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.

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.

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.

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.

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.

So says Lucian Bebchuk in the WSJ:

While AIG has thus far been able to cover derivative losses using government funds, the possibility of large additional losses must be recognized. AIG recently stated that it still has about $1.6 trillion in “notional derivatives exposure.” Suppose, for example, that AIG ends up with losses equal to, say, 20% of this exposure — that is, $320 billion. Suppose also that the value of AIG’s current assets, including the shares in its insurance subsidiaries, is $160 billion. In this scenario, the government’s fully backing AIG’s obligations would produce an additional loss of $160 billion for taxpayers. Should the government be prepared to do so?

The alternative would be to put AIG into Chapter 11. In this case, AIG’s creditors, including its derivative counterparties, would obtain the company’s assets. They would end up with a 50% recovery on their claims, bearing those $160 billion of losses themselves.

…

It is important to understand that the government can also employ intermediate approaches between fully backing AIG’s derivative obligations and no backing. For example, the government could place AIG in Chapter 11, but commit to provide supplemental coverage that would make up any difference between the value that creditors would get from AIG’S reorganization and, say, an 80% recovery. Such an approach could allow setting different haircuts for different classes of creditors. The government, for example, might elect not to provide such supplemental coverage to executives owed money by AIG.

At a minimum, the government should conduct “stress tests,” estimating potential losses in alternative scenarios, and formulate a policy on the magnitude and fraction of derivative losses it would be willing to cover. A policy that doesn’t fully back AIG’s obligations should be seriously considered.

Read the whole thing.

Here is Larry Ribstein commenting on Lucien Bebchuk’s recent WSJ op-ed criticizing the stimulus bill paycaps,

 Harvard’s Lucian Bebchuk, perhaps the leading academic critic of executive pay, has found a regulation of executive pay he didn’t like – the stimulus bill. …

Academics often do not seem to understand when they propose regulatory fixes that they do not control the lawmaking process. I and many others have pointed out that whatever problems there are with executive pay are best fixed by the market than by turning regulators loose amid populist angst over high-paid executives. Professor Bebchuk, at least, is now learning about the dark side of regulating governance. I fear he may have his eyes opened further over the next few years.

Perhaps the financial crisis will create a substantial increase in demand for public choice economics, or at least force some of its key insights into the forefront of public debate.

Oh, those monikers always confuse me.  So much seems to hang on the right label. When does government intervention in the economy become so extreme that it is appropriate to label it socialist?  Here at TOTM we’ve had this discussion before.

But no mind–call it “toast,” or call it “eggplant,” or just call it stupid, but in a few minutes Obama appears ready to announce that the US government will now set salaries for bank executives.  As Thom pointed out recently, of course, the banks have brought this on themselves to some extent.  As Thom said,

Look, I agree that private firms that get in bed with the government open themselves up to all sorts of meddling in their affairs and that it’s appropriate for the government to exercise some measure of control over the firms it subsidizes.

And I agree–it’s hard to suggest that the banks’ new overlord doesn’t have the right to do whatever it wants to manage its new charges.  The problem is that with power comes responsibility, or so they say.  Just because the Obama administration can cap bank salaries at $500,000 and prohibit severance pay doesn’t mean that it should.

The need to manage the politics here is almost certain to bungle the economics; the desire to punish and an undercurrent of class warfare is almost certain to damage or kill what remains of the teetering financial industry.

Why would Ken Lewis settle for a $500,000 salary when he can make millions at a hedge fund? What precedent will this set not only for government meddling in executive pay in the economy more broadly (rumors of Obama’s support for mandatory say on pay are gaining strength) but governance contracts more generally? Ken Lewis may stick around for a little while because the public opprobrium of leaving Bank of America for something so crass as money will itself be costly. But the ramifications for the executive labor market generally–and for corporate governance generally–are staggering.  I’m pretty sure this is socialism. Or maybe fascism. It’s definitely stupid.

My own take on some of the important implications of this is laid out in an earlier series of posts at TOTM, collected here and in my Hydraulic Theory article. Capping salaries (and some perks, as I understand it) will ensure that the water flows in a different direction.  Certainly there will be “pool effects,” as I describe in my article (the limitations on pay will attract a qualitatively different type of person to executives ranks, not necessarily for the better).  Unless all categories of perks are covered, there will also be behavioral effects (Ok, so executive jets are out, but what about nicer offices?). Has anyone thought through this? Do the pointy heads (now 50% pointier!) in government know how to run the entire financial industry? Probably not.  It’s politics, of course, which is why I marvel whenever anyone suggests that the government can do a better job at . . . anything.  For a lot of people, the prospect of Barack Obama and Larry Summers running the world is a glorious one.  I think this is a mistake.  As impressive as they are, they are not immune to politics (and how!) and the strangling limitations of ignorance.

Man, I hate eggplant.

UPDATE: It’s official: The camel’s nose–and head and body–is under the tent:

The administration also will propose long-term compensation restrictions even for companies that don’t receive government assistance, Obama said.

Those proposals include:

• Requiring top executives at financial institutions to hold stock for several years before they can cash out.

• Requiring nonbinding “say on pay” resolutions — that is, giving shareholders more say on executive compensation.

• A Treasury-sponsored conference on a long-term overhaul of executive compensation. (emphasis added)