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Henry Manne on academic corporate law

Law and economics superstar Henry Manne has a fabulous essay in the latest issue of the Emory Law Journal, A Free Market Model of a Large Corporation System, in which he makes a telling observation about recent corporate law scholarship:

Scholars have for too long been led by events into accepting the status quo and building on it. As the total picture gets more and more complicated and messier and messier, it is much easier to do limited "event studies" or other partial equilibrium analyses. This necessarily results in a loss of a sense of history and a lack of a proper cynicism about the beneficence or legitimacy of previous government regulation.

Academic careers can be ruined by too much departure from the conventions of the moment, even though the cumulative effect of this is to limit any chance for large-scale rethinking of a whole field. What is needed now is a larger debate on the real costs and benefits of market and regulatory alternatives to corporate governance. This could in time result in a very different accepted wisdom about large corporations.

52 Emory L.J. 1381, 1400 (sub. req'd). [Ed.: Thunderous applause in the hall.]

Omnicare v. NCS Healthcare: The precommitment issues

In class yesterday, we tackled the Delaware supreme court's decision in Omnicare v. NCS Healthcare, 818 A.2d 914 (Del. 2003), in which the Delaware supreme court held that an exclusive merger agreement -- such as a no shop or best efforts clause -- must include a fiduciary out, at least where the agreement presents target shareholders with a “fait accompli.” No Delaware court has yet offered a persuasive reason for their hostility to no shop clauses and the like. Instead, the invalidity of such strategies has been asserted by mere fiat. If Omnicare proves anything, it proves that the Delaware supreme court's fiat is not infallible.

NCS was an insolvent health care company considering a “pre-packaged” bankruptcy reorganization. Omnicare, a competitor health care firm, offered to acquire NCS’ assets for $225 million (later raised to $270 million and then to over $313 million) in a bankruptcy sale pursuant to § 363 of the Bankruptcy Code. Omnicare’s proposal was substantially less than NCS’ outstanding debt, which meant that NCS’ shareholders would get nothing and many creditors would be paid only in part. Negotiations broke down and were discontinued.

A few months later NCS was approached by Genesis, another health care firm. Genesis proposed a merger that would have paid off most of NCS’ creditors in full, provided substantial recovery for holders of NCS’ notes, and given NCS’ shareholders a small return on their investments. NCS formed a special committee of independent directors to conduct the negotiations. Because Genesis had lost a prior bidding war to Omnicare, Genesis insisted on an exclusivity arrangement pursuant to which NCS would not conduct merger negotiations with any other potential bidder while the negotiations between NCS and Genesis were underway. When Omnicare tried to reopen negotiations, the independent committee decided to honor the exclusivity agreement with Genesis because they believed there was a substantial risk that Genesis would walk away from the deal, allowing Omnicare to press its bankruptcy sale plans.

In light of Omnicare’s bid, NCS’ independent directors did extract significantly better terms from Genesis. In return, however, Genesis’ insisted on substantial deal protections. First, it required a termination fee of $6 million. Second, NCS’ board agreed to submit the Genesis deal to a shareholder vote even if the board withdrew its recommendation that the shareholders approve the deal. Third, the agreement contained a no shop clause. Finally, Genesis insisted on a shareholder lockup.

The shareholder lockup was possible because two shareholders had a majority position. NCS had two classes of common stock. Class A was standard common with one vote per share. Class B was super-voting rights stock with 10 votes per share. The vast majority of the Class B stock was owned by NCS’ board chairman and its CEO. The chairman and CEO thereby had effective voting control of NCS. At Genesis’ insistence, the chairman and CEO agreed to vote in favor of the merger. NCS was a party to that agreement, apparently to validate it under Delaware’s antitakeover statute.

In combination, these provisions presented the minority shareholders of NCS with a fait accompli. There was no way they could reject the deal as long as the two controlling shareholders voted for it, as they were obliged to do. When Omnicare nevertheless made a higher offer to acquire NCS, Omnicare and some NCS shareholders sued to invalidate the agreement.

By a 3-2 vote, the Delaware supreme court struck down the NCS-Genesis merger agreement. In his dissent, Chief Justice Veasey noted that “[s]plit decisions by this Court, especially in the field of corporation law, are few and far between.” 818 A.2d at 940 n.90. There is a strong unanimity norm in that court. David A. Skeel, Jr., The Unanimity Norm in Delaware Corporate Law, 83 Va. L. Rev. 127 (1997). The willingness of Justices Veasey and Steele to dissent indicates the high profile nature of the Omnicare decision.

The majority acknowledged that “[a]ny board has authority to give [a bidder] reasonable structural and economic defenses, incentives, and fair compensation if the transaction is not completed.” In addition, the majority acknowledged that the controlling shareholders “had an absolute right to sell or exchange their shares with a third party at any price.” Yet, the majority nevertheless concluded that NCS’ board “was required to contract for an effective fiduciary out to exercise its continuing fiduciary responsibilities to the minority stockholders.”

The court based that requirement on a notion that the board has an on-going fiduciary duty to constantly reevaluate its decision. The court’s initial order stated that the measures at issue in that case were preclusive because, “[i]n the absence of a fiduciary out clause, [they] precluded the directors from exercising their continuing fiduciary obligation to negotiate a sale of the company in the interest of the shareholders.” When the court later issued its full opinion, the court again advanced the pernicious notion that the board must “discharge its fiduciary duties at all times” even “as circumstances change.” In dissent, Justice Steele aptly criticized the majority for adopting “proscriptive rules that invalidate or render unenforceable precommitment strategies negotiated between two parties to a contract who will presumably, in the absence of conflicted interest, bargain intensely over every meaningful provision of a contract after careful cost benefit analysis.”

I find the Delaware court’s hostility to no shops and other forms of exclusive merger agreements very puzzling. As I discussed in an earlier post, precommitment strategies are commonplace. Think of Odysseus lashing himself to the mast so that he can hear the Sirens’ song without running his ship aground. Hostility to precommitment strategies certainly does not follow a fortiori from the mere fact that directors are fiduciaries. Why should informed directors acting in good faith not be allowed to lash themselves to the mast of a particular deal? Case law in other jurisdictions allows them to do precisely that. See, e.g., Jewel Cos., Inc. v. Pay Less Drug Stores Northwest, Inc., 741 F.2d 1555 (9th Cir. 1984), which specifically validated no shop clauses by permitting the target’s board to “lawfully bind itself in a merger agreement to forbear from negotiating or accepting competing offers until the shareholders have had an opportunity to consider the initial proposal.” Id. at 1564.

The Jewel approach makes much more sense than that of Omnicare. Suppose the board of directors makes an informed decision that the merger proposal on the table is the best deal they are likely to get for their shareholders and that granting a no shop clause is necessary and appropriate to induce the prospective acquirer to make a formal bid. The board recognizes that a no shop clause will impede its ability to negotiate with any competing bidders who subsequently emerge, but the board decides to accept that risk and go forward. In doing so, the board relies on the old adage that a bird in the hand is worth two in the bush. So long as the decision to enter into the no shop clause was an informed one, why should a board of directors have an on-going fiduciary duty to constantly reevaluate its decision?

Reference: Mergers and Acquisitions at 189-91 and 367

Delaware corporate law's puzzling hostility to precommitment strategies (II)

Dead hand and no hand pills are a type of precommitment strategy. Individuals and entities use precommitment strategies all the time. In The Odyssey, for example, Homer tells a classic story of using a precommitment strategy to achieve a desired goal. Circe warned Odysseus that his course would lead him past the Sirens, whose song famously enchanted all who passed near them. Once trapped, the passerby would be warbled to death by the sweetness of their song. Following Crice’s advice, Odysseus adopted a plan by which he would be able to hear the Sirens’ song but still escape their trap. Odysseus charged his men to lash him to the mast of their boat and not to release him until they were far beyond the Sirens. Odysseus then stopped up his sailor’s ears with beeswax, so they could hear nothing. As his ship passed the Sirens, their song overwhelmed Odysseus’ will power and he tried desperately to get his men to approach the Sirens. Unable to hear the song, and thus being free of its enchantment, however, his men merely tied him even more tightly to the mast and sailed on. Only once they were safely past the Sirens did they release Odysseus.

Homer’s tale illustrates the use of a precommitment strategy to solve the problems known to behavioral economists as time inconsistent discount rates and multiple selves. The discount rate an individual applies when making net present value calculations often declines as the date of the reward recedes. Professors Korobkin and Ulen offer the following example: “Suppose that an individual is to choose between Project A, which will mature in nine years, and Project B, which will mature in ten years. Suppose, further, that an individual who compares the two projects across all their different dimensions prefers Project B to A. Now suppose that we bring the dates of maturity of the two projects forward while maintaining the one-year difference in their maturity dates. Because discount rates increase as maturity dates get closer, it is possible that the individual’s preference will switch from Project B to Project A as the dates of maturity decline (but preserving the one-year difference).” Russell B. Korobkin and Thomas S. Ulen, Law and Behavioral Science: Removing the Rationality Assumption from Law and Economics, 88 Cal. L. Rev. 1051 (2000). One effect of time inconsistent discount rates is that people “always consume more in the present than called for by their previous plans.” Richard H. Thaler, The Winner’s Curse 98 (1992).

The somewhat related multiple selves phenomenon posits that individuals do not have a single utility function, but rather multiple competing utility functions. Because each “self” orders preferences differently, there is an ever-present risk that the self predominating at a given moment may make decisions not in the complete individual’s best interest. Again, Korobkin and Ulen explain: “A stiff tax on cigarettes, to take an obvious example, can be viewed as aiding the future-oriented self in its battle with a more present-oriented self that values immediate gratification over long-term health. . . . Today’s self can attempt to make commitments that either will completely bind tomorrow’s self or, at least, raise the cost of taking action that today’s self wishes to avoid.” In Homer’s tale, Odysseus had himself lashed to the mast precisely so that his present-oriented self could not satisfy its desire to prolong exposure to the Sirens’ song. Being lashed to the mast was a precommitment strategy by which he avoided making an unwise decision in the future. Hence, Odysseus privileged the desires of his farsighted “planner” self, who was concerned with lifetime utility, over those of his myopic and selfish “doer” self. Bank Christmas Clubs are predicated on the same idea. By prohibiting the withdrawal of funds until late November, Christmas Clubs prevent people from acting on hyperbolic discounting proclivities, and assure the future availability of funds to pay for Christmas presents. In general, precommitment strategies are desirable because they disempower the myopic “doer” self. As such, “people rationally chose to impose constraints on their own behavior.” See generally Richard H. Thaler & H.M. Shefrin, An Economic Theory of Self-Control, 89 J. Pol. Econ. 392 (1981).

Accordingly, there are many situations in which both individuals and organizations make enforceable precommitments. Such precommitments are beneficial because they protect ourselves against passion and time inconsistency. In using contractual devices to make a precommitment, the incumbent board likewise binds itself—and future boards—to a particular strategy. In striking down the dead hand and no hand poison pills on authority grounds, the Delaware courts seemingly have limited the use of such precommitment strategies by adopting a broad principle that boards have an ongoing duty to constantly re-evaluate their decisions.

Boards commonly enter into contracts limiting their future authority to varying degrees. Bond indentures commit the board to long-term obligations that will continue to bind future boards for many years. To be sure, the constraint on the authority of future boards is relatively modest, as such boards could always choose to breach the contractual obligations imposed by the indenture, but it nevertheless remains the case that their authority has been constrained.

Merger agreements likewise commonly contain provisions by which the board of directors binds itself to particular courses of conduct. A best efforts clause, for example, obliges the target’s board to use its “best efforts” to consummate the transaction. No shop clauses prohibit the target corporation from soliciting a competing offer from any other prospective bidders. The no negotiation covenant, a variant on the no shop theme, goes further to prohibits negotiations with unsolicited bidders.

Fair price shark repellents commonly include continuing director provisions. Like the dead hand pill, the continuing director provision of a fair price shark repellent allows a bid to go forward only if approved by those members of the board of directors who were on the board when the acquirer first triggered the defensive provision. If the fair price shark repellent was included in the articles of incorporation, rather than the bylaws, it might satisfy the supreme court’s view that “any limitation on the board’s authority be set out in the” articles of incorporation. Query, however, whether a typical fair price provision would contain language explicitly authorizing a limitation of the board’s authority and whether the Delaware courts would require an explicit statement to that effect.

All such corporate actions would be vulnerable to an authority-based challenge if the supreme court’s reference to “any limitation on the board’s authority” is to be taken literally. Yet, if the word “any” is not to be taken literally, where is the firebreak between permissible and impermissible limitations?

If there is no firebreak, what should the Delaware supreme court have done? Instead of creating a novel doctrine based on statutory authority, the court should have relied on the well-established principles outlined in Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985), and its progeny. Dead hand and no hand pills unquestionably raise very serious issues of target director fiduciary duty. The market for corporate control and, in particular, the unsolicited tender offer are critical accountability mechanisms by which agency costs are constrained in the corporate setting. Director action that impedes unsolicited bids therefore is tainted by a conflict of interest, as Unocal recognized. Indeed, it is difficult to imagine a legally cognizable threat sufficiently severe for a dead hand pill to pass muster under the proportionality prong of Unocal. Binding someone else’s hands, as the dead hand pill does, does seem more problematic than binding one’s own. Such concerns become even more pronounced, when the decision to disable another is tainted by a conflict of interest situation.

Yet, never before had the Delaware supreme court adopted a prophylactic prohibition in response to that taint. To the contrary, the court rejected just such an approach when it rejected academic calls for a rule mandating director passivity in the face of an unsolicited bid. Moreover, Delaware courts have employed even Unocal cautiously. They recognize the danger “that courts—in exercising some element of substantive judgment—will too readily seek to assert the primacy of their own view on a question upon which reasonable, completely disinterested minds might differ.” City Capital Assoc. Ltd. Partnership v. Interco, Inc., 551 A.2d 787, 796 (Del. Ch. 1988).

The Delaware supreme court should acknowledge that both self-disablement by the board of directors and disablement by the board of other constituencies are legitimate and accepted corporate governance practices. It then should emphasize that such self-disablement raises issues of fiduciary duty, especially when tainted by the sort of potential conflict of interest inherent in takeover defense decisions.

References:

Corporation Law and Economics at 685-90.

Dead Hand and No Hand Pills: Precommitment Strategies in Corporate Law

Delaware corporate law's puzzling hostility to precommitment strategies

In Carmody v. Toll Brothers, the Delaware chancery court (per Vice Chancellor Jack Jacobs) cast considerable doubt on the validity of so-called dead hand poison pills. Carmody v. Toll Bros., Inc., 723 A.2d 1180 (Del.Ch.1998). In addition to fairly standard flip-in and flip-over features, the Toll Brothers pill provided that it could be redeemed only by those directors who had been in office when the shareholder rights constituting the pill had become exercisable (or their approved successors). This provision was intended to foreclose a loophole in standard poison pills. Most pills are subject to redemption at nominal cost by the target’s board of directors. Such redemption provisions purportedly allow the target’s board to use the pill as a negotiating device: The poison pill makes an acquisition of the target prohibitively expensive. If the prospective acquirer makes a sufficiently attractive offer, however, the board may redeem the pill and allow the offer to go forward unimpaired by the pill’s dilutive effects. Although such redemption provisions gave the target’s board considerable negotiating leverage, and were one of the justifications used to defend the whole idea of the poison pill, they also made the target vulnerable to a combined tender offer and proxy contest. The prospective acquirer could trigger the pill, conduct a proxy contest to elect a new board, which, if elected, would then redeem the pill to permit the tender offer to go forward. The dead hand pill was intended to close this loophole by depriving any such newly elected directors from redeeming the pill. A shareholder sued, alleging both lack of authority and breach of fiduciary duty claims.

In denying Toll Brothers’ motion to dismiss, Vice Chancellor Jacobs indicated that dead hand pills likely ran afoul of several aspects of Delaware law. First, such pills implicated the Delaware statutes governing the powers of directors: “Absent express language in the charter, nothing in Delaware law suggests that some directors of a public corporation may be created less equal than other directors, and certainly not by unilateral board action.” Second, by deterring proxy contests by prospective acquirers, the dead hand pill effectively disenfranchised shareholders who wished to elect a board committed to redeeming the pill. Accordingly, the shareholder stated a claim under Stroud v. Grace, 606 A.2d 75, 92 n. 3 (Del.1992), in which the Delaware supreme court held that defensive measures that disenfranchise shareholders are strongly suspect and cannot be sustained absent a compelling justification. Finally, Vice Chancellor Jacobs concluded that the plaintiff-shareholder had stated a “far from conclusory” breach of fiduciary duty claim. Although standard pills had been upheld against such claims, the dead hand pill was both preclusive and coercive. It was coercive because the pill effectively forced shareholders to re-elect the incumbent directors if they wished to be represented by a board entitled to exercise its full statutory powers. The pill was preclusive because the added deterrent effect of the dead hand provision made a takeover prohibitively expensive and effectively impossible.

In Mentor Graphics v. Quickturn Design Systems, 728 A.2d 25 (Del. Ch. 1998), Vice Chancellor Jacobs likewise invalidated a so-called no hand pill. Unlike Toll Brother’s pill, Quickturn’s pill contained no provision for redemption by continuing directors. Instead, it made the pill nonredeemable for six months after a change in control of the board. Vice Chancellor Jacobs concluded that the no hand pill violated the target board’s fiduciary duties and, accordingly, declined to address plaintiff’s authority-based claims.

The Delaware supreme court affirmed, but on different grounds. 721 A.2d 1281 (Del. 1998). The supreme court’s opinion focused on the board’s authority. According to the court’s opinion, Delaware law “requires that any limitation on the board’s authority be set out in the” articles of incorporation. The no hand pill limited a newly elected board’s authority by precluding redemption of the pill—and thereby precluding an acquisition of the corporation—for six months. Consequently, the no hand pill tended “to limit in a substantial way the freedom of [newly elected] directors’ decisions on matters of management policy.” Accordingly, it violated “the duty of each [newly elected] director to exercise his own best judgment on matters coming before the board.” Absent express authorization of such a limitation in the articles, the no hand pill was invalid as beyond the board’s authority.

In striking down the no hand pill as lacking statutory authority, the Delaware supreme court relied solely on section 141(a) of the Delaware General Corporation law. Section 141(a) states:

The business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors, except as may be otherwise provided in this chapter or in its certificate of incorporation. If any such provision is made in the certificate of incorporation, the powers and duties conferred or imposed upon the board of directors by this chapter shall be exercised or performed to such extent and by such person or persons as shall be provided in the certificate of incorporation.

On its face, section 141(a) is directed to an entirely different problem than the one raised by the no hand pill. In particular, note the reference in the second sentence of section 141(a) to the “powers and duties” of the board being “exercised or performed” by such other persons as provided in the certificate of incorporation. This language clearly reflects a concern with the special problems of close corporations, whose shareholders often seek to modify the default rules of corporate governance so as to run the firm as though it were a partnership. Hence, section 141 is concerned with attempts to transfer the board’s authority to some other body (such as the shareholders) rather than self-imposed limitations on the board’s authority. On its face, the statute therefore provides no support for the court’s holding. As we will see in the next post, moreover, the court’s policy rationale holds even less water.

References:

Corporation Law and Economics at 685-90.

Dead Hand and No Hand Pills: Precommitment Strategies in Corporate Law

The corporate governance racket

The special report on corporate governance in yesterday's WSJ (sub. req'd) included an interesting article by Phyllis Plitch entitled A Piece of the Action: Corporate governance is hot -- and there's no shortage of companies promising to help:

With corporate governance showing no signs of fading as a hot business buzzword as executives scramble to meet new regulations, companies of all kinds and sizes are trying to get a piece of the action. "This looks like the first widespread new potential to sell software and services to the whole economy since the dot-com bust three years ago," says Lane Leskela, research director at Gartner Inc. Mr. Leskela says he found at least 50 high-tech vendors marketing services related to the Sarbanes-Oxley Act of 2002, the legal centerpiece of sweeping reforms aimed at preventing corporate malfeasance. The businesses, he says, range "from the usual suspects all the way down to companies no one has really heard of before." ...

To critics, however, the onslaught of "you must hire us" pitches can scare companies into thinking they have no choice but to pony up big bucks. Some promotions "seem designed to put the fear of God in companies -- that complying is so difficult, you can't possibly do it without expensive and extensive outside help," says Beth Young, senior research associate at the Corporate Library, an independent research firm and corporate watchdog. "It's making people extremely paranoid about the requirements and what it takes to comply."

Well, that's just great. As an investor, I don't want my portfolio companies spending a dollar on "good corporate governance" unless doing so adds at least a buck to the bottom line. I don't have any voice in how much to spend on corporate governance, however. The board of directors and top management make that decision (as they should, of course). Unfortunately for the bottom line, however, directors and management have a strong incentive to over-invest in corporate governance consultants and so on.

Why? The answer lies in the incentive structures of the relevant players. Who pays the bill if a director is found liable for breaching his federal or state duties? The director. if the director has adequately processed decisions and consulted with advisors, will the director be held liable? Unlikely. Who pays the bill for hiring corporate governance consultants, lawyers, investment bankers and so on to advise the board? The corporation and, ultimately, the shareholders. Suppose you were faced with potentially catastrophic losses, for which somebody offered to sell you an insurance policy. Better still, you don't have to pay the premiums, someone else will do so. Buying the policy therefore doesn't cost you anything. Would not you buy it? isn't that exactly the choice we're giving directors and senior managers?

Corporate governance reforms have thus given us the corporate governance racket. We know that these reforms have significantly raised the regulatory burden on Corporate America. Will we get a commensurate bang for our buck? Regular readers know that I'm very skeptical. What I've tried to show here is even modest reforms can result in costs that outweigh their benefits so long as those upon whom the reforms impose new liabilities control the purse strings.

The LA Strikes and the Economic Analysis of Unions

The LA grocery strike is getting to be a real pain. I rely on our neighborhood Ralph's for staples. Oddly enough, it also houses the only branch of my bank in our neighborhood. My problem is that, contrary to what I bet you suspect, I will not cross picket lines. Why not?

First, I come from a long line of union members. Second, Catholic Social Teaching emphasizes that workers have a natural right both to form unions and to strike. As I read the relevant encyclicals and pastoral letters, this teaching is not a matter of prudential judgment, but rather an authoritative teaching to which faithful Catholics must give religious assent. Finally, unions potentially are an important way of minimizing transaction costs.

Labor contracts are subject to moral hazard problems on both sides. Workers shirk—providing less effort than that to which they have agreed. Owners behave opportunistically—providing fewer rewards than promised. Preventing such shirking is one of the principal functions, in economic terms, of any labor relations system. Hence, at least among lawyer-economists in the transaction costs branch of law and economics, the once widely-held view that unions exist to capture monopoly rents for workers in the form of higher wages and superior benefits has given way to an understanding that unions play an important role in reducing transactions costs by constraining strategic behavior by management. Because workers value job security, firms can obtain lower labor costs if they can credibly promise to refrain from opportunistic conduct. One way of bonding that promise is to sign a collective bargaining agreement with a union. Collective bargaining transforms the decisionmaking process from unconstrained management prerogative to limited managerial discretion bounded by claims of right sounding under the agreement. The seniority system, with its ports of entry, internal promotion ladders, and protection from lay-offs, offers job security. Union monitoring helps ensure compliance by the firm with its contractual obligations. Grievance procedures allow for dispute resolution. Collective bargaining thus becomes a burden on the enterprise, in that it raises the transaction costs associated with decisionmaking processes and limits management discretion. Yet, because that burden serves to make the firm’s promises to its employees more credible, it is one rational managers would accept. (Putting the theory into practice, of course, has been a problem. Unions have been plagued by internal agency costs and been a source of social costs.) For a more detailed explanation see my articles Employee Involvement in Workplace Governance Post-Collective Bargaining and Corporate Decisionmaking and the Moral Rights of Employees.

Update re decisionmaking heuristics: One of my colleagues dropped by the office this afternoon to object that, whatever merit my arguments may have, I have not made a case for refusing to cross all picket lines. Good point. Neither efficiency or morality compels the result that every strike is worth respecting. My rule against crossing crossing picket lines, however, is economically justified as a transaction cost minimizing decisionmaking heuristic. Bounded rationality is a neo institutional economics concept capturing the idea that we all have inherently limited memories, computational skills, and other mental tools. These limitations become a significant constraint on decisionmaking under conditions of complexity and uncertainty. Under those conditions, we can reduce decisionmaking costs by adopting a heuristic -- a rule of thumb -- for making judgments. Yes, the rule of the thumb inevitably produces errors, but the benefit in time and effort saved may outweigh error costs. A rule of thumb of not crossing any picket line saves me the time and effort necessary to figure out whether a given strike is morally and economically justified.

Dow 10000, Psychology, and the ECMH

PoliBlog has an insightful post on the possible economic and political impact that would follow from the Dow getting back above 10,000:

While I am hardly saying that if the Dow hits 10k or more (and stays there) that that guarantees any particular outcome in the 2004 elections, can anyone argue that it wouldn’t help President Bush? Can anyone make the argument that a falling or stagnant stock market doesn’t help the Democrats? The election will turn on multiple factors, and the economy is always one them. So, good economic news, especially good economic news that is widely disseminated and fairly easily understood, certainly helps the party in power.

The problem is that it is not clear the Dow will stay above 10,000 in the near term. The WSJ (sub. req'd) is reporting on how 10,000 has emerged as a psychological barrier:

It sounds odd to some rationalists, but the Dow Jones Industrial Average has had a problem with the number 10000 .... Whenever the Dow has reached the 10000 level, it has run out of steam, sooner or later. The blue chips first surpassed 10000 in 1999, and eventually got as high as 11722.98 before succumbing to a bear market and falling back. Since that fizzle, the Dow industrials have moved past the milestone again and again. In all, they have surged above 10000 a total of 18 times, based on the average's closing value, only to lose momentum and fall below again on a later day. It makes no rational sense that a big round number like that should be a barrier, and yet...

As a quasi-rationalist, how can I square this evidence with my general belief in the efficient capital markets hypothesis (ECMH)? Easy.

ECMH's fundamental thesis is that, in an efficient market, current prices always and fully reflect all relevant information about the commodities being traded. In other words, in an efficient market, commodities are never over- or under-priced. The current price is an accurate reflection of the market's consensus as to the commodity's value. A hard rationalist version of the ECMH would claim that investor psychology is irrelevant. The hard rationalist version, however, is almost certainly wrong. Research in cognitive psychology suggests that investor idiosyncrasies do not always cancel one another out. Instead, investors sometimes act like a herd all running in the same direction, which can produce pricing errors. Large speculative bubbles that appear out of nowhere and crash without apparent reason are the most visible form of this phenomenon.

There is considerable evidence that markets adapt to investor irrationality over time, however. If investor irrationality produces pricing errors, it becomes possible to profit by taking advantage of them. At one time, for example, the capital markets showed a systematic bias against small cap firms. As a result, it was possible to earn abnormal returns by investing in a portfolio weighted towards small caps. Over time, many investors did so, including a substantial number of mutual funds that specialized in small cap investing. As a result, the small cap anomaly gradually faded to the point at which it was no longer possible to systematically beat the market by investing in them. Interestingly, however, the Dow 10,000 barrier has elicited a market adaptation that -- at least in the short run -- is likely to reinforce investor irrationality:

In practical terms, short-term investors have learned to make money by speculating that the market will gyrate when it hits key psychological points. ... People use index futures and other devices to bet that stocks will sag as they hit a symbolic barrier.

These bets create downward pressure that reinforces investor skepticism. Fortunately, there is evidence that experienced traders can learn their way out of the irrational behavior patterns that lie at the bottom of so many market anomalies. Herd behavior, moreover, is a fairly fragile thing. Introduction of credible new information can have a cascade effect, in which market opinion changes almost instantaneously. Enough good economic news therefore should eventually overcome the psychological barrier and let the Dow get back above 10,000, just as the Dow eventually managed to stay above 1,000.

Comments on Bebchuk and Cohen Firms’ Decisions Where to Incorporate

A perennial topic in academic corporate law is whether the evolution of state corporate law is better described as a race to the top or a race to the bottom. According to the "race to the bottom" hypothesis, states compete in granting corporate charters. After all, the more charters (certificates of incorporation) the state grants, the more franchise and other taxes it collects. Because it is corporate managers who decide on the state of incorporation, states compete by adopting statutes allowing corporate managers to exploit shareholders.

Many legal scholars reject the race to the bottom hypothesis. According to a standard account, investors will not purchase, or at least not pay as much for, securities of firms incorporated in states that cater too excessively to management. Lenders will not make loans to such firms without compensation for the risks posed by management's lack of accountability. As a result, those firms' cost of capital will rise, while their earnings will fall. Among other things, such firms thereby become more vulnerable to a hostile takeover and subsequent management purges. Corporate managers therefore have strong incentives to incorporate the business in a state offering rules preferred by investors. Competition for corporate charters thus should deter states from adopting excessively pro management statutes. The bulk of the empirical research appears to bear out this view of state competition, suggesting that efficient solutions to corporate law problems win out over time.

Lucian Bebchuk and Alma Cohen have made an important recent contribution to the debate in an empirical paper entitled Firms’ Decisions Where to Incorporate. Bebchuk and Cohen claim two key empirical findings:

[First, their] study has … produced findings that cast substantial doubt on the proposition that there is a vigorous competition among states over corporate charters. ... The overwhelming majority of non-Delaware companies are simply incorporated in the states where their headquarters are based.

[Second, their] findings indicate that the incorporation market rewards states that amass antitakeover statutes. ... At one end of the spectrum, states with no antitakeover statutes, such as California, do poorly and retain a relatively small fraction of the companies located in them. At the other end of the spectrum, states that amass most or all standard antitakeover statutes are the ones most successful both in retaining in-state companies and in attracting out-of-state companies.

In other words, the market for state competition in corporate charters is not perfect, and (2) agency costs affect management decisionmaking. Neither result will surprise any informed observer of the corporation law scene. The question is what, if anything, does confirming those points prove? Bebchuk clearly intends it to be one more nail in Delaware’s coffin. Does it succeed in slaying the race to the top beast?

Bebchuk and Cohen construct the following version of the race to the top hypothesis as a foil against which to argue:

[The] conventional view regards incorporation choices as a “pure” choice of a legal regime, based only on a comparison of states’ corporate law systems and a judgment on which of those systems would be best for the firm. … On this view, all states are viewed as “selling” their corporate law system to all publicly traded firms, and not especially to the firms located in them.

They then assert that their data disproves that conventional view.

Their chosen foil, however, is a caricature of the race to the top hypothesis. Did Ralph Winter or Roberta Romano, for example, ever claim that a Los Angeles-based lawyer sits down and thumbs through all 50 state statutes before deciding where to incorporate a client? If so, I missed it. Tellingly, there is no citation of any source setting out the purported “conventional view.” In my view, a fairer picture of the conventional view is that each state views itself as competing with Delaware, not with the other 48.

Why isn’t there greater state-to-state competition in the market for corporate charters? We all know that lawyers play a big role in the decision of where to incorporate. Lawyers are subject to the same bounded rationality constraints everybody else is, as well as the familiar incentives of agency cost economics. Under such conditions, lawyers naturally will adopt a heuristic; and, home state versus Delaware is far and away the most sensible heuristic.¹ Bebchuk and Cohen’s data are consistent with this hypothesis, but I doubt either the hypothesis or the data comes as a surprise to even the most ardent race to the top theorist. In other words, their data only helps disprove the race to the top hypothesis if we accept Bebchuk and Cohen’s characterization of that hypothesis, which I am not prepared to do.

Let us turn then to their second major finding, which you will recall is that the incorporation market rewards states that amass antitakeover statutes. Again, the result is not particularly surprising, although it is very helpful to have data showing the magnitude of the trend.

The causal relationship, however, is a bit harder to sort out. I said a moment ago that each state views itself as competing with Delaware, not with the other 48. One contribution of the Bebchuk and Cohen paper is to confirm that content matters, at least on the margins, in incorporation decisions. Curiously, however, their paper also provides further inferential support for the proposition that not all states are running in the race – i.e., not all states are trying to maximize the number of incorporations. Again, however, this is not a particularly surprising result. I suspect that the California legislature is annoyed that so many California-based firms incorporate in Delaware, but I don’t see any evidence that California wants to race Delaware for those incorporations. Why doesn’t California compete? California gets a very small share of state revenues from incorporation-related taxes. A key tenet of the race to the top hypothesis is that states compete to attract incorporations so as to collect the franchise taxes firms pay for the privilege of incorporating within that state. Delaware profits hugely from this competition, as Bebchuk and Cohen elsewhere observe: "Delaware's annual revenues from franchise taxes are on the order of $3,000 for each household of four in the state, and they constitute about 30% of the state's budget." This gives Delaware a strong incentive to offer corporation laws that attract entrepreneurs looking for a place to incorporate their business. In contrast, California generates such a small percentage of its revenues from incorporation-related fees, that California has very little incentive to draft corporation laws attractive to entrepreneurs and managers. Instead, California can indulge the luxury of allowing its corporation laws to reflect the overall anti-business/anti-capitalist leanings of the state's dominant left-liberal political elites. This is significant because it relates to Bebchuk and Cohen’s second finding. They view a particular type of content – antitakeover – statutes as being a driving engine of the incorporation decision. Arguably, however, causation runs in the other direction. In other words, California doesn't retain so few incorporations because it has no antitakeover statute; California has no antitakeover statute because it retains so few incorporations ... and doesn't care.²

A second reason to doubt the causal inferences drawn in the paper is suggested by their finding that large firms based in small states tend to incorporate in their home state. Bebchuk and Cohen posit, correctly I think, that this result reflects the ability of such firms to exercise clout through local favoritism. Many – probably most – state antitakeover laws are adopted at the behest of a large firm that is currently the subject of a takeover bid. At least two of the extreme statutes they discuss, Massachusetts and Pennsylvania, fall into that category. (The takeover of Armstrong World occasioned Pennsylvania’s disgorgement statute, while the bid for Norton was the motivation behind the Massachusetts classified board statute.) Hence, antitakeover statutes may be a symptom of local clout rather than an engine of incorporation decisions. The fact that the extreme statutes have not helped Pennsylvania or Massachusetts in attracting incorporations tends to confirm that interpretation.³

Granted, some large states have antitakeover statutes. All I am trying to suggest is that the causation analysis may be more complex than Bebchuk and Cohen acknowledge.

Having said that, I am persuaded by their finding to the extent it demonstrates that the content of state law matters, at least at the margins. Amassing state takeover laws really does seem to help states attract and retain incorporations. Does that disprove the race to the top hypothesis? As I read the pro-race to the top literature, proponents of the race to the top hypothesis concede that state regulation of corporate takeovers is an exception to the rule that efficient solutions tend to win out when states compete. And a very important exception, at that.

Bebchuk and Cohen therefore again construct a foil against which to argue:

The proliferation of antitakeover statutes is consistent with the view that state competition provides adverse incentives with respect to issues, such as the level of antitakeover protections, that have a substantial effect on the private benefits of managers. … However, the proliferation of state antitakeover statutes might present a problem for those holding the dominant view that state competition is generally beneficial. Supporters of this view have sought to reconcile it with their belief that state antitakeover statutes do not serve shareholders by arguing that state competition does not encourage, and is thus not responsible for, the adoption of antitakeover statutes.

Granted, there are passages in the pro-race to the top literature than can be read as making the point Bebchuk and Cohen claim for it. Yet, I do not think it is the only arrow in the race to the top quiver – or even the most significant one. As I read Roberta Romano’s The Genius of American Corporate Law, for example, her principal explanations for Delaware’s failure to adopt a strong antitakeover statute are three-fold: ⁴ (1) Delaware’s diverse corporate constituency, which includes both potential targets and potential bidders. (2) The lack of dominance by any one firm, which makes it easier for pro-takeover forces to have an influential lobby. (3) The importance of the Delaware bar, which benefits from takeover activity. (Pp. 59-60) This last point is confirmed by Larry Ribstein’s recent paper, Lawyers as Lawmakers paper, which argues that states where transactional lawyers are powerful (e.g., Delaware) are likely to have efficient laws in areas where ex ante choice of law is viable, as with corporate governance. So the problem in California, for example, is that the trial lawyers are more powerful than the transactional lawyers.

Hence, contrary what the paper argues, it is possible to simultaneously believe that antitakeover laws are bad public policy and that state competition is a race to the top. Markets are not perfect. Efficient solutions usually win out, but not always, and antitakeover statutes are a readily explicable exception to the general rule.

So what are we to conclude about this second finding? There is an agency cost problem in the decision of where to incorporate, with some managers opting for the protections provided by state anti-takeover laws. Coupled with the home state versus Delaware heuristic I posted earlier, this explains Bebchuk and Cohen’s result that adoption of antitakeover statutes helps a state retain or even attract incorporations. Again, however, I think is neither surprising nor fatal for the race to the top project.

Let us assume, however, that I am wrong about that – i.e., assume Bebchuk and Cohen have finally slain the race to the top. Does that validate their normative agenda? As they explained in a recent Daily Deal article, their normative agenda has two pieces:

First, to invigorate competition a federal incorporation option should be provided. Such an option has been offered in Canada with considerable success.

Second, it would be desirable for the federal government to provide a mandatory switching rule under which shareholders would be able to initiate and approve, even over the objection of management, a reincorporation to another jurisdiction. Such a measure would tie success in the incorporation market more closely to the provision of rules that serve shareholders.

I have little sympathy for either goal.

Lucian would have made my life easier, of course, if he proposed mandatory federal incorporation. Instead, he proposes only an option. As a good contractarian, how can I argue against giving people more choices? Suffice it to say that Bebchuk and Cohen’s paper does demonstrate that the content of corporate matters, at least at the margins.⁵ If so, I doubt whether a federal incorporation option would keep Delaware up nights. Anybody who watched Congress make a hash out of Sarbanes-Oxley or the SEC muck up shareholder access and still thinks the federal government can do a better job than Delaware is beyond my powers to help.

Turning to Bebchuk and Cohen’s second idea – a shareholder power to initiate reincorporation – why is it necessary? When a corporation goes public, shareholders in a sense approve the choice of state of incorporation by buying shares. Shareholders who don’t like Pennsylvania’s antitakeover laws can decline to buy those shares unless the startup entrepreneurs opt-out of the statute. (Granted, there are imperfections in the IPO market, as result of which the impact of the incorporation choice may not be fully priced, but are we to think there is no effect?) When a public corporation changes its state of incorporation, it does so through a merger that typically requires shareholder approval. When Adolph Coors recently asked shareholders to approve a merger to change its corporate domicile to Delaware, by the way, 80% of the shareholders approved. Given that shareholders already have a voice in selecting the state of incorporation, I don’t see what this proposal adds. On top of which, as those of you who have been following my work on director primacy know, I am no fan of proposals that shift power from boards to shareholders. But that is a topic for another day.

Notes

¹In California we also think about Nevada, which is consistent with their finding that Nevada is coming in (a very distant) second in the race.

²The preceding paragraph will be familiar to regular readers. I extracted it from an earlier post. It’s encouraging that blogging and scholarship are proving to have at least some synergies.

³Bebchuk and Cohen conclude, by the way, that Pennsylvania’s statute has not hurt that state in the incorporation market. Why should it? It is very easy to opt out of the statute and the vast majority of firms have in fact opted out. Given an easy opt-out, why should the statute discourage Pennsylvania incorporations. The much more significant finding is that the statute has not helped Pennsylvania attract incorporations.

⁴A word perhaps should be said at this point about Bebchuk and Cohen’s critique of the standard argument that Delaware has weak anti-takeover protections. They acknowledge, as they must, that Delaware has no antitakeover statute. Instead, they argue that Delaware has a “large body” of case law validating the just say no defense. As our exchange in the Stanford colloquium last year illustrated, Lucian and I read the Delaware cases quite differently. As I read the Delaware cases, especially recent decisions like Omnicare and Quickturn, I come away doubting that “just say no” is good law in Delaware today, if it ever was.

⁵Content isn’t the only thing that matters, of course. Delaware’s other advantages include having a separate court, the Court of Chancery, devoted largely to corporate law cases. The Chancellors have great expertise in corporate law matters, making their court a highly sophisticated forum for resolving disputes. They also tend to render decisions quite quickly, facilitating transactions that are often time sensitive.

Gordon Smith on "The Attraction of Delaware"

At his new Venturpreneur site, Gordon Smith chimes in on the Delaware v. California discussion Mike O'Sullivan of Corp Law Blog and I have been having. (HERE for Smith; Here for O'Sullivan; Here for me):

Steve Bainbridge offers another content-driven explanation for Delaware. His purpose is not so much to explain Delaware as to explain why not California (as if the recent recall election isn't reason enough!), but his argument rests on assumptions about the importance of content. He writes provacatively: "California can indulge the luxury of allowing its corporation laws to reflect the overall anti-business/anti-capitalist leanings of the state's dominant left-liberal political elites. In other words, California doesn't retain so few incorporations because it has no antitakeover statute; California has no antitakeover statute because it retains so few incorporations ... and doesn't care." One problem with this argument is that takeover laws do not seem to be an important determinant in the incorporation decision. (See Rob Daines' recent work on this.) Another, more serious, problem is that it does not explain the relative lack of success of all 48 other states in the hunt for corporate charters. Most of those states have anti-takeover statutes -- indeed, most have statutes much more protective of managers than Delaware's -- and still they fail to attract firms from outside their state.

I don't agree with Gordon's assessment of the empirical evidence. The most recent empirical study is Bebchuk and Cohen's paper Firms' Decisions Where to Incorporate. Bebchuk and Cohen find that "the fraction of local firms that each state retains is correlated with the number of antitakeover statutes that the state has." (21). A finding even more pertinent to Smith's argument is Bebchuk and Cohen's result "that offering a stronger antitakeover protection is also helpful in attracting out-of-state incorporations." States that do so do not do as well as Delaware, but they do better at attracting out-of-state firms than states with no antitakeover law. I will have some critical things to say about Bebchuk and Cohen's paper when I post my comments from the Vanderbilt conference (probably on Saturday), but these findings strike me as persuasive evidence that content matters a lot. Content is not all that matters -- other factors were suggested by the Coors reincorporation proxy blawgged a while back and there is a trumping factor I'll identify in my post this weekend -- but it does matter.

Gaming Papal Elections

CatholicPages.com offers a good article on how a new Pope is elected (link via Relapsed Catholic). There's been a key change in the rules since John Paul II was elected:

To be elected Pope, one Cardinal must receive more than two-thirds of the votes. Except that if 30 elections have taken place without any one Cardinal being elected Pope, then the Cardinals may then elect by simple majority.

Perhaps in response, the Cardinals will no longer have to "stay in uncomfortable, makeshift quarters in the Papal Palace," but instead "will stay in the Domus Sanctae Marthae, hotel-style accommodation in Vatican City." Under the old system, when countless ballots were theoretically possible, the lousy accomodations presumably encouraged the Cardinals to reach consensus. (I remember stories about how LBJ used to lock employers and union leaders into a room to settle strikes.) Volokh Conspirator (and Marginal Revolutionist) Tyler Cowen brings a little game theory to the task of analyzing the electoral process:

Assume that each cardinal wishes to back the winning candidate, all other things being equal. You have more leverage if you are part of the winning coalition. So you may support your favored candidate at the beginning, but drop that support if it becomes clear your favorite has no chance. You will then switch to the next best alternative, which is some weighted average of how much you like the candidate and how strong a contender the candidate is. Of course you might never back a candidate you abhor, or a candidate whose chances are hopeless.

The first round of voting reveals information, namely who has how much support. ... You don't have to be the leader in the first round to become Pope. You might be the second or third choice of the voters who supported non-viable candidates, they will switch to you as their candidates drop out. You might then pull into the lead, thereby picking up yet additional support. Still, you have to become established as a leading alternative candidate, pretty early on in the game.

The voting method encourages conservatism of choice, and that indeed is my prediction for the day. Radical challengers have a hard time appearing inevitable or focal. ... Oddly, it can be worse for a candidate to appear "too inevitable." That forces many second-tier candidates to lose their supporters, which can coalesce support around somebody else, too quickly. There is an old saying: "He who enters a conclave as Pope comes out a Cardinal."

He concludes by showing his cards:

When the choice is announced, Andrew Sullivan will be disappointed. But Andrew should have heart, and remember the old political saying, "Only Nixon Can Go To China."

Let's hope not, as Right Coaster Tom Smith explains:

[Today's NYT includes an essay by Andrew Sullivan on his] conscience as a gay man in the Catholic Church. I wonder what the odds would be of getting one's struggles of conscience published on the op-ed page of the times if the chase was, "you know, I should go back to the Church," or "I guess conventional morality was right about X after all." Remote, I should think. We find out Mr. Sullivan was unable to bring himself to go to Mass this Sunday because a gay couple he knows was kicked out of their parish choir for getting civilly unionized in Canada. ... I guess the gist is that Mr. Sullivan is threatening to quit the Church if it doesn't shape up on gay issues. But he's not quite fed up yet, I guess. Maybe the Church can have one last chance. Me, I think the corruption at Vatican I that Acton complained about is embarassing, the whole Spanish Inquistion thing was bad, persecuting Protestants generally no better, priests taking part in recent genocides in Africa even worse, pedophile priests awful, etc., etc. Being a Catholic is like being an American. There is a lot you have to put up with. But the best of it is pretty good, and we have good enemies.

Yep.

Smoking bans and private property rights

Smoking bans continue to proliferate. Montgomery County, Maryland, for example, just adopted one of the toughest laws in the country. The debate over smoking bans typically is viewed as a clash between the rights of smokers and those of non-smokers, with the latter’s rights routinely prevailing. In my view, however, the issue really is one of property rights. The secondhand smoke problem usually is the principal justification for banning smoking in public places. Fair enough. I will concede that smoking has negative externalities. Externalities sometimes justify government intervention. If I run a factory that spews pollution into the air, the damage to my neighbors and the environment is part of the overall social cost of running my factory. Because I don't bear those costs, however, I have no incentive to reduce the pollution my factory generates. By adopting appropriate regulations, the government can force me to internalize the cost of pollution, which is a fancy way of saying that the government can force me to take those costs into account when I make decisions. The mere existence of an externality does not justify legislation, however. In a free society, with limited government and respect for private property rights, at least two conditions must be satisfied before government intervention is warranted. First, my actions must in fact produce external costs. Second, there must be a market failure -- that is, people must be unable to solve the problem without government help. Because I’ve conceded the first prong of the test, the merits of public smoking bans comes down to the question of whether the problem can be solved private ordering. In other words, if we let the owners of private property decide whether people will be allowed to smoke on their premises, will non-smokers be exposed to unreasonable costs? An affirmative answer is clearly appropriate in some situations. There are some public places in which non-smokers may find themselves a "captive audience" -- that is, situations in which the non-smoker cannot avoid exposure to secondhand smoke. Government offices that serve the public are a good example. If a non-smoker gets a traffic ticket, he may have no choice but to go down to the courthouse. A smoking ban thus might be reasonable in the court building. These sorts of situations are quite limited, however. Let's start with the most basic example: my backyard. Should I have the right to smoke a cigar on my back porch, where the only person who smells it is my dog? Presumably so, since I'm not imposing on anyone (my dog seems to like the smell). If you admit that a ban on smoking in my backyard is not appropriate, let's turn to restaurants. Smoking bans routinely apply to restaurants, but restaurants are clearly places in which private ordering can work and in which government intervention is unnecessary. Consider the following case: The 21 Club restaurant had a long history of being a cigar-friendly environment. Non-smokers who ate there did so knowing that they may be exposed to cigar smoke. On what basis can such people complain? Do they not assume the risk of being exposed to secondhand smoke by visiting an establishment that allows patrons to smoke cigars? Conversely, other restaurants -- say, those wishing to attract a family clientele -- may forbid smoking in whole or in part. If I choose to patronize these establishments, I have no right to expect to be able to smoke there. This is what I mean by a system of private ordering: If the place is one that nonsmokers can readily choose to avoid, then they have no right to insist on imposing their preference for a smoke-free environment on me or (and this is the key point) the owner of the establishment. Absent a showing that private ordering can't work, the owner of private property has a right to decide what conduct will take place on his property even if that property is open to the public. So long as non-smokers are free to decide not to enter an establishment in which smoking is allowed, the necessary prerequisite for regulating private property simply doesn't exist. The same sort of analysis could be extended to a host of contexts. Many argue for a ban on smoking in the workplace. And if, for example, an employer concludes that it is cheaper to hire non-smokers, who could object to his banning smoking on his premises? But if another employer concludes that it is cheaper to hire smokers -- perhaps because they'll take lower pay in order to be able to smoke at work -- why should we object to that choice'? So long as non-smokers have other employment options, if they choose to work for an employer that allows smoking, they have no basis to complain. Indeed, there is no externality, because the employer's decision imposes no costs on the non-smokers to which they have not consented. Many restaurants and workplaces have voluntarily banned smoking. In view of this evidence that private ordering can work, I see no justification for overriding private property rights by banning smoking in private establishments.

Does state law permit corporations to forbid shareholders from nominating directors?

By Corp Law Blog's count, the SEC's shareholder access rule proposal poses over 320 questions for commenters. I will not be answering all of them. As I work up my comment letter to submit to the SEC, however, I will post my answers to those I find interesting. 

Today's question:

[A]s proposed, a company would become subject to the security holder nomination procedure in Exchange Act Rule 14a-11 only where the company's security holders have an existing, applicable state law right to nominate a candidate or candidates for election as a director. To eliminate any uncertainties in this regard, the proposed rule would state that the security holder nomination procedure would be available unless applicable state law prohibits the company's security holders from nominating a candidate or candidates for election as a director. If state law permits companies incorporated in that state to prohibit security holder nominations through provisions in companies' articles of incorporation or bylaws, the proposed procedure would not be available to security holders of a company that had included validly such a provision in its governing instruments.

Does state law permit this? A recent Delaware decision suggests an affirmative answer, albeit with qualifications. In Harrah's Entertainment, Inc. v. JCC Holding Co., 802 A.2d 294 (Del.Ch. 2002), the Honorable (and estimable) Leo Strine noted that:

Because of the obvious importance of the nomination right in our system of corporate governance, Delaware courts have been reluctant to approve measures that impede the ability of stockholders to nominate candidates. Put simply, Delaware law recognizes that the "right of shareholders to participate in the voting process includes the right to nominate an opposing slate." And, "the unadorned right to cast a ballot in a contest for [corporate] office ... is meaningless without the right to participate in selecting the contestants. As the nominating process circumscribes the range of choice to be made, it is a fundamental and outcome-determinative step in the election of officeholders. To allow for voting while maintaining a closed selection process thus renders the former an empty exercise." (310-11)

On the other hand, Delaware law also has a fairly strong streak of freedom of contract. A corporation thus may opt out of the default voting -- and nominating -- rules, provided it does so clearly and unambiguously:

When a corporate charter is alleged to contain a restriction on the fundamental electoral rights of stockholders under default provisions of law - such as the right of a majority of the shares to elect new directors or enact a charter amendment - it has been said that the restriction must be "clear and unambiguous" to be enforceable. (310)

Because restrictions on shareholder voting rights, such as a departure from the one share-one vote norm, must be in the articles of incorporation (DGCL § 212), it would be advisable to include a restriction on shareholder nominations in the articles rather than the bylaws. Not only would a bylaw provision be of dubious enforceability, under DGCL § 109(a) the shareholders always retain the right to initiate amendments to the bylaws. For existing companies, getting the shareholders to approve a charter amendment banning stockholder nominations likely will be tough -- probably few would even try to buck the inevitable bad press and institutional investor complaints. Assuming the rule goes through in present form, however, it will be interesting to see how many IPOs include such a provision.

Chander's "Minorities: Shareholders and Otherwise" (revised)

Yesterday's faculty collquium speaker was Anupam Chander, of the UC Davis School of Law (visiting Cornell), who presented his paper "Minorities, Shareholder and Otherwise," which is forthcoming in the Yale Law Journal. You can download a copy of this very interesting paper here; the abstract follows:

Corporate law understands what constitutional law does not. Being a minority matters to law. While constitutional law moves towards colorblindness, shunning knowledge of minority status, corporate law places minorities at the heart of its endeavor. This Essay seeks to reconcile the "minorities" in corporate and constitutional law, developing a larger theory of minority status and its relevance to legal decision. I begin by rereading the corporate canon. I show that body's concern not just for wealth maximization, but also its distribution. I reveal corporate law's deep commitment to protecting minority shareholders, operationalized through an elaborate common law and statutory framework. Ironically, it is corporate law, not constitutional law, that is obsessed with issues such as fairness, oppression, and power. My Essay highlights this and then applies corporate law's theory of minority/majority relations to three hot button debates in the constitutional law realm: affirmative action (currently before the Supreme Court), California's Racial Privacy Initiative (on the ballot for 2004), and the demographic shift to a majority minority polity (already a reality in California).

Chander is very smart and interesting, and so is his paper. It's a very clever idea, which is quite well-executed. Most important, it's quite novel, which is what really counts in the academic reward system. Yet, as explained below, I think I must respectfully dissent.

Corporate law permits discrimination among shareholders. Probably the best known examples are the discriminatory self-tender offer Unocal used to fend off Boone Pickens and the poison pill. Instructively, however, those devices involve discrimination directed against someone who is trying to become a majority shareholder. As Chander correctly observes, corporate law has many doctrines intended to protect minority shareholders and to ensure fair treatment of such shareholders. Chander then claims that constitutional law is much less concerned with protecting racial minorities. Obviously, this will strike many as a controversial claim, especially after last term's Supreme Court decisions in Grutter and Lawrence. Indeed, Chander's analysis seems far more persuasive as a critique of Scalia's color blindess-based dissent in Grutter than of the majority opinion.

Turning to the corporate law analogy, an initial question is whether the appropriate analogy is to the close or public corporation. It’s an important question because fairness is much more of a concern in the law of close corporations than in that of public firms. Close corporations are like the body politic because exit is costly in both, while secondary capital markets make exit from public corporations quite easy. Yet, it is very doubtful one would want to export the law of close corporations to the constitutional context.^{1 Close corporations are often described as “incorporated partnerships,” which explains why fairness is such a big issue in the close corporation context. Query, however, whether partnership is a useful way of thinking about the body politic. Partnerships make decisions by consensus, which they can do because partners typically have comparable interests (profit maximization) and equal access to information. In a pluralistic body politic, those conditions do not hold, and decisionmaking must be effected through the exercise of authority. As such, the body politic most closely resembles the public corporation, where fairness concerns – while still present – are more attenuated.}

Consider, for example, former Delaware Chancellor William Allen’s opinion in Mendel v. Carroll. The Carroll family collectively controlled Katy Industries, Inc., owning at various times 48 to 52% of the stock. Even when they did not have an outright majority, their status as the largest shareholder ensured that they had effective control. The Carroll family had proposed a freeze-out merger that would have involved cashing out the minority shareholders at about $26 per share. A competing offer was made by a group organized by a fellow named Sanford Pensler at about $28 per share. The Carroll Family withdrew their merger proposal, but also announced that they had no interest in selling their shares. Their opposition to the Pensler proposal effectively precluded it from going forward. Minority shareholders sued, alleging that the Carroll Family violated its fiduciary duties and that the board of directors violated its fiduciary duties. Specifically, the minority wanted the board to issue more stock to dilute the Carroll family’s holdings to the point at which they no longer have control. Chancellor Allen held: “The board's fiduciary obligation to the corporation and its shareholders, in this setting, requires it to be a protective guardian of the rightful interest of the public shareholders. But while that obligation may authorize the board to take extraordinary steps to protect the minority from plain overreaching, it does not authorize the board to deploy corporate power against the majority stockholders, in the absence of a threatened serious breach of fiduciary duty by the controlling stock.” [651 A.2d 297, 306 (Del. Ch. 1994).] Mendel thus illustrates the extent to which corporate law is far more tolerant of hegemony than constitutional law.^{2 As the Massachusetts court observed in Wilkes v. Springside Nursing Home, 353 N.E.2d 657 (Mass. 1976), there must be a balance between the fiduciary duty of the majority and its right to selfish ownership, which gives the controlling group “some room to maneuver” in setting policy. Hence, it is not clear to me that corporate law provides a useful lens through which to view constitutional law problems like affirmative action. Nothing I saw in Grutter suggests that racial majorities are entitled to “selfish ownership” of the body politic.}

Another way of getting at my problem with the paper might be to examine the corporate law doctrine that permits a controlling shareholder to freeze-out the minority, so long as the controlling shareholder pays a fair price. If we export both corporate law's solicitude for minority shareholders and corporate law's tolerance of hegemony to the constitutional context, Plessey was correct and Brown was not. The racial majority would be permitted to freeze-out the minority from their schools, for example, so long as they gave the minorities fair treatment, which leads directly to separate but equal schools. For a while post-Plessey the Supreme Court actually tried to enforce separate but equal by monitoring whether the separate schools really were equal. The Court gave that project up in Brown, however; and rightly so, because it never worked. Separate but equal was inherently unequal and properly was struck down. Accordingly, I am left unpersuaded that exporting corporate law principles to the constitutional context does very much to advance the analysis in the latter, unless one is prepared to be very selective about which corporate law principles one is prepared to export and which one intends to leave behind. But that seems to defeat the purpose of the exercise.

In sum, it is a very interesting paper that is well-worth reading. The idea is clever and the execution is impressive. In my view, however, it would have been even more impressive if Chander had been willing to make the move of advocating that con law adopt corporate law’s more tolerant view of hegemony. That would have been a really radical and daring step. But go download the paper and decide for yourself.

^{1 Chander denies any agenda of exporting the fairness technologies, which tends to make the normative payoff kind of anticlimactic.}

^{2 Chander forthrightly acknowledges this difference between corporate and constitutional law; indeed, the differing ways in which the two bodies of law view power is a motivation for the paper.}

Is Delaware corporate law predictable or indeterminate: Corp Law Blog votes for predictability

The race to the top versus race to the bottom debate usually focuses on the quality of Delaware law. As part of their case, proponents of the race to the bottom thesis have embraced USC law professor Ehud Kamar's claim that Delaware law is indeterminate. I have never bought that argument. Granted, Delaware corporate law consists mainly of standards rather than rules, but it is still highly predictable.

The quantity -- and thus the predictability -- of Delaware corporate law is the subject of Mike O'Sullivan's response to my earlier post Why doesn't California retain incorporations:

Delaware's strength is its wealth of published judicial decisions applying its corporate law to real world factual situations. Even the clearest statute is of limited use to a practitioner, as the real world is infinitely more varied than any statute. It's only by applying a statute to the real world over time that the statute takes on a life, assumes certain habits, develops a personality and, in a word, becomes predictable.

Comparatively few corporate law issues ever make it to litigation, let alone to a published court decision. So often, when trying to figure out how a particular corporate statute works, we simply don't have any history showing how the statute worked in similar situations. Sometimes, we don't have any history of the statute operating in any situation. This void is the enemy of predictability.

Delaware, by dint of its efficient court system, its huge pool of corporations and its long record showing, through reported court decisions, how these issues have been applied and resolved, simply has the deepest well of corporate law experience out there. This deep well gives Delaware the most predictable corporate law. For example, Delaware's highly developed body of fiduciary duty case law is both unique and invaluable. When I get questions regarding fiduciary duties for directors of Delaware corporations, chances are very good that I'll find an very similar factual situation dealt with in a prior case. Even when I don't find a similar factual situation, I know enough about how Delaware courts have applied these principles in other situations to make a well-educated guess as to how they would apply it to my situation.

So much for the indeterminacy claim.

Why doesn't California retain incorporations

Next week I'll be speaking at a Vanderbilt law school conference on corporation law, where I'll be commenting on Firm's Decisions Where to Incorporate, by Lucian Bebchuk and Alma Cohen. I'll be posting my remarks after the conference, but in the meanwhile I thought this finding was particularly blogworthy: Bebchuk and Cohen examine whether firms located in a given state (say, California) choose to incorporate in that state or to incorporate elsewhere (say, Delaware).¹ They find that California does especially poorly at retaining local business incorporations: California retains the incorporations of only 22% of businesses located within it. What explains California's lag? (2)

Bebchuk and Cohen's paper contains a variety of possible explanations, but the one I found most telling was this observation:

It is interesting to note that, in all three regressions, states that are strongly Democratic are less successful (at 99% confidence) in retaining local firms. For any given set of statutory corporate provisions, judges in states that are strongly Democratic might be expected to be more willing to intervene, which might be unattractive to those making incorporation decisions.(24)

To be sure, Bebchuk and Cohen lay more stress on the fact that California has no antitakeover statute, which is consistent with their larger thesis that the presence or absence of a takeover statute is what drives management decisions as to where to incorporate. Yet, my guess is that the absence of a takeover statute in California itself can be explained by the state's liberal legal culture. California gets a very small share of state revenues from incorporation-related taxes. (I don't have the exact figures, because franchise taxes -- as opposed to the corporate income tax -- are such a small share of the state's receipts that they don't even show up on the state's cash flow analysis.) A key tenet of the race to the top hypothesis is that states compete to attract incorporations so as to collect the franchise taxes firms pay for the privilege of incorporating within that state. Delaware profits hugely from this competition, as Bebchuk and Cohen elsewhere observe: "Delaware's annual revenues from franchise taxes are on the order of $3,000 for each household of four in the state, and they constitute about 30% of the state's budget." This gives Delaware a strong incentive to offer corporation laws that attract entrepreneurs looking for a place to incorporate their business. In contrast, California generates such a small percentage of its revenues from incorporation-related fees, that California has very little incentive to draft corporation laws attractive to entrepreneurs and managers. Instead, California can indulge the luxury of allowing its corporation laws to reflect the overall anti-business/anti-capitalist leanings of the state's dominant left-liberal political elites. In other words, California doesn't retain so few incorporations because it has no antitakeover statute; California has no antitakeover statute because it retains so few incorporations ... and doesn't care.²

UPDATE: Larry Ribstein (of the UIUC law school and the BusFilm blog) sends the following email:

See my Lawyers as Lawmakers paper. My theory in that paper predicts that states where transactional lawyers are powerful (e.g., Delaware) are likely to have efficient laws in areas where ex ante choice of law is viable, as with corporate governance. So maybe the problem in California is that the trial lawyers are more powerful than the transactional lawyers. Obviously the message that lawyers can be good is not one that is likely to captivate public opinion

UPDATE 2: The Corp Law Blog weighs in with an encomium of Delaware's judiciary and its well-established body of precedent. It's sufficiently important that I will be blogging on it separately. Stay tuned.

Notes

¹ Note that this is a different question than the one that got so much play during the recall. In the debate over California's business climate, the question was whether businesses were moving their physical location out of the state. Bebchuk and Cohen are looking at business that remain physically within, say, California but pick another state in which to incorporate the business. Hence, issues like worker's compensation costs that drive businesses to physically leave California are irrelevant to this issue, because incorporating outside California doesn't eliminate those costs.

² In other words, California is neither racing to the top nor racing to the bottom. It is doing its own quirky thing. In contrast, the states that lean Democratic but have adopted antitakeover statutes are participating in the race (whether it is to the top or the bottom).

And, in response to a reader's query, I'm not intending to suggest that California is shareholder-friendly -- although the political significance of CalPers and other state pension funds may incline the state in that direction -- so much as saying that it is anti-management.