost of trying to apply a fiduciary duty where it doesn’t really belong.  The same issues of containing a “fiduciary duty” of fair negotiations would apply here.

I suspect that if courts recognized this duty firms would comply by having their compensation consultants concoct a rigid set of procedures that would protect pay from second-guessing.  On the bright side, this could protect firms from judicial second-guessing of the size of pay packages, which Thomas & Wells show does happen periodically.  Since it’s probably not enough anymore in this regulatory environment just to say markets work, maybe Thomas & Wells is the best we can do.

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

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

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

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

Like Larry, I’ll be at Cato on Constitution Day.  TOTM will be well represented.  While Larry covers Jones v. Harris and mutual funds, I’ll have my sights on the Roberts Court’s recent decision in American Needle v. NFL.   See you there!

The abstract of my paper (co-authored with Judd Stone), Antitrust Formalism is Dead!  Long Live Antitrust Formalism! Some Antitrust Implications of American Needle v. NFL , is here:

Antitrust observers and football fans alike awaited the Supreme Court’s decision in American Needle v. National Football League for months – inspiring over a dozen articles, and even one from the quarterback of the defending champion New Orleans Saints. Yet the implications of the Court’s decision, effectively narrowing the scope of the “intra-enterprise immunity” doctrine to firms with a complete “unity of interests,” are unclear. While some depict the decision as a schism from the last several decades of antitrust law, we explain why this interpretation is meritless and discuss the practical impact of the Court’s holding. The Court’s antitrust jurisprudence over the past several decades, including that of the Roberts Court and American Needle, has broadly embraced rules that are both relatively easy to administer as well as conscious of the error costs of deterring pro-competitive conduct. Intra-enterprise immunity potentially provided such a “filter” that enabled judges to dismiss a non-trivial subset of meritless claims prior to costly discovery. The doctrine, however, proved notoriously difficult to consistently apply in situations involving common organizational structures. Consistent with error-cost principles that have been the lodestar of the Court’s recent antitrust output, American Needle gave the Court an opportunity to effectively abandon intra-enterprise immunity in favor of the Twombly “plausibility” standard. Rather than marking a drastic change in antitrust jurisprudence, therefore, American Needle should be viewed as the Supreme Court substituting an unreliable screening mechanism in favor of a more cost-effective alternative.

I’ll be helping Cato celebrate Constitution Day and the soon-to-be-published edition of their latest Supreme Court Review with my contribution on last term’s Jones v. Harris: Federal Misgovernance of Mutual Funds. See Walter Olson’s summary of the panel on the business cases. Here’s the abstract of my paper:

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

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

Hope to see some of you on Thursday.

As I discussed a couple of days ago in my post about the SEC’s moves toward imposing fiduciary duties on brokers, I have a new paper on how Congress and the courts messed up fiduciary duties in another context: Federal Misgovernance of Mutual Funds. The paper is about a Supreme Court case decided last term. The Court’s opinion followed a notable disagreement in the Seventh Circuit between Judge Easterbrook, who would basically trust adviser compensation to the robust mutual fund market, and Judge Posner, who had doubts about how well that market functions. Here’s the abstract:

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

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

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

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

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

Here’s the description:

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

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

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

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

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

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

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

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

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

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

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

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

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

Omri Ben-Shahar is the Frank and Bernice J. Greenberg Professor of Law at the University of Chicago.

I will focus my blog post on one of the proposals for reducing interchange fees: the requirement that the fees be disclosed to consumers. I am not sure how seriously this option is taken by the GAO report. Indeed, the report concedes that mandated disclosures in this context are not very likely to be effective, because “consumers are likely to disregard this kind of information.” But I will not be surprised if, of all the regulatory options discussed in the report, in the end it will be the disclosure rule that is enacted.

I am sure that readers of this blog don’t need a long explanation why disclosures would be futile in this area. Numerous studies have documented the failure of mandated disclosures in other areas of consumer credit, ranging from TILA, through other financial accounts such as depository, savings, and mutual funds, and extending to disclosure by financial brokers, investment advisers, credit reporting agencies, and even pawnshops. These mandated disclosure rules fail to inform people, to improve their decisions, or to change the behavior of the financial institutions. The fail because ordinary people can read them, can’t understand them even in the most simple format, don’t know what to do with the information even it were understood, and face way too many such disclosures in their every day lives

I recently conducted a study looking at the entire body of mandated disclosure statutes that people encounter, reaching beyond financial transactions.  (You can view a talk based on the study here). Mandated disclosures are a routine regulatory device found in insurance law, health care, informed consent doctrine, Miranda warnings, IRBs, and hundreds of product- and service-specific enactments. My study concluded that none of these disclosures do anything to help people, and many of them backfire. One of the features that runs through all these scattered disclosure statutes is how easy it is politically to enact them. When lawmakers respond to a particular problem that requires intervention—much like the one we are now discussing, interchange fees—there is often debate what rules would work, how deep the intervention ought to be, and whose interests to prioritize. But there is very little debate or opposition to disclosure mandates. Everybody supports them. The perception is that more information is always better: it helps people improve their decisions, it “bolsters their autonomy” as some like to put it, and it perfects market competition. At worse, disclosure believers think, the information will not help much, but it surely will not do any harm, and disclosure regulation involves very little budgetary allocation.

Here is a case in point. Just last month, the Federal Reserve regulated overdraft fees.  After much thought and consultation, the Fed found a solution to the problem of high overdraft fees for ATM and debit card transactions. Recognizing that many consumers would prefer that money withdrawal would be declined rather than pay a sizeable overdraft fee, the rule enacted by the FED prohibits banks from charging overdraft fees unless consumers opt in to the overdraft fee option. Sounds sensible: give people choice, and set the default rule to induce information dissemination.

But here is the catch. How, according to the legislation, would consumers learn about the size of the overdraft fees and choose, if they care, to opt in? By establishing mandated disclosure requirements! That is, to make sure that the notice is “meaningful”, the Fed, with the support of consumer advocates, mandated a new form—which they call a “segregated disclosure”—a separate sheet consumers will receive from the bank providing them “a meaningful way to consent and thus to providing meaningful choice.” The ingenious advance here, which ensures “informed choice,” is to have a separate form, with a separate notice, and a separate signature. This, supposedly, will prevent “inadvertent” consent.

Like any other technical financial disclosure, this format is unlikely to help, especially the least sophisticated consumers—those most likely to carry overdrafts. Whether it is one form of separate forms, one notice or separate notices, one signature or separate signatures, this will not change the ineffectiveness of this disclosure paradigm. Consumers will get yet another pre-printed boilerplate page, with another dotted line at the bottom, which they will happily not read.

The point is that, when all is said and done, nothing much happened. There was a moment of significant public and media attention to the problem of overdraft fees, but in the end they were not regulated. Another meaningless disclosure was added to people’s lives, already swamped with hundreds and thousands of disclosures. Politically, the Fed finished its job and the problem is now “solved.” This is a familiar pattern: a disclosure rule provides an excuse to refrain from a real solution.

Now back to interchange fees. The GAO report lists several possible policy options, from direct regulation of the fees to restrictions on the terms imposed by issuers and how they are negotiated. These are controversial options that would likely lead to substantial political wrestling. There is also much uncertainty, even among the most sophisticated of academic experts, as to the effects of these measures. Perhaps other entries to this blog will shed more clarity as to the right regulatory direction. But as long as these difficulties remain, and as long as interest groups exert pressure on lawmakers, disclosure rules will once again surface as a safe, unopposed, but unfortunately useless regulatory device.

Professor Birdthistle has a very thoughtful reply to my earlier post over at the Conglomerate on Jones v. Harris and behavioral economics.  I thank Professor Birdthistle for his reply.  I’ve learned a great deal about Jones v. Harris from reading his posts at the Conglomerate and have no doubt that I’ll learn more from this exchange.  The thrust of my original post was that, in general, my view was that behavioral law and economics has been too quick to rely on findings in the behavioral/ experimental literature demonstrating systematic deviations from rationality to justify paternalistic regulation.

The criticism was both theoretical and empirical.  I noted that these scholars often incorrectly specify the burden of demonstrating that, even assuming a rock solid empirical case for market failure deriving from cognitive quirks, the regulation is warranted and cost justified including the potential for deterring learning, efficiency explanations for the phenomenon at issue, unintended consequences, magnitude of the social costs imposed by the market failure, administrative costs, etc.  The empirical component was what amounts to playing fast and loose with the appropriate empirical burden to be assigned to these regulatory proposals and selective cherry-picking of relevant evidence.  This is a problem in the behavioral law and economics literature, and particularly among consumers of this literature rather than its producers.  For example, I noted the case of the endowment effect literature:

Indeed, one classic example of this is the reaction of the behavioral law and economics community to the Zeiler & Plott (2005, American Economic Review) analysis demonstrating that the common asymmetry between people’s valuation of gains and losses can be made to grow or to disappear by manipulating the context or circumstances under which the valuations are made.  I blogged about what I described as the Endowment Effect’s Disappearing Act here.  In the meantime, I noted back at the end of 2005 a search of the JLR database had 541 hits for “endowment effect.”  Post-2006, that number is already 255, with 210 of those also including the word “regulation.”  How many of those cite (much less discuss) Zeiler & Plott (2005)?  Sixteen.  Sixteen out of 255! That’s an incredibly disappointing figure and, at a minimum, suggests that taking empirical evidence seriously is not a top priority in the portion of this literature appearing in JLR.

Professor Birdthistle endorses my criticism that the behaviorists might be ” too quick to convert findings of investor irrationality or unsophistication into calls for regulatory intervention” but argues that I’ve missed nuances that are important in the context of this specific Jones v. Harris litigation and the mutual fund industry more specifically.

Birdthistle makes two points: (1) that I rely on the same argument as Easterbrook (echoing Schwartz & Wilde) that the presence of irrational investors does not mean that we get inefficient outcomes because competition for the sophisticates on the margin protects the naifs — an argument that is wrong because in the mutual fund industry there is a “uniquely rigid segregation of sophisticated investors from unsophisticated — with the former buying one set of investments and the latter buying a very differently priced one — which neutralizes the possibility that sophisticated sentinels will protectively police for all”; and (2) that I’m the one playing fast and loose with burdens here since 36(b) of the Investment Company Act already exists, and so the burden lies on the price theorists to present evidence sufficient to override it.

Now, I started my first post with a note that I was no expert in either this particular litigation nor the mutual fund industry.  So I hesitate to take this too much further, but I think that my points survive Professor Birdthistle’s critique and are actually fairly general points of economic theory rather than specific to the mutual fund industry.  I do think, however, that I expressed this particular economic point a bit inartfully in the first post so thought I’d take this opportunity to clarify a bit.  Besides, blogging isn’t for intellectual hesitation, is it

Birdthistle makes two points: (1) that I rely on the same argument as Easterbrook (echoing Schwartz & Wilde) that the presence of irrational investors does not mean that we get inefficient outcomes because competition for the sophisticates on the margin protects the naifs — an argument that is wrong because in the mutual fund industry there is a “uniquely rigid segregation of sophisticated investors from unsophisticated — with the former buying one set of investments and the latter buying a very differently priced one — which neutralizes the possibility that sophisticated sentinels will protectively police for all”; and (2) that I’m the one playing fast and loose with burdens here since 36(b) of the Investment Company Act already exists, and so the burden lies on the price theorists to present evidence sufficient to override it.

I’m going to defer to the experts on the Investment Company Act and appropriate burden of proof as I have no relevant expertise with this piece of legislation — I lumped the burden-shifting point in the first post into the Jones v. Harris discussion, so Professor Birdthistle’s response is fair game —- but will simultaneously defend my broader point that the style of invocation of the behavioral literature that I’ve seen in some corners of the behavioral law and economics literature is methodologically unsound to the point of eschewing serious economic analysis.

But let’s talk about the second point about the competitive effects analysis when you’ve got ex post holdup opportunities deriving from switching costs, behavioral and cognitive biases, or other sources. Professor Birdthistle writes that neither Wright nor Easterbrook discusses that:

the mutual fund industry features a uniquely rigid segregation of sophisticated investors from unsophisticated — with the former buying one set of investments and the latter buying a very differently priced one — which neutralizes the possibility that sophisticated sentinels will protectively police for all” — I believe you’re mistaken but I don’t think I was clear enough in my post about the point I was inarticulately making.

Let me offer an important clarification here.  Specifically, note that the point I’m making on the economics is different than the ex ante competition point argued by Easterbrook and responded to by Litan et al that competition for sophisticated investors on the margin will protect the unsophisticated investors.  To the contrary, my point is that sufficient ex ante competition can prevent anti-competitive outcomes EVEN WHEN the entire market consists of naive consumers.  In other words, I think the features Birdthistle assigns to the mutual fund industry cut the other way.  Let me explain with an example.

Imagine a world where the fraction of investors exhibiting these biases is 1.  Or a more complicated world like the one Birdthistle contemplates with two different markets without interaction where the fraction of investors with biases in one market is 1 (the naive market) and 0 in the other (sophisticated market).  What happens to the naifs in these markets?  It still depends on ex ante competition.  Imagine that each seller knows ex ante that he can extract an extra 10% profit out of the buyer ex post (after lock-in) because of switching costs related to behavioral biases.  Indeed, sellers will in fact hold up the buyers ex post and extract those rents.  But a complete competitive analysis must also consider what happens to the ex ante competition for these naifs.  Some elements of competition occur ex ante and others ex post.  If competition between mutual funds is sufficiently vigorous then we will still get a zero profit equilibrium.  How will that occur?  Given that sellers know that they will increase profits 10% ex post, one expects competition between sellers to dissipate that 10% profits in various forms of ex ante competition.

One cannot focus on the ex post effects that derive from cognitive biases alone and claim to have done a complete analysis.  The key is that, as I wrote:

“If sellers anticipate this ex post profitability, and there is competition among sellers, one expects these rents to be dissipated by ex ante competition across these different dimensions.   This is a key point about switching costs or other ex post holdup (or in this case the presence of behavioral quirks that make for opportunities to holdup consumers).”

I was a bit inartful about this distinction in the post — but it really is a different point that Easterbrook is making (relying on Schwartz & Wilde).

But this is why I believe that the structural evidence of low barriers to entry, shifting shares, low concentration, etc., are as important as I do.  Evidence that there vigorous competition between sellers (and nobody here claims that sellers here are irrational or unaware of any cognitive biases that are relevant) changes the predicted outcome of competition.  To be sure, its true that in this equilibrium you get difference prices and quality ex ante and ex post than you would if the biases didn’t exist, i.e. you get better consumer outcomes on dimensions of competition that are pre-lock-in and worse post.  But you do get zero profit, competitive outcomes.  They don’t resemble perfect competition — but hey, what does in the real world?

The economic point that I’m suggesting Litan et al and Posner and others do not respond to in claiming that we are getting inefficient and anticompetitive outcomes by pointing to behavioral biases and impact on single dimensions of competition is described above — and pointing to the existing of naifs doesn’t address it.

I do really appreciate the response.  Its been a lot of fun to think about this issue for an outsider…

Much has been made about the importance of Jones v. Harris as a battle in the ongoing war between behavioral economics  and rational choice/neoclassical framework (see, e.g. the NYT).   If the case if to be about the appropriate economic methodology or model for assessing legal questions, it is definitely an interesting turn to have Judge Easterbrook representing the rational choice economists while Judge Posner (who is simultaneously taking some flack for fast and loose and incorrect uses of macroeconomics) defends the behavioral view, considering that the latter wrote an important critique of the behavioral law and economics literature (here is an excellent summary of Posner’s opinion from Professor Birdthistle).  Professor Ribstein frames the issue of Jones v. Harris and the New Paternalism nicely with a prediction:

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

I’m no expert on Gartenberg or any other particular legal issues arising in Jones v. Harris.  For commentary from the real experts, see Professor Bainbridge, Birdthistle, Ribstein, or Oesterle.  But what I’m interested in more generally is the law and economics angle here.  More specifically, I’m interested in both the arguments about how the relative merits of behavioral and standard “vanilla” neoclassical economics play out in the legal sphere as well as the how these debates play out from an empirical perspective.   I’ve written on the relative performance of behavioral and “vanilla” neoclassical economics in the context of consumer product markets and found the claims supporting the former (at least in the behavioral law and economics literature) to be overstated.  In particular, I believe it is incredibly common practice in that literature to jump from the identification of a behavioral or cognitive bias identified in the experimental literature to accepting that some regulation must be appropriate,  and shifting the discussion to the design of that regulation.  Infrequently are the relative social costs of the cognitive quirk and the regulation discussed — much less unintended consequences, error costs and the sort of dynamic learning costs imposed by the new paternalism on incentives to learn and mitigate biases.

These latter types of dynamic effects are discussed by Klick and Mitchell and in Ed Glaeser’s essay on Paternalism and Psychology and are important — perhaps critical — to the accuracy of any cost-benefit analysis of regulatory proposals / legal rules aimed at “solving” cognitive bias because there is a danger that any given rule / regulation will increase the rate of errors.  This point goes directly to the appropriateness of the “libertarian” modifier for this type of paternalism when its proponents describe it as “libertarian paternalism.”  For example,  Sunstein & Thaler argue that liberty is maintained because these proposals encourage choice rather than coercion.  But the libertarian case also rests on the presumption that allowing individuals to bear the costs of their errors leads to better and more competent choices in the future.

Admittedly, estimating the true social costs and benefits of changes in legal rules is quite difficult in practice.  But the all to common formulaic approach in the behavioral law and economics literature of: (1) cite experimental evidence that identifies bias, (2) do not discuss whether this bias correlates with other biases that may be offsetting, (3) argue that the bias undercuts all of rational choice economics and its predictions, and (4) design appropriate regulation without regard for the true social costs it imposes (including error and dynamic costs) — is problematic.  (3) and (4) are problems that law and economics scholars utilizing behavioral economics are responsible for — not the folks in behavioral finance and economics actually generating theory and evidence.

Indeed, one classic example of this is the reaction of the behavioral law and economics community to the Zeiler & Plott (2005, American Economic Review) analysis demonstrating that the common asymmetry between people’s valuation of gains and losses can be made to grow or to disappear by manipulating the context or circumstances under which the valuations are made.  I blogged about what I described as the Endowment Effect’s Disappearing Act here.  In the meantime, I noted back at the end of 2005 a search of the JLR database had 541 hits for “endowment effect.”  Post-2006, that number is already 255, with 210 of those also including the word “regulation.”  How many of those cite (much less discuss) Zeiler & Plott (2005)?  Sixteen.  Sixteen out of 255! That’s an incredibly disappointing figure and, at a minimum, suggests that taking empirical evidence seriously is not a top priority in the portion of this literature appearing in JLR.

Back to Jones v. Harris and mutual funds . My sense is that some of that style of argument, and in particular failing to distinguish between the observation of a defect and a thorough analysis of its consequence in actual markets, is working its way into the Jones v Harris debate (at least in a milder form in the Posner opinion and the Litan, et al. brief (they do rely on some empirical evidence and favor litigation over excessive fees to other forms of more invasive regulation such as price controls)).

One of the most important issues here is to distinguish between behavioral quirks and competitive outcomes.  What do the theory and evidence say?

Much of the empirical debate here appears to turn on this Coates & Hubbard study showing that the mutual fund industry tends to be structurally competitive with low entry barriers, low concentration, unstable and shifting market share. Here’s how Coates and Hubbard characterize the evidence:

In sum, the market structure and performance of the mutual fund industry is consistent with strong competition among funds. New entry is common, and for decades has been a constant feature of the industry. Barriers to entry are evidently low, and funds are distributed through multiple distribution channels that themselves reflect a second layer of competition for investor assets. While our survey of evidence of the industry’s market structure is necessarily general, and thus it is possible that there are subsectors of the mutual fund industry where the market is more concentrated, barriers to entry are high, or distribution channels are few, the general survey suggests that the burden of proof should be to establish that such potentially uncompetitive subsectors exist, rather than for to critics to presume, as they have since the 1960s, that competition is generally weak among mutual funds. This general conclusion is only reinforced by a review of evidence of the performance of the fund industry. Fee reductions are common, fees have shown no dominant long-term trend, and market shares are unstable. All of this evidence – admittedly indirect – suggests that competition among funds and fund complexes is robust and, if anything, has been growing in intensity over the past decades.

Easterbrook appeals to the study while Posner and the amicus from Litan, Mason and Ayres offer various rebuttals or counter-evidence.  E.g. Litan, Mason and Ayres point out that Coates & Hubbard can’t identify the impact of changes in fees on fund market shares econometrically because individual fees are not sufficiently variable (it’s true that this weakens the strength of the evidence, correlation not being causation and all of that — but I read Coates & Hubbard as appropriately circumspect with regard to what their evidence shows and doesn’t show. Meanwhile it is true, in my view, that the body of evidence they point to is consistent with competitive conditions) and offer evidence from two other studies (Javier Gil-Bazo & Pablo Ruiz- Verdu, When Cheaper is Better: Fee Determination in the Market for Equity Mutual Funds, 67 J. Econ. Behav. & Org. 871, 883 (2008) and Guo Ying Luo, Mutual Fund Fee-Setting, Market Structure and Mark-ups, 69 Economica 245, 245 (2002)) to conclude: “thus, the overwhelming evidence is that competition in the mutual fund industry has not produced competitive outcomes.”  This is a rather loose use of the term “overwhelming” in my view — not because these studies are poorly done but because there are two of them and there are others with conflicting evidence.

There’s an important theoretical discontinuity going on here in terms of the economics.  It’s one thing to point out these behavioral anomalies.  But think for a moment about the evidence of very low market concentration and low barriers to entry.  Evidence of behavioral anomalies is not sufficient to suggest that there is not competition.  Competition is multi-dimensional: Ex ante v. ex post, price, quality, service, innovation, etc.  Imagine that a fraction of investors exhibit these cognitive biases and will be profitable to exploit ex post because they will not switch funds after poor performance and will continue to pay high fees.  If sellers anticipate this ex post profitability, and there is competition among sellers, one expects these rents to be dissipated by ex ante competition across these different dimensions.   This is a key point about switching costs or other ex post holdup (or in this case the presence of behavioral quirks that make for opportunities to holdup consumers).  Where ex ante competition is vigorous and such opportunities are anticipated — and nobody seems to dispute that both of these conditions are satisfied by the evidence presented by Coates & Hubbard — the likelihood of supranormal returns is dubious.  In other words, showing that such holdup occurs or that switching costs actually deter some switching on the margin (of course) or that behavioral quirks are real and not imagined is quite different than showing that the mutual fund industry is not competitive.  To be sure, the competitive equilibrium might look different where these biases exist, in that one might see economic rents dissipated on different margins that consumers value (if not fees, something else), but that is not the same as saying the market is not competitive.

The basic economic point is that demonstrating that some consumers are systematically irrational alone says nothing about whether fees are likely anticompetitive or supra-competitive or about the strength of the economic logic that says you’d still get competitive outcomes. A key question is whether mutual funds are earning supra-competitive rents.  And this is simply not likely in the face of low entry barriers, dynamically changing shares, plenty of entry and exit, and low concentration.    That doesn’t mean it’s impossible.  But much of this discussion is about assigning the correct burdens in the empirical debate.  It’s difficult to know when fees are high relative to some competitive benchmark precisely because we don’t observe the counter-factual, but-for world.  That’s why understanding the role of ex ante competition, even where there are ex post profit opportunities deriving from behavioral quirks or switching costs, is an important part of resolving that issue.  So is the other structural evidence that suggests that there is plenty of competition between funds.  But alas, much of the behavioral literature (and, unfortunately, Posner and the Litan, et al. brief) engage insufficiently with the nuances of this crucial analysis. As a result, their claims are significantly weakened.

Coates and Hubbard make a similar point in their paper.  As does Judge Easterbrook in offering a related point about how competition benefits the infra-marginal consumers even if they are not sophisticated (though this point is slightly different in economic substance than saying that the consumers are systematically irrational):

It won’t do to reply that most investors are unsophisticated and don’t compare prices. The sophisticated investors who do shop create a competitive pressure that protects the rest. See Alan Schwartz & Louis Wilde, Imperfect Information in Markets for Contract Terms, 69 Va. L.Rev. 1387 (1983). As it happens, the most substantial and sophisticated investors choose to pay substantially more for investment advice than advisers subject to § 36(b) receive. * * * When persons who have the most to invest, and who act through professional advisers, place their assets in pools whose managers receive more than Harris Associates, it is hard to conclude that Harris’s fees must be excessive.

Litan, et al. do respond to this point in their brief (as does Posner), so I do not mean to imply that they are unaware of the general argument.  The issue I’m interested in is figuring out is what quantity and quality of empirical evidence is necessary, when coupled with an argument about behavioral economics that consumers are sometimes irrational, to justify legal change to mitigate those biases. I don’t believe the findings of these anomalies in the literature are artificial — though some evidence is better than other evidence — but it strikes me as reasonable to believe that the burden of proof is much broader than generally assumed by proponents of libertarian paternalism in the behavioral law and economics literature.  The Litan, et al. brief and Posner opinion, in my view, both fall short of an interpretation of the existing data that grapples with the structural evidence.  I most definitely do not find the empirical case, at least from what I’ve seen so far, “overwhelming.”

The more interesting point to me is the implicit claim that citations to the behavioral literature are presumed to change or even shift the burden.  To their credit, both the Posner and Litan, et al. actually deal with some of the empirics (though not in great detail — nor do I here in the blog post).  My prior is that a mixed body of evidence and arguments about behavioral quirks does not shift the burden.  Others disagree, I’m sure.  The point of this particular post is not to quibble about the details of any specific empirical studies or make a comprehensive review of the literature.

Which brings me back to the questions which started me down this road and on this post: how should we weight behavioral / experimental evidence in these arguments?   What about evidence that the biases are mitigated over time in markets?  What about when the predictions conflict with the structural evidence?  How we we reconcile those conflicts?   And most importantly, how large is the theoretical and empirical gap between demonstration of cognitive biases in the laboratory or even real markets and satisfying the burden to show both (1) that markets do not mitigate these biases and generate competitive outcomes, and (2) if they do not, that proposed regulation will help more than it hurts (or that its benefits will exceed costs including those discussed above).

This is my tentative view, and I’d like to look more closely at the existing empirical literature before saying anything more concrete, but the more I think about this the more I think that the really important issue in Jones v. Harris is not about Easterbrook v. Posner, or even classical v. behavioral economics (though this is also important), but about how the Supreme Court assigns the empirical burden and evaluates the existing econometric literature.  Similar issues arise in antitrust, and there is a movement in antitrust (wrongheaded I believe) to integrate the insights of behavioral economics into policy and analysis,  so I have some interest in how the Roberts Court resolves both of those issues.

The governor of North Dakota recently signed into law the North Dakota Publicly Traded Corporation Act (ht: Broc Romanek). The Act resembles a shareholder activist wish list including majority voting for the election of directors, elimination of staggered boards, advisory shareholder votes on executive compensation, shareholder proxy access, proxy contest reimbursement, poison pill restrictions, etc.

While the Act is certainly groundbreaking, my view is that it was enacted as a publicity stunt. The practical effect of it is likely to be zilch. The Act only applies to public companies incorporated in North Dakota that affirmatively opt-in through provisions in their articles of incorporation. Hence, shareholders cannot unilaterally opt-in a company since an articles amendment requires board and shareholder approval. Additionally, a grand total of two public companies are incorporated in North Dakota (Dakota Growers Pasta and Integrity Mutual Funds of Minot), and there is no reason to suspect that they will opt-in.

Even if a corporation wanted to grant shareholders the rights provided for in the Act, it seems highly unlikely it would do so by reincorporating in North Dakota and opting-in. Instead, it could simply tailor its governing documents to strike what it believes to be the appropriate balance between board and shareholder power for its particular business and continue to enjoy the benefits of Delaware incorporation (business savvy judiciary, responsive legislature, etc.).

Of course, the genius of American corporate law may ultimately prove me wrong, but I doubt it.

Updated Drafts on SSRN

Josh Wright —  2 March 2007

I have just posted two revised drafts to SSRN:

  1. Slotting Contracts and Consumer Welfare (forthcoming in the Antitrust Law Journal and previously blogged about here).
  2. Antitrust Analysis of Category Management: Conwood v. U.S. Tobacco.

Both are pretty substantial revisions and so I hope that folks who have read previous drafts will check out the updated drafts.  I would particularly appreciate comments via email on the article on category management and Conwood, which was revised substantially for my testimony at the Section 2 hearings, as I have not yet decided exactly what to do with it and still have time to work on it.

These revisions essentially put to bed the part of my research agenda to do with slotting contracts and shelf space economics per se.  At least for now.  I am still working on some related questions on making sense of disclosure requirements and regulation of these and similar payments which we observe in supermarkets, mutual funds, search engines, and of course, the radio airwaves (payola).  Including that project, I’ve been off and running on the next part of my research agenda for the last year or so and should be posting the draft versions of a few new projects over the next few months.