ProfessorBainbridge.com

Group Decision Making

The cubicle culture column in today's WSJ($) has a great take on group decision making:

Some Ideas Are So Bad That Only Team Efforts Can Account for Them Years ago, when a civilian worker at one of the nation's largest Air Force bases was working for a general, she watched as a team was formed to come up with a better system to handle the mail.

Mail to the base included letters from multi-starred generals and directives that had deadlines. The "process improvement team," also known as a PIT, had a roster of middle managers, mostly civilians, who spent the better part of a month coming up with a plan.

But instead of streamlining the process, they complicated it. "I was horrified," says the woman. "There used to be eight steps; now there were 19." Each piece of official mail was viewed by a greater number of managers before getting to its intended recipient, she says, enabling the mail to be lost at home or in the bathroom, or covered with spills from someone's breakfast. And ponies could have delivered it faster. The lag between the first manager who saw a piece of mail and the person who had to act on it was two weeks, she says.

Questioning the team would have amounted to heresy, so she kept quiet until a year later, when her general emerged from his office and bellowed, "What the hell is happening to my mail?" Once enlightened, he changed everything on the spot.

The columnist's mostly negative view of team production is a salutary reminder that teams are not the panacea many managers believe them to be. Yet, I think it overstates the disadvantages of team production.

I spent a tremendous amount of time working through the literature on team decision making for my article Why a Board? Group Decisionmaking in Corporate Governance:

ABSTRACT The default statutory model of corporate governance contemplates not a single hierarch but rather a multi-member body that acts collegially. Why? This article reviews evidence that group decisionmaking is often preferable to that of individuals, focusing on evidence that groups are particularly likely to be more effective decisionmakers in settings analogous to those in which boards operate. Most of this evidence comes not from neo-classical economics, but from the behavioral sciences. In particular, cognitive psychology has a long-standing tradition of studying individual versus group decisionmaking. This article contends that behavioral research, taken together with various strands of new institutional economics, sheds considerable light on the role of the board of directors. In addition, the analysis has implications for several sub-regimes within corporate law. Are those sub-regimes well-designed to encourage optimal board behavior? Two such sub-regimes are surveyed here: First, the seemingly formalistic rules governing board decisionmaking processes turn out to make considerable sense in light of the experimental data on group decisionmaking. Second, the adverse consequences of judicial review for effective team functioning turns out to be a partial explanation for the business judgment rule.

In brief, the old joke about the camel being a horse designed by a committee captures the valid empirical observation that individuals are often superior to groups when it comes to matters requiring creativity. In addition, teams are subject to unique cognitive biases, such as groupthink, and unique sources of agency costs, such as social loafing. Even so, however, the empirical evidence I review in my article shows that groups are better at tasks requiring the exercise of critical evaluative judgment. Not only do groups clearly outperform average individuals at such tasks, there is considerable (albeit contested) evidence that the process of group interaction has synergistic effects allowing groups to outperform even the best decision makers in the given sample.

Hence, I would never ask a committee to design a new mail system. I would, however, ask a committee to evaluate whether the new mail system is working properly.

The Nose versus The Algorithm

Over at the Cyberlibris blog, Eric has a very nice post comparing economist Orley Ashenfelter's econometric approach to evaluating wine and the gustatory approach of former lawyer Robert Parker.

Ashenfelter decries what he perceives to be a sense of elitism in the wine industry: "Writers whose palates we respect act as if they were able to pick out the qualities in young wines that will emerge a decade or more from now,". Parker Jr., an influential wine critic, calls the professor's methods "Neanderthal," not to mention "ludicrous and absurd". ...

According to [University of Maryland Law Professor Garret Power], the conflict between the two men is obviously tense. However, he thinks that the disagreement between the two men is in fact a profound professional disagreement between a judge (Parker was a law student at the University of Maryland) and an economist. For Power, Robert Parker is a wine judge: "He employs the method of the common law. He sniffs, sops, and spits his way through a number of cases each week." New evidence will make him change his mind. Ashenfelter is undoubtedly a wine economist. To put it again in Power's words, "he simplifies the world of wine and gauges the quality of a vintage on the basis of variables that are subject to objective measurement."

I used to subscribe to both Ashenfelter and Parker's newsletter; I still subscribe to Parker's pay web site. As between the two, I found Parker's tasting notes far more useful; if I were collecting wine for investment purposes, however, Ashenfelter's price data and econometric analysis would be very useful. In any event, my all time tasting triumph came in a seminar given by Ashenfelter: I correctly identified the vintage and appellation of a wine that turned out to be a 1973 Latour.

Disney, Ovitz's Compensation, and the Business Judgment Rule

In my Business Associations class today, I'm teaching Brehm v. Eisner, the principal shareholder suit challenging the comepnsation Michael Ovitz received from Disney (one of the key moments in Michael Eisner's fall from investor grace). Almost a year ago, I posted Substantive due care and the business judgment rule in corporate fiduciary duty law, which explores the relevant legal doctrines in some depth. It concludes that the Disney litigation can be squared with existing doctrine:

The Disney board made a decision that, on its face, is almost impossible to defend. As the Delaware Suprme Court put it in Brehm v. Eisner, “the sheer size of the payout to Ovitz, as alleged, pushes the envelope of judicial respect for the business judgment of directors in making compensation decisions.” The board gave Ovitz cash payments of $39 million and stock options worth over $101 million for just 14 months work. The facts suggest that Eisner hired his buddy Ovitz, fell out with Ovitz and wanted him gone, cut very lucrative deals for his friend Ovitz both on the way in and on the way out, all the while railroading the deals past a complacent and compliant board. The story that emerges is one of cronyism and backroom deals in which preservation of face was put ahead of the corporation's best interests. As such, the case does not necessarily presage the emergence of what Allen called "'"objective' evaluation of the decision" made by a board. Instead, this looks like another case in which "we have reason to disbelieve the protestations of good faith by directors who reach 'irrational' conclusions?" Michael P. Dooley, Fundamentals of Corporation Law 263 (1995). Once again, a seeming inquiry into the rationality of the decision arguably masks an underlying search for conflicted interests and self-dealing.

Mark Noll on the Evangelical Mind

Mark Noll's book The Scandal of the Evangelical Mind thoughfully critiqued Protestant evangelicals for having abandoned the life of the mind. Over at Mirror of Justice, Rob Vischer reports on Noll's current thinking, which is much more optomistic. Interestingly, Noll credits the ecumenical bridges being built between evangelicals and Catholics with having revived interest in intellectual rigor among the former:

"Because evangelicals tend to disregard tradition," Noll explains, "we are liable to miss the rich contributions that other strands of faithful believers have made to interpreting and applying the multitudinous biblical words that are so potent for the life of the mind. But this can change." The first "source of hope" Noll points to in this regard is "the increasing engagement between evangelicals and Roman Catholics," which has "contributed dramatically to improved evangelical use of the mind."

Chateau Gruaud Larose (St. Julien) 1986

Gruaud-Larose has a special place in my heart, as it was the first classed growth Bordeaux that I drank on a regular basis. In most vintages, Gruaud-Larose rivals the first growths for power and longevity, yet it can be had at a fraction of their price. Until recently, it tended to be a very powerful wine with gobs of fruit and tons of tannin, which typically required – but also rewarded – long cellaring. Lately, however, the new owners seem to be striving for a less intense style. Personally, I liked the old style a lot better.

At 18 years of age, this deuxième cru classé is still a deep, inky ruby. The nose is clean and powerful, offering leather, dried fruits, and more than a minor suggestion of a humidor. On the palate, there is still a prominent core of tannins and bright acids. Although it has developed many of the traits of a mature wine, it retains an incredibly impressive youthful vitality. As for the flavor profile, this 1986 Gruaud-Larose suggests olives, prunes, cassis, and pencil shavings. Grade: A

Kramer's Letter to France

Famed wine critic Matt Kramer writes:

You’re getting cranky. The world is changing, and far from leading the charge -- and the change -- you’re insisting that everyone else is at fault.

Remember your headline-making tantrum in 2001 via the French Ministry of Agriculture? “Until recent years, wine was with us,” you said. “We were the center, the unavoidable reference point. Today, the barbarians are at our gates: Australia, New Zealand, the United States, Chile, Argentina, South Africa.”

Sure, the barbarian bit was meant to be ironic. But you don’t have to be Sigmund Freud to know that beneath the irony is a seething resentment. It’s an old story: Others are doing this to you.

Well, it’s not so. You’ve done it to yourself.

The details make for a damning indictment of France's once world-leading wine industry.

Behrens & Hitchcock Winery Claret (Napa Valley) 2000

Wow! I've been hearing about B&H for years, but somehow had never gotten around to trying one of their wines. I'm clearly going to have to make up for lost time. This is a delicious blend of Cabernet (both Sauvignon and Franc) and Merlot. Black cherries, blackberries, and mocha java, with a hint of black olives on the finish. Given its solid core of tannins and acids, it will continue to improve for a number of years, but it also is quite delicious right now. I'm going to buy more if I can find some. Grade: A-

Mondavi for sale?

A while back, I posted Passing the Family Business On: The Sad Example of the Mondavi Family, in which I used the famed Mondavi Winery as a business case to illustrate the difficulties of inter-generational transfers of a large publicly-held but family-controlled firm. As we discussed therein, Mondavi's current business model appeared unsustainable over the long-haul.

We may be approaching a denouement. Mondavi's most recent 10-K annual report announced a major restructuring of the brand structure:

The Company has historically operated in one business segment. On August 20, 2004, the Company announced that it would create two separate operating units within the Company, one focused on the Company's "lifestyle" brands, and the other on its "luxury" brands. The Company's "lifestyle" brands are brands which generally sell for up to $15 per bottle at retail (including Woodbridge and Robert Mondavi Private Selection), while the Company's "luxury" brands generally sell for over $15 per bottle at retail (including Robert Mondavi Winery, Arrowood, Byron and many of the Company's joint venture brands). The board and management are considering various strategic alternatives, some of which would involve layoffs and significant restructuring charges including write-downs which could materially impair future earnings.

Apparently they've settled on selling off the luxury brands. James Laube reports:

Amid a flurry of activity at Robert Mondavi Corp. today, Michael Mondavi resigned from the publicly traded company, which then announced that it would explore divesting itself of its luxury brands, such as Robert Mondavi Winery, Opus One and Ornellaia.

That would leave Robert Mondavi Corp. to focus entirely on lower-priced, large-production brands such as Woodbridge, Robert Mondavi Private Selection and La Famiglia from California, as well as Kirralaa from Australia and new brands, for which the company sees greater growth potential and higher financial returns.

But the company's announcement late this evening left many questions unanswered, including whether the Mondavi family members might try to acquire their original Robert Mondavi Winery in Napa Valley. In its statement, the company declined to speculate if the luxury brands might be sold to family members -- who are the company's most powerful shareholders -- or in some instances sold back to the joint-venture partners. One source said a "strategic review" is underway, with all options being considered. Other sources indicated that some family members and partners were scrambling to come up with funds to make the acquisitions.

A solution in which the volume brands are retained by the public corporation, while the prestige luxury brands return to private ownership makes eminent sense. My sense of the wine industry is that the really big bucks - the kind public corporations need to keep investors happy - are in the high volume/low price sector. In contrast, even though Mondavi's luxury brands command high prices (Opus One and Private Reserve going for well over $100 per bottle at retail), they are also enormously expensive to produce. They are made from low yielding vines planted on very expensive land and handcrafted in the wineries. Indeed, high quality and high profitability seem to be incompatible. Economists Morton and Podolny report:

Many industries are characterized by heterogeneous objectives on the part of firm owners. Owners of private firms, in particular, are likely to maximize utility, rather than profits. In this paper, we model and measure motivations of owners in on particular industry, the California wine industry. In both a formal model and an empirical analysis, we examine the implications of these motivations for market behavior. We find evidence that owners with strong non-financial motivations choose higher prices for their wines, controlling for quality; owners with strong profit-maximizing motives choose lower prices for their wines, controlling for quality. We also find that utility-maximizers are more likely to locate at the higher end of the quality spectrum, whereas profit-maximizers are more likely to locate at the lower end.

Since many observers believe quality has slumped at Mondavi's luxury brands lately, returning them to private ownership thus may be the best hope for a resurgence of quality.

Those darn shrimp at LAX

I found the conclusion of C.C. Kraemer column Fairy Shrimp vs. Man a little over the top (well, maybe even way over the top). As a regular user of Los Angeles International Airport, however, I couldn't agree more with the basic gist of the column:

The [fairy] shrimp lives -- exists? -- in a depression at the end of a runway [at LAX]. Officials have fenced off 108 acres for its privileged use, even though no shrimp worth eating has been found there, just eggs that haven't yet hatched, even after having been in the spot for years. The U.S. Fish and Wildlife Service wants the area to be designated as a preserve for the fairy shrimp. That probably sounds reasonable, since the property is likely to sit idle because of its location. Who would want it for anything? But an argument by LAX officials demonstrates that this is yet another case of man forcing man to yield to a lower life form.

It's not that the relatively small tract has been set aside. It's the ripple effect that area would have. Designating the area as a preserve for the fairy shrimp would require it to have standing water. That attracts birds. Though they both have wings and fly, birds and aircraft do not mix well.

Sometimes the results are disastrous. Yeah, it makes a mess of the bird. But too often it's equally as ruinous for humans. Jetliners full of passengers have been known to go down after sucking birds into their engines.

Takeoff is a critical moment for a flight. If something is thrown off -- even a bird being chewed up by a turbofan engine with 65,000 pounds of thrust -- it makes the takeoff that much more difficult. The Bird Strike Committee USA, made up partly of federal and aviation industry officials, says that a 12-lb Canada goose hitting an aircraft traveling 150-mph at lift-off is similar to the force created when a 1,000-lb weight is dropped from a height of 10 feet. That should be enough to violate the structural integrity of the hull of any jetliner.

Species preservation is an important goal, but the species I care most about is the human one. Fill in the depression.

On the Nature of the Common Law

I recently had occasion to reread Professor Melvin Eisenberg's ambitiously titled book, The Nature of the Common Law, which I highly recommend as a short and very accessible introduction to some very complex ideas.

Eisenberg's stated goal "is to develop the institutional principles that govern the way in which the common law is established in our society." In doing so, Eisenberg addresses the functions of courts in American society, modes of legal reasoning and the process of overturning prior precedents. Yet Eisenberg never loses sight of his central thesis, namely that "all common law cases are decided under a unified methodology, and under this methodology social propositions always figure in determining the rules the courts establish and the way in which those rules are extended, restricted, and applied." To say that courts should and do rely on social propositions (such as moral norms and public policy) in deciding common law cases is hardly new. Eisenberg's contribution comes in mapping a coherent course between the Scylla and Charybdis of modern jurisprudence. He explicitly rejects theories claiming that some cases can be decided without reference to social propositions. On the other hand, Eisenberg also rejects theories claiming that legal reasoning is nothing more than a mask for the social and political values of the decisionmaker. Any complex society needs an institution before which claims based on existing societal standards can be heard. In our society, that institution is the courts. "If the courts resolved disputes by reasoning from those moral norms and policies they think best, there would be no institution to which a member of the society could go to vindicate a claim of right based on existing standards." Second, since the judicial system is a peculiarly undemocratic institution, the legitimacy of the adjudicative process requires courts to look to "existing legal and social standards rather than those standards the court thinks best." Finally, prohibiting the courts from employing their personal standards makes legal reasoning fairer and more easily replicable by the profession.
Common law adjudication thus is not merely the ad hoc application of whatever social propositions a particular judge is taken by; rather, he lays out institutional principles that constrain and guide the adjudicative use of social propositions. According to Eisenberg, adjudicators may only employ those norms or policies that "can fairly be said to have substantial support in the community, can be derived from norms [or policies] that have such support, or appear as if they would have such support." Two critical assumptions underlie this claim: (1) that social morality is a meaningful concept; and (2) that judges are capable of discerning and effectively applying social morality. As space does not permit one to do full justice to Eisenberg's defense of those assumptions, suffice it to say that the argument is well-crafted and even-handed.

Eisenberg's second claim is that courts have a duty to utilize only those social propositions that have the requisite degree of social support. "By accepting and retaining office the judge undertakes an ongoing commitment to carry out the rules of the office," one of which is "a moral obligation to faithfully employ the norms of social morality ... whether or not he privately agrees with those norms." One may be skeptical about the force of an oath of office in constraining judicial discretion, but this is not the only arrow in Eisenberg's quiver. A variety of corrective forces come into play when a judge strays from those social propositions having the requisite degree of support. From the aggrieved litigant's perspective, the best outcome will be a reversal on appeal. Even if the decision stands, however, it may nevertheless soon be consigned to the dust bin of legal history. Lawyers will make a decent living arguing that the rule should be overturned or distinguished in future cases. Commentators and other courts may point out the decision's flawed reasoning. In extreme cases, the legislature may step in. In sum, common law decisions do not live in a vacuum. The wider arena of legal discourse acts a significant check on judicial error, whether the "error" is deliberate or accidental.

At first glance, Eisenberg's thesis appears to create substantial problems of doctrinal stability. He is unwilling, however, to make doctrinal propositions entirely defeasible in the face of changing social propositions. Accordingly, he constrains the use of social propositions by giving some counter-balancing weight to the value of doctrinal stability. In areas where parties are unlikely to plan their behavior based on existing doctrines, doctrinal stability may be relatively unimportant and a court should be fairly liberal in bringing out of whack doctrines back into line. But in areas such as property and estates, where planning is common and reliance on doctrinal stability is likely, courts should be more reticent. In these latter areas, techniques such as signaling (in which the court suggests that it will revisit the issue later) or prospective overturning may be more appropriate than an immediate reversal of existing doctrine.

For readers persuaded by Eisenberg, or at least interested in seeing his ideas play out, the book's only major flaw is likely to be its length: It is too short. For example, I would have been interested in Eisenberg's view of the claim that efficiency is the sole acceptable and/or the prevailing norm in common law adjudication. Perhaps the most glaring omission, however, is Eisenberg's failure to discuss in more detail the relationship of statutory interpretation to common law adjudication. Nonetheless, it belongs in every common lawyer's library.

Peter Ackroyd, The Life of Thomas More

As a lawyer and Catholic convert, Thomas More is my patron saint and one of my heroes. As anyone who has read or seen "A Man for All Seasons" knows, More was martyred by Henry VIII for refusing to support the English Reformation. More's critics delight in the supposed irony that More was executed for his beliefs in the same way as certain Protestants were executed on More's orders when he was Chancellor of England. In the modern age, when toleration is regarded as the chief virtue, More's stance is easy to dismiss as illiberal and medieval. Yet, to his credit, in this important biography of More, Peter Ackroyd does not fall into the modernist trap. Historical figures must be judged by reference to the standards of their day and the "permanent things," but not by modern sensibilities. Ackroyd therefore presents More as a man of his times. It was a complex time amd More was a complex man.

I honestly wish I liked this biography better. I find Ackroyd's prose to be dense and heavy going. Especially annoying is his frequent use of quotations that he fails to render in modern English. Fifteenth century English is almost a different language than 21st century English and many of the quotations arealmost unintelligible. Granted, a scholarly work of history should not take liberties with translation. But this is a narrative history for a generalist audience, which appropriately has laxer standards.Having said that, I still recommend Ackroyd's biography and am very glad I finally finished it. One comes away impressed with More's humanity, and inspired by his example. More had flaws beyond his supposed intolerance...as Ackroyd demonstrates, for example, More loved bawdy humor. Yet, when push came to shove, More demonstrated great moral courage. It is an inspiring story. I just wish it were told better.

How many spaces after a full stop?

A colleague sent around the following email, which prompted some thoughts about writing style that segued into the hot topic du jour:

I was taught as a young dude that there should be *two* spaces following a period that concludes a sentence (prior to beginning a new sentence in the same paragraph). For some reason, the advent of word processors (and perhaps a mania for saving space on the page) has led some people to advocate the reduction of this number to *one* space. I find this unsightly (if not unseemly) and cannot bring myself to break the habit of following the period with two spaces. Is there a consensus on which is the proper style?

The Chicago Manual of Style's website relates:

The view at CMS is that there is no reason for two spaces after a period in published work. Some people, however—my colleagues included—prefer it, relegating this preference to their personal correspondence and notes. I’ve noticed in old American books printed in the few decades before and after the turn of the last century (ca. 1870–1930 at least) that there seemed to be a trend in publishing to use extra space (sometimes quite a bit of it) after periods. And many people were taught to use that extra space in typing class (I was). But introducing two spaces after the period causes problems: (1) it is inefficient, requiring an extra keystroke for every sentence; (2) even if a program is set to automatically put an extra space after a period, such automation is never foolproof; (3) there is no proof that an extra space actually improves readability—as your comment suggests, it’s probably just a matter of familiarity (Who knows? perhaps it’s actually more efficient to read with less regard for sentences as individual units of thought—many centuries ago, for example in ancient Greece, there were no spaces even between words, and no punctuation); (4) two spaces are harder to control for than one in electronic documents (I find that the earmark of a document that imposes a two-space rule is a smattering of instances of both three spaces and one space after a period, and two spaces in the middle of sentences); and (5) two spaces can cause problems with line breaks in certain programs.

As both my colleague's email and the CMS commentary suggests, there was a convention back in the manual typewriter days of using two spaces after a full stop, but the advent of wordprocessing seems to have undermined, if not wholly eliminated, that convention. (I note, however, that the rise of hte internet and concomitant HTML style conventions may have been an even more important factor.) John Rhodes reports:

In late September 1998 I asked several people what I thought was a simple typographic question. I was thinking about doing a quick eye tracking study with a colleague and I wondered if there was any empirical research available that showed that a single space after a period was "better" than two spaces, or vice versa.

While this was originally a question about web usability, I realized that the spacing issue is basically irrelevant! Steve Outing of Planetary News correctly pointed out that almost all browsers will only render one space after the period, regardless of how many spaces you put into the HTML code. Note however, that spaces can be hard-coded into the HTML using " ". ...

One of the next things I realized is that, in general, the spacing after a period will be irrelevant since most fonts used today are proportional. That is, each character is not the same size. Amy Gahran of Contentious kindly indicated that very few monospaced (i.e., non-proportional) fonts are used today on the Internet, except for perhaps Courier. This is generally the case offline as well. Proportional fonts are used much more often. For your information, I did not get any good feedback about the various fonts that are used for other Internet applications and activities, such as chat rooms and email. My guess is that they are mostly monospaced, but it is just a guess.

Like Amy Gahran, Kathy Gill told me that the current typographic standard for a single space after the period is a reflection of the power of proportionally spaced fonts.

"The only reason that two spaces were used after a period during the 'typewriter' age was because original typewriters had monospaced fonts -- the extra space was needed for the eye to pick up on the beginning of a new sentence. That need is negated w/proportional space type, hence [it is] the typographic standard."

While I'm on the topic, here's what one of the folks at The Design & Publishing Center had to say about the history of typographic spacing: "In the days of typewriter manuscripts the extra space was necessary to separate the ends and beginnings of sentences. The space character never changed. With the advent of electronic typesetting, the software attempts to 'fit' the type to specific line lengths, it both expands or contracts the available space to make the type fit. Word spacing is where most of this space 'play' takes place."

The relevance to Ra^thergate is self-evident. In all the reporting on the Killian memos, however, I have yet to see any reportage on the number of spaces following the full stops. Has anybody tried to figure out whether there are one or two? If so, email me and I'll post a link. Update: Steve Minor says there are two spaces!

Director independence

I just ran across a very interesting paper by a couple of Swedish economists, Board Independence and Product Market Competition in Swedish Firms, in which they conclude:

This study suggests that firms in highly competitive industries should have fewer outside board members, whereas companies operating in less competitive industries should have more outside directors. Specifically, we argue that board independence is less relevant or even redundant in highly competitive industries, where the firm is already monitored by a competitive product market. Using publicly traded Swedish firms for empirical testing, this study finds that board independence reduces firm performance in industries with highly competitive product markets. On the other hand, board independence enhances firm performance among companies facing less competitive product markets.

I don't know enough about the Swedish economy to predict with complete confidence that the same result would hold in the US, but it wouldn't surprise me a bit. Independent directors are not the sole mechanism by which management’s performance is monitored. Rather, a variety of forces work together to constrain management’s incentive to shirk: the capital and product markets within which the firm functions; the internal and external markets for managerial services; the market for corporate control; incentive compensation systems; auditing by outside accountants; and many others. The importance of the independent directors’ monitoring role in a given firm depends in large measure on the extent to which these other forces are allowed to function. For example, managers of a firm with strong takeover defenses are less subject to the constraining influence of the market for corporate control than are those of a firm with no takeover defenses. The former needs a strong independent board more than the latter does. Hence, I'm inclined to file this one away as another data point supporting my view that government-mandated one-size-fits-all rules requiring firms to have specific numbers of independent directors and to put them in specific roles are bad public policy. (See, e.g., A Critique of the NYSE's Director Independence Listing Standards.)

The corporation as lobster trap

The lobster trap is a useful metaphor for many legal regimes. A real lobster trap is easy to get into, but very difficult to exit. There is an emerging consensus amongst corporate governance theorists that the lobster trap aptly describes an important aspects of the corporation; namely, the ease with which investors can out equity into the firm but the difficulty with which they can get it out. My friend and UCLA colleague Lynn Stout has just posted to SSRN an accessible and fairly short essay exploring these ideas:

ABSTRACT: Legal experts traditionally distinguish corporations from unincorporated business forms by focusing on such corporate characteristics as limited shareholder liability, centralized management, perpetual life, and freely transferred shares. While this approach has value, this essay argues that the nature of the corporation can be better understood by focusing on a fifth, often-overlooked, characteristic of corporations: their capacity to lock in equity investors' initial capital contributions by making it far more difficult for those investors to subsequently withdraw assets from the firm. Like a tar pit, a corporation is much easier for equity investors to get into, than to get out of.

An emerging school of theorists has begun to explore the implications of this idea for corporate law and practice. The idea is still novel enough to lack a uniformly-accepted label - in addition to the phrase capital lock-in, scholars have described this aspect of incorporation as affirmative asset partitioning, the absence of a repurchase condition, and asset separation from shareholders. Whatever label one chooses, the idea shows great promise for illuminating a variety of thorny problems that have long troubled corporate scholars and practitioners.

In illustration, this essay considers how the idea of capital lock-in sheds light on three corporate mysteries: the sui generis nature of corporate directors' fiduciary duties; the rise of the large modern service partnership; and lawmakers' enthusiasm for meddling with corporate governance rules.

Could Shareholders Sue CBS Over the Forgery?

Glenn Reynolds sent along what I assume is an email from one of his readers re the CBS forgery story:

The officers and directors of CBS have fiduciary duties to the shareholders of CBS. Likewise the officers and directors of CBS's corporate owners have fiduciary duties to the shareholders of their companies. I.e., at some point their personal assets will be on the line for this. Additionally a stockholders' derivative action might now be feasible.

I'm as annoyed/amused as anybody by the forgery story (see, e.g., this post). So I hate to throw cold water on Glenn's reader's idea, but there is zero - nada, zilch - chance a shareholder derivative suit over the forgery story would succeed. (The following is adapted from the chapter on shareholder litigation in my treatise Corporation Law and Economics.)

First, any shareholder suit would have to be brought as a derivative one on behalf of the corporate entity rather than a direct shareholder class action. “Direct” shareholder suits arise out of causes of action belonging to the shareholders in their individual capacity. It is typically premised on an injury directly affecting the shareholders and must be brought by the shareholders in their own name. In contrast, a “derivative” suit is one brought by the shareholder on behalf of the corporation. The cause of action belongs to the corporation as an entity and arises out of an injury done to the corporation as an entity. The shareholder is merely acting as the firm’s representative. The basic tests are: (1) Who suffered the most immediate and direct injury? The shareholder or the corporation? Note that it is not enough for a shareholder to allege that the challenged conduct resulted in a drop in the corporation’s stock market price. (2) To whom did the defendant’s duty run? The shareholder or the corporation? As employees of CBS, Dan Rather and his fellow journalists owe a duty to the entity but owe no relevant duties directly to the shareholders thereof. In addition, to the extent the shareholders of CBS are injured, it will be a result of the prior injury Rather did to the corporate entity's reputation.

Second, because the suit must be brought derivatively, a shareholder-plaintiff will run into procedural barriers that likely will be insurmountable on these facts. Because the derivative suit is premised on a cause of action belonging to the corporation, one might assume that the corporation would simply bring the lawsuit itself. Derivative suits in fact are relatively rare; most corporate lawsuits are brought by the entity, rather than its shareholders. The derivative suit, of course, was devised so as to permit shareholders to seek relief on behalf of the firm in those cases where the corporation’s management for some reason elected not to pursue the claim. Logically, however, it would seem that the corporation should be given an opportunity to decide whether to bring suit before a shareholder is allowed to file a derivative suit. Accordingly, Federal Rule 23.1 provides that shareholders may not bring suit unless they first make demand on the board of directors or demand is excused.

Although the demand requirement looks like a mere procedural formality, it has evolved into the central substantive rule of derivative litigation. The foundational question in derivative litigation is the extent to which the corporation, acting through the board of directors or a committee thereof, is permitted to prevent or terminate a derivative action. Put another way, who gets to control the litigation—the shareholder or the corporation’s board of directors? Curiously, the answer to that question depends mainly on the procedural posture of the particular case with respect to the demand requirement.

New York and Delaware both require demand in all cases except those in which it is excused on grounds of futility. In the seminal Aronson v. Lewis decision, the Delaware supreme court set forth the following test for demand futility:

[T]he Court of Chancery in the proper exercise of its discretion must decide whether, under the particularized facts alleged, a reasonable doubt is created that: the directors are (1) disinterested and (2) independent and (3) the challenged transaction was otherwise the product of a valid exercise of business judgment.

The third prong will fall out in this case. The Delaware supreme court in Rales v. Blasband held that where the litigation, inter alia, arises out of some transaction or event not involving a business decision by the board (as this one would) only the first two Aronson prongs are in play: "a court must determine whether or not the particularized factual allegations of a derivative stockholder complaint create a reasonable doubt that, as of the time the complaint is filed, the board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand."

As to the first prong, directors are interested if they have a personal financial stake in the challenged transaction or otherwise would be materially affected by the board’s actions. The prospect of being sued is not enough; rather, there must be a financial interest in the underlying transaction. Obviously, this basis for excusing demand is irrelevant in this case. There's no way any of the directors have a direct, pre-existing financial stake in this story.

Under the second prong, the key doctrinal question is whether the directors can base their judgment on the merits rather than on extraneous considerations. Again, demand is not excused simply because the plaintiff has named a majority of the board as defendants. Indeed, it is not enough even to allege that a majority of the board approved of, acquiesced in, or participated in the challenged transaction. In other words, merely being named as defendants or participants does not render the board incapable, as a matter of law, of objectively evaluating a pre-suit demand and, accordingly, does not excuse such a demand. Instead, demand typically will be excused under this prong only if a majority of the board was dominated or controlled by someone with a personal financial stake in the transaction. Directors whose independence is compromised by undue influences exerted by interested parties are presumed, as a matter of law, of being incapable of exercising valid business judgment. Again, I can't see demand being excused under this prong. The board simply wasn't involved, as far as we now know.

Let us assume for sake of argument that Rather and his fellow journalists were grossly negligent in running the story. Because there is no evidence that CBS' board of directors were involved in any way in the decision to run the story, the shareholder will be unable to satisfy the Aronson standard for demand futility. Accordingly, the shareholder will have to make demand on the board that they sue Rather before the shareholder would be allowed to sue. (If the shareholder files the lawsuit without first making demand, the court would stay the litigation and require the shareholder to make demand.)

Where the shareholder makes demand, either pre-suit or after a judicial determination that demand was required, the board is expected to undertake a two-step process. The board must first inform itself of the relevant facts relating to the challenged transaction or other alleged wrongdoing, as well as the legal and business considerations attendant to resolving the matter. Any factual investigation must be reasonable and conducted in good faith, but within those parameters the board has great discretion. Having done so, the board must elect amongst the three principal alternatives available to it: (1) accepting the demand and prosecuting the action; (2) resolving the matter internally without resort to litigation; or (3) refusing the demand.

If the board accepts the demand and then attempts to resolve the matter through a settlement of the derivative claim with the shareholder-plaintiff, the parties must comply with the judicial approval requirement of Federal Rule 23.1 or its relevant state counterpart. Suppose, however, that the corporation resolves the matter through a settlement with the alleged wrongdoers. In that case, the judicial approval requirement under Federal Rule 23.1 and its state counterparts does not apply. If the corporation gives the defendants a sweetheart deal, of course, the shareholder-plaintiff could initiate a new derivative suit for “fraud or waste in releasing corporate claims for inadequate payment.” Presumably the same would be true if the corporation accepted demand but then lost the case due to a failure to vigorously prosecute it.

Anecdotal evidence strongly suggests that the board’s typical response, however, is to refuse the demand. If the board does so, the shareholder may seek judicial review of that refusal, but the plaintiff bears the burden of proving that the refusal was wrongful. Worse yet, at least from plaintiff’s perspective, the relevant standard of review is the business judgment rule. Worst of all, again from plaintiff’s perspective, plaintiff is not entitled to discovery.

Some suggest that the wrongful refusal inquiry should be directed at the business judgment rule’s applicability to the underlying challenged transaction where that transaction “was approved by the same directors who are reviewing the plaintiff’s demand.” In Grimes v. Donald, however, the Delaware supreme court made clear that the inquiry is directed to whether “the board in fact acted independently, disinterestedly, or with due care in response to the demand.” Note the potential for even a clear case of self-dealing, such as an interested director transaction, to be immune from challenge through a derivative suit so long as a majority of the board was not involved. A disinterested and independent majority of the board is deemed capable of deciding whether to refuse demand, at least where the decision does not involve fraud, illegality or self-dealing on the part of a majority of the board. A demand refusal by such a board will be protected by the business judgment rule.

So now we see the bottom line. If a shareholder sues CBS over Rather's conduct, the suit will be derivative. Demand will be required. The board of directors will refuse demand. The business judgment rule will insulate the board's decision. So the lawsuit will be dismissed. I guarantee it.

Some readers doubtless will be outraged by this result. But there are good and sufficient reasons for courts to defer to the board's judgment in these cases. If you want to know why, however, you'll have to buy the book.