Category: Corporate Finance

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Brian Tamanaha’s Straw Men (Overview)

(Cross posted from Brian Leiter’s Law School Reports)

Brian Tamanaha previously told Inside Higher Education that our research only looked at average earnings premiums and did not consider the low end of the distribution.  Dylan Matthews at the Washington Post reported that Professor Tamanaha’s description of our research was “false”. 

In his latest post, Professor Tamanaha combines interesting critiques with some not very interesting errors and claims that are not supported by data.   Responding to his blog post is a little tricky as his ongoing edits rendered it something of a moving target.  While we’re happy with improvements, a PDF of the version to which we are responding is available here just so we all know what page we’re on.

Stephen Diamond explains why Tamanaha apparently changed his post: Ted Seto and Eric Rasmusen expressed concerns about Tamanaha’s use of ad hominem attacks.

Some of Tamanaha’s new errors are surprising, because they come after an email exchange with him in which we addressed them.  For example, Tamanaha’s description of our approach to ability sorting constitutes a gross misreading of our research.  Tamanaha also references the wrong chart for earnings premium trends and misinterprets confidence intervals.  And his description of our present value calculations is way off the mark.

Here are some quick bullet point responses, with details below in subsequent posts:

  • Forecasting and Backfilling
    • Using more historical data from SIPP would likely have introduced continuity and other methodological problems
    • Using more years of data is as likely to increase the historical earnings premium as to reduce it
    • If pre-1996 historical data finds lower earnings premiums, that may suggest a long term upward trend and could mean that our estimates of flat future earnings premiums are too conservative and the premium estimates should be higher
    • The earnings premium in the future is just as likely to be higher as it is to be lower than it was in 1996-2011
    • In the future, the earnings premium would have to be lower by **85 percent** for an investment in law school to destroy economic value at the median
  • Data sufficiency
    • 16 years of data is more than is used in similar studies to establish a baseline.  This includes studies Tamanaha cited and praised in his book.
    • Our data includes both peaks and troughs in the cycle.  Across the cycle, law graduates earn substantially more than bachelor’s.
  • Tamanaha’s errors and misreading
    • We control for ability sorting and selection using extensive controls for socio-economic, academic, and demographic characteristics
    • This substantially reduces our earnings premium estimates
    • Any lingering ability sorting and selection is likely offset by response bias in SIPP, topcoding, and other problems that cut in the opposite direction
    • Tamanaha references the wrong chart for earnings premium trends and misinterprets confidence intervals
    • Tamanaha is confused about present value, opportunity cost, and discounting
    • Our in-school earnings are based on data, but, in any event, “correcting” to zero would not meaningfully change our conclusions
  • Tamanaha’s best line
    • “Let me also confirm that [Simkovic & McIntyre’s] study is far more sophisticated than my admittedly crude efforts.”

Big Rig? Libor & Beyond

BankstersTo inaugurate a series of posts about scandals and crime in the financial sector, I wanted to highlight John Lanchester’s work in the London Review of Books on “banks’ barely believable behaviour.” He mentions the still unwinding Libor scandal up front:

Libor is the single most important number in international financial markets, used as a reference point throughout the global financial system. It is a range of interbank lending rates, set after consultation between the British Bankers’ Association and two hundred and fifty-odd participating banks. During the daily process, each bank is asked the rate at which it could borrow money from other banks, ‘unsecured’ i.e. backed only by its own creditworthiness rather than by specific collateral. The question is, in effect: what would your credit be like today, if you had to ask? . . . .

It seems bizarre that something so central to the global markets – $360 trillion of deals are pinned to Libor – should have such a strong element of invention or guesswork. The potential for abuse is immediately apparent. As Donald MacKenzie prophetically said, ‘the obvious risk to the integrity of the calculation is that a bank on a Libor panel might make a manipulative input, trying to move Libor up or down so as to influence interest rates or the value of its swaps portfolio.’ Surprise! After the crisis, when investigators were taking an energetic interest in Libor, it turned out that that was exactly what had been happening, not just at one or two banks but across an entire swath of the industry.

Lanchester only brings up LIBOR as the opening act for what he considers a far deeper scandal in Britain—PPI. And guess what—it’s not just LIBOR where we’re seeing these concerns about privileged access to information turning into profit. Here are some other “rigging” scandals of recent vintage:
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Warren Buffett’s Single Bid Rule

Among the many ways that Warren Buffett is unusual is his approach to the role of price in business acquisition negotiations. Other people commonly haggle over price. Tactics include sellers naming an asking price that is higher than warranted or buyers making a low-ball bid. Some people enjoy the give and take and many believe it is a way to produce value in exchange.

Buffett eschews such exercises as a waste of time. One of Berkshire’s acquisition criteria (in addition to size, proven earnings power, quality management in place and relative simplicity of the business) is having a price. Eschewing the games so many negotiators like to play over ranges of values, Buffett wants a single price at which each side can say yes—or walk away. His bid is his bid; when he gives you a bid, what you have is what most people classify as the “best price,” “final offer,” or “highest bid.”

Buffett has repeatedly statesd this policy, along with the other acquisition criteria, in every Berkshire Hathaway annual report since 1983 (and once in a 1986 ad in the Wall Street Journal). Yet I know many people who are skeptical about whether Buffett and Berkshire actually adhere to this policy—doesn’t he engage in price negotiations in at least some cases, they ask? Aren’t there situations in which the value of an exchange is not discovered other than through the dynamic of negotiations, including about appropriate methodology?

To answer such questions, I examined the 16 Berkshire Hathaway acquisitions over the past two decades that involved public company targets. Unlike private company targets, those companies are required by U.S. federal law to publicly disclose the background of the transaction, including negotiation over all material terms, such as price. Read More

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Legal Diversification

I’ve just posted my latest paper, Legal Diversification, on SSRN. The paper starts from the premise that investors derive significant protection from the risks of capital investment by diversifying their holdings. By the same token, it seems to me that investors may be able to realize benefits from the broad diversity of corporate and securities laws governing investment opportunities.

The Essay introduces a new dimension of diversification for investors: legal diversification. Legal diversification of investment means building a portfolio of securities that are governed by a variety of legal rules. Legal diversification protects investors from the risk that a particular method of minimizing agency costs will prove ineffective and allows investors to own securities in a variety of firms, with each security governed by the most efficient set of legal rules given the circumstances of the investment. Diversification of investment by legal rules is possible because of the varied menu of legal rules firms can choose from when organizing and raising capital. The most recent addition to the securities laws, the JOBS Act, may compromise the diversity of legal rules that protects investors by pushing even more firms toward organizing as public corporations, thereby threatening to curtail or eliminate the variety that allows effective diversification.

The Essay makes several contributions to the literature. By introducing legal diversification, it reveals a new understanding of how investors, issuers, and society can benefit from maintaining a variety of legal rules to govern investment in businesses. The corporate law scholarship has long advocated preserving a variety of rules under which firms can organize, but it has yet to consider how investors can take advantage of that variety to protect themselves before market competition has revealed the “best” rules. Legal diversification also complements recent literature emphasizing the importance of diversity in financial regulation by highlighting another reason diversity of legal rules is important to healthy capital markets. Legal diversification fills gaps in the literature advocating regulatory diversity by offering an explanation for why that diversity is a valuable protection for investors and an indispensable mechanism for allowing firms to choose the most efficient legal rules to govern their organization and operation.

I’m still working on editing the draft, so would greatly appreciate any thoughts or comments you may have on the project.

 

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Debating “The Shareholder Value Myth”

Many thanks to Larry and the Concurring Opinions folks for inviting me to blog this month. This is my first time blogging and I’m glad to finally try it out.

On Wednesday, I attended an event promoting Lynn Stout’s book The Shareholder Value Myth, sponsored by the Federalist Society and the American Enterprise Institute. The event was structured as a debate of Stout’s thesis with Jonathan Macey (who wrote this review of the book) taking the opposing position. In her book, Stout argued that the widely accepted norm that corporations are owned by shareholders and exist to maximize shareholder wealth is a destructive myth. Instead, Stout claimed, corporations own themselves and in running corporations, managers can and should pursue any lawful purpose.

It is a real credit to Lynn that there was such a lively, thought-provoking debate about the topic. That corporate managers have an obligation to work on behalf of shareholders to maximize shareholder wealth may be the most basic tenet of corporate law and policy. Options theory aside, many think of shareholders as the “owners” of the corporation and even those who question whether shareholders technically own the corporation do not doubt that the corporation should be operated in such a way as to maximize shareholder value. This unwritten “norm” has dominated corporate law, policy, scholarship, and, indeed, management for a long time (for precisely how long, Stout and Macey disagreed).  It is extremely impressive that Stout has been able to provoke a debate about the viability of this fundamental norm.

Wednesday’s debate was the second time I’d seen Stout present at a Federalist Society event. Both times, she began her presentation by arguing that hers was the truly conservative position. It seems an unlikely claim that surprises the audience given what her conclusions are, but I think it highlights what Stout does so well – she reaches her audience with their priors in mind in order to really draw them into her ideas where they might be tempted to dismiss her arguments out of hand. Her presentation was not about good corporate behavior or environmentalism, themes she touched upon in the book, but rather about how debunking the shareholder value myth would allow corporate law to favor state law over federal regulation, to prefer common law rules to statutory regulation, to enhance private ordering, and to honor the lessons of history.

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Today’s Stock Market Bubble: Mr. Market Is Alive and Still Unwell

The stock market rallies while recession continues to plague America. Chief executives worry, companies hoard cash, uncertainty haunts our banking system. Gas prices are up, GDP growth is down, unemployment is up, government debt and size are up and political leaders do not show the ability to come to grips with any of it.

Yet the Dow Jones Industrial Average, heading for 15,0000, exceeds levels not seen since October 2007, a few months before the current crisis showed up.  Believers in the efficiency of stock markets will take this as a sign of good times ahead, believing that markets reveal better than anything else the truth about business fundamentals.  Skeptics will plan to cite this as the first sign of a bubble.  Which view is the more plausible?

Believers in stock market efficiency buy the revolutionary ideas, hatched during the past 50 years, called modern finance theory.  This elaborate theory boils down to the notion that the best estimate of the value of a stock is its prevailing market price. The practical implication, of course, is that it is a waste of time to study individual investment opportunities in public securities. According to this view, you will do better by randomly selecting a group of stocks for a portfolio by throwing darts at the stock tables than by thinking about whether individual investment opportunities make sense.

Reverence for these ideas is not limited to ivory tower academics, but became standard dogma throughout financial America, from Wall Street to Main Street. Many professionals still believe that stock market prices always accurately reflect fundamental values, that the only risk that matters is the volatility of prices, and that the best way to manage that risk is to invest in a diversified group of stocks.

But a distinguished line of investors stretching back to Ben Graham and forward to Warren Buffett challenges such dogma by logic and experience.  Graham preached, and Buffett has successfully practiced, a different approach. Graham, who taught at Columbia Business School in the 1950s and ran an investment partnership, wrote a number of classic works, including The Intelligent Investor. There Graham argued that price is what you pay and value is what you get. These two things are rarely identical, but most people rarely notice any difference, he believed.

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Call for Papers: National Business Law Scholars Conference

I am delighted to pass along the following notice from the organizers of the National Business Law Scholars Conference.  I’m also honored to report that they have asked me to deliver the keynote at this year’s conference, and I look forward to doing so.  

Deadline Extended to May 31

We have received an enthusiastic response to the Call for Papers for the National Business Law Scholars Conference, scheduled for June 12-13, at The Ohio State University School of Law.  We will have additional openings for anyone who would like to make a presentation but has not yet responded.  Thus, we have extended the deadline to MAY 31st.  See the Call for Papers, re-posted below with the extended deadline date, for details on how to submit:

National Business Law Scholars Conference: Call-for-Papers

The National Business Law Scholars Conference (NBLSC)  will be held on Wednesday, June 12th and Thursday, June 13th at The Ohio State University Michael E. Moritz College of Law in Columbus, Ohio.  This is the fourth annual meeting of the NBLSC, a conference which annually draws together dozens of legal scholars from across the United States and around the world.  We welcome all on-topic submissions and will attempt to provide the opportunity for everyone to actively participate.  Junior scholars and those considering entering the legal academy are especially encouraged to participate.

To submit a presentation, email Professor Eric C. Chaffee at echaffee1@udayton.edu with an abstract or paper by MAY 31, 2013.  Please title the email “NBLSC Submission – {Name}”.  If you would like to attend, but not present, email Professor Chaffee with an email entitled “NBLSC Attendance”.  Please specify in your email whether you are willing to serve as a commentator or moderator.  A conference schedule will be circulated in late May.

Conference Organizers:

Barbara Black (University of Cincinnati)
Eric C. Chaffee (University of Dayton)
Steven M. Davidoff (The Ohio State University)

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Theseus’s Paradox – Form and Substance in Evolving Capital Markets

Living in Beijing underscores the importance of change and adaptation.  There is a noticeable drop in the amount of processed sugar in foods, reflecting local (and healthier) tastes.  Virtually every restaurant delivers, including McDonald’s (which raises the ques­tion, if you’re going to order delivery, why McDonald’s?).  And, most parti­cularly, I recently joined the thousands of Chinese students and pensioners who weave in-and-around traffic on electric battery-powered mopeds.  It is a great way to get around the city (even if some of the pensioners have a tendency to cut you off).

The same focus on change arises in the capital markets.  A person who owns or sells a security is presumed to own or sell the financial risk of that security.  By selling shares, for example, the costs and bene­­­fits of those shares—the rise or fall in share price—are understood to run with the instru­­ments being sold.  Changes in the capital markets, how­­ever, have begun to call that pre­sump­tion into question.  Increasingly, market partici­pants can use new trading methods to sell instru­­­­­ments to one person, but transfer their financial risk to someone else.  The result is greater complexity and new chal­lenges to regulation and the regu­lators.

To what extent should the securities laws adjust to reflect those changes?  The answer largely turns on the question of “identity.”  Moving from modern-day Chinato to ancient Greece, the Greek historian Plutarch identified the question in his story of Theseus, the mythical king of Athens.  For many, Theseus is known for slaying the Mino­taur, a half-man, half-bull monster that devoured children sent to Cretein tribute to King Minos.  According to Plutarch, after Theseus returned to Greece, his boat remained in Athensharbor for centuries as a memo­­rial to his bravery.

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