Author: Kelli Alces


Admitting “Egregious Intentional Conduct”

Last week, new SEC Commissioner Mary Jo White announced that the SEC would start to be more aggressive in some settlement negotiations by requiring companies or individuals to admit fault in order to settle civil cases. She emphasized that the SEC would still allow defendants to “neither admit nor deny” wrongdoing in most settlements, but proposed the change in cases of “egregious intentional conduct or widespread harm to investors.” The purpose of the change is to give the public what they apparently crave – an admission of wrongdoing, blame, assurance that the wrongdoer knows what he/she/it did and has been punished.

The new policy brings to mind more questions than answers. Why was the SEC ever allowing defendants to neither admit nor deny in cases of “egregious intentional misconduct”? There are certainly advantages to the “neither admit nor deny” policy. It encourages cooperation from defendants so that the truth will be revealed more quickly and completely. It encourages quick settlements and so avoids litigation costs. Litigating the big cases would be very expensive for everyone involved. Settlement seems much more cost-effective and parties are far more willing to settle if they do not have to admit responsibility. Still, when the SEC has significant evidence of “egregious intentional conduct or widespread harm to investors” and allows the responsible parties to pay a fine (really, allowing the corporation to pay a fine) without so much as admitting responsibility, it is hard to take its role as a law enforcement agency seriously.

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Questioning Performance Pay

Performance pay is tricky. At a very basic level, it challenges the notion that corporate managers, as fiduciaries of the firm, should “renounce all thought of self” as it places their self-interest at the forefront of the decisions they make on behalf of the corporation. Performance pay is designed with the hope that it will align those managers’ personal interest with the goal of shareholder wealth maximization as we concede that we cannot simply trust managers to selflessly pursue the interests of others. Indeed, it may do more harm than good to the extent it gives managers both the permission and the means necessary to profit personally from corporate success without suffering in the face of corporate failure.

Last week, at the National Business Law Scholars’ Conference in Columbus, Ohio, I heard Michael Dorff present his book, Indispensable and Other Myths: The True Story of CEO Pay, forthcoming from the University of California Press this spring. In it, he argues that performance pay for CEOs is not effective to enhance firms’ values. This is true, he claims, in part because CEOs generally do not strongly influence corporate return and in part because performance pay is not effective to improve the performance of creative or analytical tasks, that is, exactly the kinds of tasks we expect CEOs to carry out. He cites numerous empirical and psychological studies to support his thesis that performance pay is ineffective at best and harmful at worst.

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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.



Could There Be More Berkshire Hathaways?

Berkshire Hathaway is a hybrid between an investment firm and an operating company, akin to a publicly traded partnership that actively owns operating companies.  Berkshire’s management, guided by Warren Buffett and Charlie Munger, chooses a diverse portfolio of firms to invest in, then monitors those firms as an active, attentive owner would.  Berkshire shareholders are treated as co-owners of the firm and managers of subsidiaries are expected to act as though they were the sole owners of their divisions.  Everyone is expected to have a long-term time horizon.  Everyone is expected to pay attention. 

Despite being operated very differently from most modern, publicly traded corporations, Berkshire Hathaway is remarkably successful.  Some might attribute the firm’s great success to the particular business acumen of Buffett and Munger.  Others might attribute it to the fact that the firm is run by its controlling shareholders.  In letters to shareholders, edited by Larry Cunningham into essays in The Essays of Warren Buffett: Lessons for Corporate America, Buffett himself attributes the firm’s success to a number of his business philosophies that define every part of Berkshire’s operations from executive compensation to corporate charitable giving to bookkeeping and communication with shareholders.

In light of the tremendous success of Berkshire Hathaway as a whole, and its various subsidiaries individually, I have often wondered why there are not more firms like it.  Of course, there is only one Warren Buffett, a point Berkshire shareholders apparently make every year at the annual meeting.  But why are more firms not adopting Buffett’s business philosophies and strategies?  Berkshire might provide a model for investment firms trying to build a diverse portfolio of firms to offer their investors.  It may also teach institutional shareholders how to monitor the managers of the firms in which they have invested.  Officers and directors could learn how they should operate a firm for long-term success and how managers should be compensated to encourage optimum performance without giving them perverse incentives. Read More


Short-termism: Fact or Fiction?

Last week, I wrote about Lynn Stout’s new book, The Shareholder Value Myth, and her argument that shareholder value maximization should not be the goal of managers in corporate decision making, nor should it be the purpose of corporate operations. In the book, and in her presentation last week, Stout seemed particularly concerned that managers of public companies seem to manage firms with an eye to current stock price and so may take action to increase earnings in the short term at the expense of long term viability. For example, a firm might not invest in research and development in order to keep the cash on the books and enhance current share price without having to take the risk that a long term investment in innovation might not work out. More perniciously, managers may manipulate financial reports in order to boost current stock price in the hopes that next quarter’s numbers will take care of themselves somehow.

If these short-termist tendencies were a pervasive problem, that would be troubling indeed. In some ways, evidence of short-termism seems to be all around. Executives are paid handsomely in the form of stock option awards that allow them to capitalize on sharp increases in stock price. If stock price falls shortly after the executive exercises her options, the executive does not have to disgorge her gain. Executives are under constant pressure to “meet expectations” and the average CEO tenure is relatively short (less than seven years, according to Steven Kaplan & Bernadette Minton). A CEO could well drive up the stock price of one company with a creative display of smoke and mirrors and move on to her next employer before the first one tanks from her failure to plan for its future. If public corporations were being run to seem to flourish today while disaster lurks next year, then our economy would suffer greatly.

Many blame executive compensation, particularly compensation with stock options, for managers’ seeming short-term focus on daily stock prices. (On the other hand, Gregg Polsky and Andrew Lund have argued that incentive compensation may not matter much, given the other incentives managers have to abide by shareholders’ wishes.) Stock options not only focus managers’ attention on stock prices, but they also have the effect of increasing managers’ appetite for corporate risk-taking. Options give managers an incentive to take big risks in the hopes of big returns as they are insulated from losses. Stout pointed out that current executive compensation schemes tie managers’ interests to those of well-diversified shareholders (which is exactly what they were designed to do), and that connection is harmful because if no one has an interest in the corporation’s long-term viability, companies will fail frequently and spectacularly and impose significant social costs in doing so. A well-diversified shareholder can diversify away firm-specific risk, so is not vulnerable to the risk of loss associated with any one firm, but society suffers if public corporations are driven to insolvency by greedy short-term shareholders. With bubbles bursting all around us, how can one argue that short-termism is not a problem?

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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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