Professor Bainbridge...on law, politics, religion, culture & food

The Passivity of Institutional Investors

Megan McArdle:

I wish someone had a better answer to the question of why large institutional investors aren’t more active in corporate governance.

I’m not entirely sure what she means by “better” answer, but there is a clear answer. I argued in Shareholder Activism and Institutional Investors that:

… institutional investor activism is rare and limited primarily to union and state or local public employee pensions. As a result, institutional investor activism has not - and cannot - prove a panacea for the pathologies of corporate governance. Activist investors pursue agendas not shared by and often in conflict with those of passive investors. Activism by investors undermines the role of the board of directors as a central decision-making body, thereby making corporate governance less effective. Finally, relying on activist institutional investors will not solve the principal-agent problem inherent in corporate governance but rather will merely shift the locus of that problem.

Specifically, I explained that:

Most institutional investors compete to attract either the savings of small investors or the patronage of large sponsors, such as corporate pension plans. In this competition, the winners generally are those with the best relative performance rates, which makes institutions highly cost-conscious.  Given that activism will only rarely produce gains, and that when such gains occur they will be dispensed upon both the active and the passive, it makes little sense for cost-conscious money managers to incur the expense entailed in shareholder activism. Instead, they will remain passive in hopes of free riding on someone else’s activism. As in other free riding situations, because everyone is subject to and likely to yield to this temptation, the probability is that the good in question—here shareholder activism—will be under-produced.

In addition, corporate managers are well-positioned to buy off most institutional investors that attempt to act as monitors. Bank trust departments are an important class of institutional investors, but are unlikely to emerge as activists because their parent banks often have or anticipate commercial lending relationships with the firms they will purportedly monitor. Similarly, insurers “as purveyors of insurance products, pension plans, and other financial services to corporations, have reason to mute their corporate governance activities and be bought off.” Mutual fund families whose business includes managing private pension funds for corporations are subject to the same concern.

This leaves us with union and state and local pension funds, which in fact generally have been the most active institutions with respect to corporate governance issues.  Unfortunately for the proponents of institutional investor activism, however, these are precisely the institutions most likely to use their position to self-deal—i.e., to take a non-pro rata share of the firms assets and earnings—or to otherwise reap private benefits not shared with other investors.

Put bluntly, passivity is inherent in the nature of the beast.

The Derminants of CEO Pay

Megan McArdle reviews the Logic of Life, by Tim Harford, focusing on the chapter dealing with CEO pay. She concisely tackles tournament theory, management power, and outrage as prime determinants of CEO pay. For my take, see Executive Compensation: Who Decides?

Defective Stock Issuances Under Delaware Law

Stephen Bigler and Seth Tillman have posted a new article, Void or Voidable?—Curing Defects in Stock Issuances Under Delaware Law:

It is not unusual for practitioners reviewing a Delaware corporation’s stock records to find omissions or procedural defects raising questions as to the valid authorization of some of the outstanding stock. Examples of such omissions and defects are limitless, but not infrequently found examples include the absence of board resolutions authorizing the issuance of stock shown by the transfer books as having been issued, the absence of evidence that issuances were properly authorized by the requisite votes of the board or, if required, by the stockholders, the absence of evidence that the consideration to have been received by the corporation in exchange for the stock was in fact received, the issuance of more shares than were authorized by the certificate of incorporation at the time, the issuance of stock prior to the filing of the charter amendment or certificate of designations authorizing or creating the stock, and similar procedural and substantive irregularities. Not infrequently, these defects occurred some time ago, and the stock in question may have changed hands multiple times since issuance.

They analyze how most lawyers would respond to these problems and suggest a statutory fix.

UCLA Gets $1.5 Million for Entertainment Law Chair

UCLA announces:

The UCLA School of Law has received a $1.5 million commitment from the Shapiro Family Charitable Foundation to establish the Pete Kameron Endowed Chair in Law in honor of the long and distinguished career of Pete Kameron, a philanthropist and legendary music industry figure.

The chair will be awarded to a legal scholar of the highest academic and professional caliber whose work addresses issues that have an impact on, or are related to, music, entertainment or intellectual property law.

It’ll be tough to choose someone to hold the chair, because we are blessed with a number of faculty members who are highly qualified scholars in those fields. 

The Newest Corporate Governance Blogger is….

... Carl Icahn. The Icahn Report’s website is up, but no blog posts yet.

Section 16(b) Quiz

I gave this to my class today as an exercise:

1. Shania is president of Acme, Inc. Her transactions were as follows:

• March 1: bought 100 shares at $10


• April 1: sold 70 shares at $12


• May 1: bought 50 shares on May 1 at $9


• May 15: sold 25 shares at $13


• December 31: sold 35 shares at $20

What liability does she have, if any?

2. Selena is not an officer or director of Ajax, Inc. At all relevant times, Ajax has 1,000 shares outstanding. Selena’s transactions are as follows:

• January 1: buys 50 shares at $10


• February 1: buys 55 shares at $10


• April 1: buys 50 shares at $10.


• May 1: sells 60 shares at $15


• May 2: sells 55 shares at $20

What liability does she have, if any?

ABA Stoneridge Panel

This Friday at the ABA mid-year meeting here in Los Angeles, there will be a panel on the Stoneridge case, in which yours truly will be participating. The program is free to area law students and mine are encouraged to attend. The program registration form is here. The program description follows:

Argued before the Supreme Court on October 9, 2007, by panelist Stanley M. Grossman, the case of Stoneridge Investment Partners v. Scientific-Atlanta is viewed by many securities law experts as a potential watershed that may significantly expand investor rights.

Specifically, the case deals with the question of whether there exists an implied private right of action against third parties for primary liability in connection with a fraud under Sec. 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5. One of the major issues the panel will discuss is the scope of impl! ied private rights of action. These judicially created actions are not limited to securities law. They are found in other substantive areas of administrative law such as Title IX (education), the FCC, and various civil rights statutes. Whether courts should continue to imply private rights of action at all is something one of the Justices commented on during the Stoneridge oral argument. The plaintiffs in Stoneridge have argued that the law permits it to sue actors who participate in a fraudulent scheme, not as aiders or abettors, but as “primary violators” who are ultimately tied to market movements. The defendants have countered that the law reaches only those who make deceptive communications to shareholders or engage in fraudulent trading on the market.

All of the panelists below have either written, or participated in, the writing of the briefs filed with the Supreme Court in this case.

Panelists:

Stephen Bainbridge, Professor, UCLA Law School, Los Angeles, CA

Robert R. Gasaway, Partner, Kirkland & Ellis LLP, Washington, D.C.

Stanley M. Grossman, Partner, Pomerantz Haudek, New York, NY

Thomas Karr, Assistant General Counsel, Securities and Exchange Commission,
Washington, D.C.

Behavioral Economics and Regulation

Dealbreaker.com:

… calls for additional regulation often depend on a double standard under which market process are characterized by imperfect information and dominated by self-interest while regulatory processes are somehow viewed as well-informed and public-minded. Why are people so attracted to regulatory solutions when despite the lack of evidence for concrete benefits?

David Hirshleifer has a delightful paper that sees through one prominent anti-market double standard and suggests an answer—several in fact—about why regulation is unduly attractive. His approach is simple. He points out that the findings of behavioral psychology—that people are often irrational, biased and ill-informed—apply to regulators as well as investors and consumers.

“The psychological attraction theory of regulation holds that regulation is the result of psychological biases on the part of political participants and regulators, and the evolution of regulatory ideologies that exploit these biases,” he writes.

The cumulative effect of these biases is overregulation. “[Since the universe of possible tempting regulations is unlimited, the theory predicts a general tendency for overregulation, and for rules to accrete over time like barnacles, impeding economic progress. The theory also predicts occasional drastic increases in regulation in response to market downturns or disruption.”

You can download the paper here. (Hat tip to Ribstein.)

Not to pat myself on the back or anything, but in Mandatory Disclosure: A Behavioral Analysis, 68 University of Cincinnati Law Review 1023 (2000), I wrote that:

Assume arguendo that capital markets fail to produce optimal disclosure through voluntary corporate action. The mere existence of such a market failure does not—standing alone—justify legal intervention. In addition to the standard prudential arguments in favor of limited government, which counsel caution in concluding that a purported market failure requires government correction, behavioral economics itself argues against presuming the desirability of intervention:

Proposals designed to address biases generally entail the intervention of judges, legislators, or bureaucrats who are [themselves] subject to various biases. The very power of the behavioralist critique—that even educated people exhibit certain biases—thus undercuts efforts to redress such biases. In addition, the decisions of government actors also may be adversely influenced by political concerns—specifically interest group politics. Thus interventions to “cure” bias-induced inefficiency may ultimately produce outcomes that are worse than the problem itself.

In other words, the claim that law can correct market failures caused by decisionmaking biases or cognitive errors treats regulators as exogenous to the system. Once the state is endogenized, however, regulators must be treated as actors with their own systematic decisionmaking biases. It thus becomes evident that behavioral economics loops back on itself as a justification for legal intervention.

Having said that, Hirshleifer indeed does a great job of making the point in a way that seems irrefutable.