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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Here’s the description:

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

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

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

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

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

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

The full table of contents is below the fold.  Get it while it’s hot! (more…)

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

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

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

Backdated options and incentives (Bill Sjostrom)

Jenkins channels Manne (Geoff Manne)

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

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

Thoughts on Walker on Backdating (Josh Wright)

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

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

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

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

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

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

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

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

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

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

From Larry Ribstein:

A few years later, Henry Butler and I wrote a book decrying SOX, and discussing the evidence that was accumulating against it, as well as the SOX suit. Here’s an excerpt from the book abstract:

If the suit is successful, Congress likely will have an opportunity to repair the constitutional defect. Although political reality suggests that Congress will not abandon SOX, it may respond to the mounting criticism by fixing its most egregious faults.

The pro-SOX media and pundits scoffed at the suit. But as I pointed out back in 2008 when some DC Circuit judges appeared receptive to plaintiff’s argument, the suit “may actually have some legs.”

The appellate court rejected the suit, but the Supreme Court agreed to hear it. I joined an amicus brief arguing for unconstitutionality.

Now the pundits have retrenched a little to the position that even if the PCAOB goes, the rest of the act will be saved despite the absence of a severability clause. But the pundits have been surprised how far this suit has gotten already, and they may well be surprised again.

Meanwhile, Congress is thinking about amending the law to exempt small firms. This bill gives some indication of what might happen to SOX if the whole thing has to go back to Congress.

As I said back in 2006:

SOX wasn’t just a bad law, but a uniquely bad law, passed under uniquely bad conditions without any of the safeguards that normally accompany major legislation.  And even if repeal or drastic shrinkage is impossible, it’s still necessary to make the case as a warning against future SOX’s.  One way to do that is to establish SOX as a paradigm of bad law. In other words, to make Sarbanes and Oxley the Edsel Fords of corporate governance regulation.

I’ve been watching the SOX debacle play out for seven years. It will be interesting to see how this ends.

President Barack Obama, June 1, 2009:

What we are not doing, what I have no interest in doing, is running GM. GM will be run by a private board of directors and management team with a track record in American manufacturing that reflects a commitment to innovation and quality. They, and not the government, will call the shots and make the decisions about how to turn this company around. The federal government will refrain from exercising its rights as a shareholder in all but the most fundamental corporate decisions. When a difficult decision has to be made on matters like where to open a new plant or what type of new car to make, the new GM, not the United States government, will make that decision.

Reality, October 29, 2009:

Since the financial crisis broke, Congress has been acting like the board of USA Inc., invoking the infusion of taxpayer money to get banks to modify loans to constituents and to give more help to those in danger of foreclosure. Members have berated CEOs for their business practices and pushed for caps on executive pay. They have also pushed GM and Chrysler to reverse core decisions designed to cut costs, such as closing facilities and shuttering dealerships.

Democratic Sen. Amy Klobuchar of Minnesota persuaded GM to rescind a closure order for a large dealership in Bloomington, Minn. In Tucson, Arizona Democratic Rep. Gabrielle Giffords did the same for Don Mackey, owner of a longstanding Cadillac dealership with 80 employees. Rep. Giffords argues it made sense, even for GM, to keep the Mackey dealership, which sold 750 cars last year. “All I did was to help get GM to focus on his case,” she says.

Lawmakers say it’s their obligation to guard the government’s investments, ensure that bailed-out firms are working in the country’s interests and protect their constituents.

Who would have predicted this?

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

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

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

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

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

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

***

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

Well, he warned us.  But now that it’s here it sounds so incredible.

Under the plan, which will be announced in the next few days by the Treasury Department, the seven companies that received the most assistance [from the various US government bailouts] will have to cut the cash payouts to their 25 best-paid executives by an average of about 90 percent from last year. For many of the executives, the cash they would have received will be replaced by stock that they will be restricted from selling immediately.

And for all executives the total compensation, which includes bonuses, will drop, on average, by about 50 percent.

* * *

And at all of the companies, any executive seeking more than $25,000 in special perks — like country club memberships, private planes, limousines or company issued cars — will have to apply to the government for permission.

I eagerly await David Zaring’s explanation of the actual mechanism for this, assuming anyone knows what it is.  Did the companies sign contracts accepting such oversight and control when they accepted TARP funds, even though I don’t think TARP came with these kinds of compensation restrictions?  Did ARRA effectively alter TARP agreements?  If so, how?

Marc Hodak, as always, is on the compensation issue.

Anyway, have no fear.  Pay Czar Feinberg knows best.  Da, comrade.

TOTM is very pleased to announce a new permanent member, J.W. Verret (George Mason).  J.W. has been blogging at Volokh Conspiracy recently, but he’s been a guest over at The Conglomerate, and the Harvard Law School Corporate Governance Blog.  Quite frankly, it would be difficult to miss him if you’ve been following the recent events in the world of financial regulation.  Professor Verret has been talking about financial regulation and corporate law every where from The NewsHour with Jim Lehrey, to CNN Money, ESPN.com, The American Lawyer, Forbes, and of course, testimony before various House and Senate Committees regarding the Obama Administration’s 2009 financial regulatory reform proposals.

J.W. received his JD and MA in Public Policy from Harvard Law School (where he was an Olin Fellow under Lucian Bebchuk) and the Harvard Kennedy School of Government, respectively, in 2006.  Professor Verret then served as a law clerk for Vice-Chancellor John W. Noble of the Delaware Court of Chancery. Prior to joining the faculty at Mason Law, Professor Verret was an associate in the SEC Enforcement Defense Practice Group at Skadden, Arps in Washington, D.C. He has written extensively on corporate law topics, including a recent paper, Delaware’s Guidance, co-written with Chief Justice Myron T. Steele of the Delaware Supreme Court. His academic work has been featured in the Yale Journal on Regulation, The Business Lawyer, the Delaware Journal of Corporate Law, the University of Pennsylvania Journal of Business Law, and the Virginia Law and Business Review. Professor Verret was recently selected by the Northwestern Law School Searle Center on Law, Regulation, and Economic Growth for a 2009-2010 Searle-Kaufmann Research Fellowship.

J.W. will be finishing up his stint as a visitor at Volokh this week, but we’re happy to give him a permanent blogging home here at TOTM thereafter.

My colleague JW Verret is blogging over at Volokh on his new paper Treasury, Inc.: How the Bailout Reshapes Corporate Theory and Practice.  Here’s an excerpt from his first post to get you started:

Most of the debate over the bailout has been whether we should have bailed out the finance and automotive sectors in the first place, done something else, or done nothing at all.  Fascinating question, and it is fun watching the economists fight that one out, but that’s not the question that interests me.  My focus is the tectonic shifts in corporate theory and practice that result as companies have given the Treasury and the Federal Reserve equity stakes in exchange for TARP bailout money.  To sum up my position: the theory and practice of corporate and securities law are unprepared for the presence of a control shareholder, like the government, that also enjoys sovereign immunity from the federal securities laws and state corporation law.

The six central theories of corporate law, which at times stand in mutual and vigorous opposition, all break down in the presence of an immune control shareholder.  Debates about whether we should give more power to shareholders to maximize shareholder wealth, give more power to directors to do the same, or abandon wealth maximization as our paradigm and take a progressive view toward stakeholders, all lose their usefulness in the chaotic presence of a controlling immune shareholder.

The corporate practitioner’s view is equally problematic.  We will need to rethink everything we know about insider trading, securities class actions (for which Treasury may end up serving as a lead plaintiff), and state law fiduciary duties for control shareholders.  A Board’s ability to approve transactions may be endangered.  Finally, the government may obtain the right to nominate candidates for the Board of Directors of public companies under the SEC’s new proxy access rule at TARP recipients in which the government owns a mere 1% stake.

To defend this idea, over the next week I will need to answer a few questions first.  Is the government really a control shareholder, and in which firms?  Do Treasury and the Federal Reserve enjoy complete sovereign immunity in their exercise of shareholder power?  And is there any way to limit the fallout going forward?  We will also take a look at a bi-partisan bill from Senator Warner and Senator Corker to which I have contributed language that may limit some of the damage, the TARP Recipient Ownership Trust Act of 2009.

Go check out the whole thing.

Between the various power grabs and dubious regulatory proposals (each more dubious than the last!) from the likes of Geithner, Bernanke, Frank (.pdf), Dodd, etc., etc. you’d be excused for thinking the financial news from Washington (remember when financial news used to come from New York?) was all bad and growing only worse.

But there is a bright spot in this sad state of affairs:  SEC Commissioner Troy Paredes.  Appointed shortly before Bush left office (with one hand he gave us Troy Paredes; with the other he gave us import duties on Roquefort cheese. I leave it to you to assess the net), Troy is a once and presumably future law professor, treatise author, and all-around sound thinker on issues of corporate governance, corporate law and securities regulation.

Troy has voted against the SEC’s misguided proxy access proposal (see his official comments on the topic here), and he has made impassioned speeches evidencing an otherwise absent understanding of basic corporate governance explaining why the proposal (and others in the same vein) are problematic.  Fundamental to his approach are an understanding of  the role of risk, a humility born of his appreciation for the complexity of markets, and a constant emphasis on data and evidence-based regulation.

For example, here are some essential points from an excellent speech on the overall regulatory response to the crisis. You’ll never here the likes of Barney Frank, Tim Geithner or Larry Summers (the government incarnation) saying these things:

My basic point is this: Even in times of crisis and hardship, when the benefits of regulation seem apparent and there is pressure to “do something,” we cannot overlook the risk of overregulating. It is essential for the government to retain a healthy respect for the role of markets; and we must appreciate that there are limits to what we can and should expect from regulation.

* * *

Regulating to avoid excessive risk is not costless, whatever the benefits may be of securing the financial system and protecting investors and others from misfortune. Some risks simply are worth it if avoiding them is too costly because legitimate, wealth-creating enterprises and transactions are stifled. In other instances, efforts to clamp down on certain practices and activities may have unintended adverse effects, some of which could exacerbate the concern the regulation targets. This includes the prospect that government action may foster moral hazard. When properly framed, then, the regulatory objective should be to achieve the optimal degree of risk, not necessarily to minimize risk. Achieving the optimal degree of risk involves making tough tradeoffs, netting costs against benefits.

* * *

But I am more troubled by “how” systemic risk might be regulated. Identifying a market failure does not necessarily tell us what the appropriate government response should be. Even when there is a market breakdown, it remains possible for the government’s response to do more harm than good.

* * *

My principal concern turns on the potential scope of the systemic risk regulator’s authority. As a threshold matter, I still have not heard a satisfying definition of what constitutes a systemic risk. Systemic risk is easy enough to conceptualize in theory, but it is much more difficult to identify in practice. What does it mean for a firm to be “too big” or “too interconnected” to fail? A sort of “I know it when I see it” approach to regulating systemic risk is untenable. Such open-endedness accords the regulator too much discretion and is too unpredictable.

Moreover, Troy has made a basic, fundamental argument that I have heard from literally no one else in Washington in all of the debates surrounding executive compensation:  While managers may take on too much risk, they also may take on too little (an argument I have also recently made here):

In large part, the disclosure amendments respond to the potential that companies will take excessive risks. As regulatory reforms are proposed to address excessive risk taking, it is important not to overlook that just as a company can assume too much risk, a company also can be overly cautious. Placing undue emphasis on mitigating downside risk can be costly if it chills enterprises from taking the kind of prudent business risks that drive competition, innovation, and entrepreneurism. Our dynamic economy — marked by a constant stream of cutting-edge goods and services and an ever-expanding set of opportunities — depends on the willingness of individuals to take risks.

Most recently he has spoken about the impending Jones v. Harris case in the Supreme Court (on which see this essential post by Josh), and made some sensible remarks concerning the risks of intrusion (by courts as well as regulators) into well-functioning (and, to be fair, already-regulated) market transactions:

First, adequate market discipline can obviate the need for more exacting and burdensome regulation, including demanding judicial scrutiny of advisory fees. One can conceive of the section 36(b) fiduciary duty as compensating for a lack of competition in the mutual fund industry. Put differently, the legal accountability of section 36(b) can be thought of as substituting for a lack of market-based accountability. The industry, however, has changed since section 36(b) was adopted in 1970 and Gartenberg was decided in 1982. To the extent the industry has become more competitive, it may argue for greater judicial deference to the bargain the adviser and the fund strike. In the face of sufficient market forces that constrain advisory fees, the need for courts to monitor as strictly the adviser/board fee negotiations is mitigated.

Second, courts are not well-positioned to second-guess the business decisions that boards and others in business make in good faith. Judges may exercise expert legal judgment, but not expert business judgment. A judge may be equipped to monitor a board’s decision-making process, but should steer clear of the temptation to override substantive outcomes. These sensibilities cut against reading section 36(b) as implementing a sort of substantive limit on fees and instead recommend that courts focus on the process by which the fees were determined.

Of course I would be more strident and incautious in my remarks, but then I am not a public official with a need to ensure I don’t marginalize myself (a fact that may be endogenous to my stridency and recklessness, come to think of it).

There is more from Troy (find his speeches and statements here (scroll down)), and I expect we will see much more to come.  I know that there are many of us in the legal and academic communities who welcome these views, and I hope we will do whatever we can to ensure that they gain as much currency as possible.  I harbor no illusions about Troy’s ability to redirect Barney Frank’s steamroller, but I am delighted that he is out there, at the highest ranks of the government, fighting the good fight.

I have said it before and I’ll say it again: All of this hand wringing over executive compensation seems to exist in a parallel world where corporate executives have no risk aversion, where there is no real competition for managerial talent, and where firms can only take on too much–never too little–risk.  And this in a day and age (the age of never-ending financial reform regulation, Lehman/Bear, enormous public scrutiny of financial and banking industries, etc.) when the downside from excessive risk-taking is now either a) extremely large or b) non-existent (but only because of guaranteed government bail-outs).  In either case, fiddling with compensation schemes will not help matters.

And yet, as Marc Hodak reports, the German banking regulator is adopting strict compensation controls–including clawbacks–with no actual evidence that compensation played a role in the crisis nor that controlling it will improve matters. And those clawbacks? For deals that “go sour.”  That’s right:  Ex post punishment for any downside, no matter the ex ante expected value of the bet.  Limited upside and negative downside.  The perfect recipe for optimal corporate governance.

Here’s Marc:

There is no distinction between whether the bets that led to those losses were good ones or bad ones at the time they were made, only whether or not they turned out bad.  Consider the following scenario:  A banker sees an opportunity to bet $100 on a project that has even odds of either doubling his money or losing half of it.  He would be a moron banker to pass up this bet.  The bank wants to encourage him to find these bets and make them.  They have two choices on how to reward him.  They can either reward him based on the expected value of the bets, i.e., $25 in this case, or they can reward him based on whether the bet actually succeeds of fails, i.e., plus $100 or negative $50.  A reward based on the latter has a much higher cost to the bank since it must compensate the banker for the added uncertainty.

According to the new rules, the bank must adopt the latter, costlier scheme.  They will have no ability to pay people bonuses for their expected value contributions if they must claw them back if good bets sour, as they often do in the business world.  And that latter scheme has additional problems in the real world besides cost.  In some cases it may be easier to estimate the quality of a particular bet than to know its actual result if the results of that bet get tied up into the results of other bets from the same book.  In some cases, the results of particular bets, even if they can be tracked, may not be known for several years, possibly after the banker has moved onto another position.  Delaying bonuses also significantly increases compensation costs since one must be compensated for deferring compensation.  If you don’t defer the compensation, and you have to take it back later, then you have the logistical issue of recouping compensation already paid–in essence  reaching into someone’s personal savings to get back the cash.

What did the regulator say to all these problems?

For the first time, Bafin has established provisions for clawing back money from individual employees if the deals they do turn sour.  In so doing, Lautenschlaeger acknowledged that she had overridden concerns from the banks that such provisions are unworkable.

We have a term for that over here.  It begins with an “f” and end[s] in “you.”

Ironically, the banks’ reactions to these provision are almost certain to both increase the costs to the banks, and also reduce the alignment of their bankers.  That’s what happens when you base prescriptions on the wrong diagnosis.

In the US we go even further. We have a “pay czar” (gag!) who claims unfettered power, including the power to clawback compensation for, well, any reason he feels like.  His exact words:  “Anything is possible under the law.”  At least his jurisdiction is (for now?) limited to firms that received TARP money.  I wonder if he’s ever heard of agency theory or thinks that compensation performs any function other than unduly lining greedy pockets.

Meanwhile, every week brings an new op-ed from Lucian Bebchuk or a shrill commentary from Simon Johnson and/or James Kwak pinning the responsibility for the crisis on excessive pay, with seemingly no regard for the risk (heh) of excessive risk aversion and the natural risk aversion of managers relative to shareholders.  It may be that things have gotten out of whack in some firms (although Falenbrach and Stultz in the article linked above find no evidence of this for banks), but the solution is not to regulate performance-based compensation schemes out of existence.  (Nor will nominally independent boards help any (see here, for example)).

It would be nice if the “solutions” to our financial market woes bore more relationship to the problems.

If you haven’t been living under a rock recently, you’ve seen an incredible amount of hand wringing–and proposed regulation–around “excessive compensation.”  I’m a little too lazy to amass all the relevant links here, but both the administration and the congress are introducing regulations/bills and talking about the issue extensively.

Commentators, too, have gotten in on the act, and one of the most respected, Alan Blinder, has recently penned a much-lauded WSJ op-ed on the topic, titled, “Crazy Compensation and the Crisis.”  The op-ed is well-written, and even makes some good points.  Here’s an excerpt I can get behind:

What to do? It is tempting to conclude that the U.S. (and other) governments should regulate compensation practices to eliminate, or at least greatly reduce, go-for-broke incentives. But the prospects for success in this domain are slim. (I was in the Clinton administration in 1993 when we tried — and failed miserably.) The executives, lawyers and accountants who design compensation systems are imaginative, skilled and definitely not disinterested. Congress and government bureaucrats won’t beat them at this game.

I might disagree with the emphasis–I would say that even if government could be successful at regulating pay practices it shouldn’t do it, but the point is certainly a good one.  Blinder is also right on when he notes the benefits in this regard of partnerships over public corporations, a persuasive point Larry Ribstein has been making for a long while.

But the premise of the op-ed–and a lot of corporate governance talk these days–strikes me as problematic, incomplete and revisionist.  Here’s a key bit:

Take a typical trader at a bank, investment bank, hedge fund or whatever. Darwinian selection ensures us that these folks are generally smart young people with more than the usual appetite for both money and risk-taking. Unfortunately, their compensation schemes exacerbate these natural tendencies by offering them the following sort of go-for-broke incentives when they place financial bets: Heads, you become richer than Croesus; tails, you get no bonus, receive instead about four times the national average salary, and may (or may not) have to look for a new job. These bright young people are no dummies. Faced with such skewed incentives, they place lots of big bets. If tails come up, OPM will absorb almost all of the losses anyway.

The op-ed has been cited favorably by commentators ranging from the predictably-tiresome-and-unlikely-to-know-better (Frank Pasquale) to the informative-but-reflexively-pro-regulation (James Kwak) to the always-interesting-and-not-normally-in the-company-of-the-likes-of-Frank-Pasquale (Marc Hodak).

But it strikes me as shocking that Blinder (and his supporters)–who expresses surprise as well as dismay at the extent to which compensation schemes reward the upside so heavily and induce risk-taking–doesn’t even mention Agency Theory.

While Blinder may be surprised that corporate boards have been making such silly mistakes for so long, I would think that every professor or finance, corporate governance, corporate law, securities, and a few other disciplines besides would know that one of the fundamental problems of the corporate form is aligning risk-averse managerial interests with risk-preferring, diversified, shareholder interests.  Remove insider trading and short-selling from the equation and you’re left with potentially-large stock options and other forms of performance-based, deferred compensation.  Which have been lauded and paraded around for years as the salvation of entire industries.  So before we stare in amazement that firms are engaging in these sorts of compensation schemes (schemes that may lead to huge upside paydays, and even some large downside paydays, as well) perhaps we should understand the basic theory behind such behavior–as well as the raft of empirical studies supporting the theory.

Look–this isn’t to say that there might not be problems.  Efforts to align incentives may be out of whack, of course–only a fool would presume perfection on the part of market actors.  But only a greater fool would grant the government the power to control compensation schemes, and do so without acknowledging that there are incentive alignment problems; that there are agency costs; and that firms–to say nothing of broader markets–are complex entities not amenable to easy political solutions.  Alan Blinder should know this, and while his restraint is admirable (at least now–I guess he was more ambitious when he was in the Clinton administration) this is just fodder for the corporate governance revisionists who act like agency theory doesn’t exist and only criminals and greedy bloodsuckers design (and receive) executive compensation schemes.  (Actually, come to think of it, once the government starts setting corporate pay, this will almost be true!  I kid, I’m kidding.  Mostly).

Addendum: I should note two more things.  First, I was being a bit flip.  Blinder is clearly (and appropriately) sensitive to the agency problem of the separation of ownership and control inherent in compensation committees’ paying executives with shareholders’ money.  The problem I have is in the failure to acknowledge that there is another agency problem to deal with:  It is too facile to solve the one without concern for the other.

The second point I should make is that Marc Hodak, at least, among the op-ed’s fans, understands the agency problem, and shouldn’t be tarred with my criticism.  His citation to Jensen & Murphy’s “It’s not How Much You Pay, But How” article reflects exactly this concern–the focus should be structuring compensation to account for various agency problems, not blithely limiting its size.  The irony (to answer, I think, Marc’s riddle) is that Jensen and Murphy noted that, at least in 1990, all else equal, the size of executive compensation seemed low.  Again–the real concern was/is with appropriate structure, but at the end of the day, appropriate structure would, I think, for Jensen and Murphy in 1990, have resulted in higher payouts.  Blinder and, to name a few others, Obama, Barney Frank and Chuck Schumer, don’t seem to see it this way at all.

I have been asked a few times today to opine, as a corporate and securities law scholar, on President Obama’s nomination of Judge Sonia Sotomayor for the Supreme Court.  (Cnn.com has a couple of quotes reflecting my thoughts.)

I have three main comments:

First, this is a pivotal time in American securities and corporate law jurisprudence.  Any appointment to the Supreme Court has the potential to significantly influence the evolution of corporate and securities law.  The Supreme Court has recently granted certiorari for a couple of big-ticket securities and corporate law cases, and there is every reason to believe, particularly in light of the SEC’s recently announced rulemaking and Senator Schumer’s recently proposed Shareholder Bill of Rights Act of 2009, that the Supreme Court will continue to handle important business matters like these in the near future.  Federal preemption, Securities and Exchange Commission rule-making authority, corporate governance reform, damages, and the reach of federal securities laws are all incredibly important topics that are certain to come before the Supreme Court in the next few terms.

Second, it is difficult to gauge where exactly Judge Sotomayor falls on the spectrum of pro-management versus pro-investor jurists.  Is she a shareholder primacist, does she defer to the invisible hand of the market, does she interpret Section 10(b) of the Securities Exchange of 1934 broadly or narrowly?  These are questions to which Judge Sotomayor’s judicial writings provide no clear answers.  Sotomayor was nominated to the federal bench by President Bush, so one might have suspected that she would embrace ardent pro-management leanings.  However, the business and securities opinions she has penned have not evinced such a bent.  For example, she penned the Second Circuit’s relatively recent shareholder-friendly opinion in Merrill Lynch v. Dabit (a detailed summary of the case is available here).  Indeed, upon reflection, one recalls that Sotomayor was viewed as a less conservative Bush nominee (proposed by Moynihan) when she was appointed, and it was President Clinton who elevated her to the Second Circuit.  Yet Judge Sotomayor has dismissed numerous cases in favor of management despite her more liberal affiliations.

Third, Judge Sotomayor has a strong background in sophisticated corporate and securities law cases, as she comes from the Second Circuit, a jurisdiction that generates a significant number of these cases (given that Wall Street falls within the jurisdiction of the Second Circuit).  This bodes well, in that pundits often query whether Supreme Court jurists fully appreciate the complex business nuances arising in many securities and corporate matters.  That Judge Sotomayor has been both a district court judge and an appellate judge in a jurisdiction where these difficult business cases arise delights me, and I think she would add a valuable perspective on the Supreme Court.

Taking off the “corporate and securities law scholar” hat, and putting on the “Chair of the American Association of Law Schools Section on Women in Legal Education” hat, I can say that I am thrilled that President Obama has nominated a woman to the Supreme Court.  I was disheartened that Justice O’Connor’s seat was not filled by a woman, but I remain optimistic that someday the number of women on the Supreme Court will mirror, as a percentage, the number of women in the average law school entering class. 

Of course, given that, in the almost 30 years since a woman first ascended to the United States Supreme Court, we appear to have reached a plateau, with only two women serving at any one time over the past 16 years, perhaps my optimism is misplaced.  I remain optimistic nevertheless.