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

The Grasso Lawsuit’s Demise: Why Don’t Courts Decide Compensation?

Joseph Bachelder offers a detailed and insightful analysis of why Eliot Spitzer’s much ballyhooed excess compensation lawsuit against former NYSE CEO Richard Grasso fizzled in the NY courts. One of his theories takes a deeply Legal Realist approach:

One explanation may lie in the March 2008 downfall of Mr. Spitzer, the initiator of the litigation. His aggressive attacks on financial service companies and executives employed by them, for example, destroyed careers and cost some of those companies dearly. Mr. Spitzer’s personal downfall occurred in March 2008, while governor. No doubt, the continuance of this litigation, in a very troubled economic environment for the country, including financial centers like New York, must have seemed an especially undesirable legal intervention at this particular time.

Another is consistent with judicial review of corporate governance generally:

A second reason for the abrupt dispatch of the Spitzer/Grasso litigation certainly must have been the reluctance of courts to be the arbiters of reasonable compensation. ... Courts do not want to be involved in disputes over the size of pay. They will explain at length why they are unable to arbitrate such disputes based on principles such as those imbedded in the business judgment rule or, as in the Grasso case, based on their interpretation of a statute like the N-PCL. But after all the interpretation and elaboration, the real point seems to be that courts do not like deciding whether the size of executive pay in a particular case is reasonable.

The analogy he draws to the Disney litigation is apt.

Judicial reluctance to review executive pay makes perfect sense. Justice Jackson famously observed of the Supreme Court: “We are not final because we are infallible, but we are infallible only because we are final.” Neither courts nor boards are infallible, but someone must be final. Otherwise we end up with a never ending process of appellate review. The question then is simply who is better suited to be vested with the mantle of infallibility that comes by virtue of being final—directors or judges?

Corporate directors operate within a pervasive web of accountability mechanisms. A very important set of constraints are provided by a competition in a number of markets.  The capital and product markets, the internal and external employment markets, and the market for corporate control all constrain shirking by directors and managers.  Granted, only the most naïve would assume that these markets perfectly constrain director decisionmaking.  It would be equally naïve, however, to ignore the lack of comparable market constraints on judicial decisionmaking. Market forces work an imperfect Darwinian selection on corporate decisionmakers, but no such forces constrain erring judges.  As such, rational shareholders will prefer the risk of director error to that of judicial error. Hence, shareholders will want judges to abstain from reviewing board decisions.

Judicial review also threatens to deter boards from engaging in optimal risk taking. In theory, if judicial decisionmaking could flawlessly sort out sound decisions with unfortunate outcomes from poor decisions, and directors were confident that there was no risk of hindsight-based liability, the case for the business judgment rule would be substantially weaker.  As long as there is some non-zero probability of erroneous second-guessing by judges, however, the threat of liability will skew director decisionmaking away from optimal risk-taking.

The Grasso suit died because it never should have been brought in the first place.

Technology Killed Socrates

Usha Rodrigues notes that the proliferation of laptops in the classroom means that “students inherit “scripts” from prior classes, and thus are primed with the “right answers” to the professor’s questions.” Of course, students with laptops often (depending on the availability of internet or intranet connections, text each other answers.

Increasingly, if you want to stick to the outdated and absurd Socratic method, you not only have to be a pedagogic fogey but a technology luddite.

The Obama-Biden Ticket: Implications for Delaware

David Skeel:

Obama has suggested that he will support more federal regulation of corporations. And he has signaled his support for bankruptcy reform that would allow borrowers to write down the value of their mortgages in bankruptcy. He also has sharply criticized the major bankruptcy reforms passed in 2005, which made bankruptcy more difficult for consumer debtors.

Biden has been on the other side of most of these issues.

As a senator from Delaware, he fiercely protected Delaware’s interest in state rather than federal regulation of corporate law. In bankruptcy, he was a leading Democratic advocate of the 2005 bankruptcy reforms, which were viewed by many as a valentine to the credit card industry, much of which is centered in Delaware. (He did vote in favor of the mortgage write down proposal this spring, but it was a fairly meaningless vote because it was clear the proposal wasn’t going anywhere).

Whose views would be reflected in an Obama presidency? Although Biden can certainly be expected to adjust his perspective to more closely fit Obama’s current positions in business reforms, his voice also could dampen Obama’s enthusiasm for reform during an Obama presidency.

But it’s also possibility that Biden’s presence on the ticket could actually make reform more rather than less likely. As a longtime member of the Judiciary Committee, Biden has almost single-handedly thwarted a number of reform proposals that would have interfered with Delaware’s prominence as a popular destination for corporate bankruptcy filings. He has been similarly effective in protecting Delaware’s other corporate interests. With Biden out of the Senate and no longer principally focused on Delaware voters, that obstacle might be gone. Which could mean more federal intervention in these areas in an Obama presidency.

Marcel Kahan and Ed Rock likewise have argued that:

Delaware is itself interested in limiting federal intrusions into corporate law and Delaware’s interests are influentially represented, among others, by Delaware’s Senator Joseph Biden, one of the most senior Democrats on the Judiciary Committee, through which any major proposal would have to pass. ...

Senator Biden has been able to block the enactment of a 1997 proposal by the National Bankruptcy Review Commission to eliminate state of incorporation as a venue for bankruptcy cases.

Francis Pileggi comments:

U.S. Senator Joe Biden has had a profound and lasting impact on Delaware business litigation at least via his role in the selection of members of the local U.S. District Court (and “Delaware members” of the Third Circuit Court of Appeals), as well as (at least indirectly, one might argue) the selection of judges for the Bankruptcy Court--not to mention his role in federal legislation that increased the number of bankruptcy judges in Delaware, which exceeds the number of active judges on the U.S. District Court bench.

OTOH, I’ve heard from several Delaware lawyers and judges that they don’t trust Biden to protect Delaware’s interests. Thoughts?

The Jerry Seinfeld Precedent

Larry Ribstein has the details of a case in which the court relied on an episode of Seinfeld to resolve a dispute between author Tom Clancy and his ex-wife. The mind boggles.

Independent Contractor or Employee?

In tomorrow’s Business Associations class, we’ll be tackling principal’s liability for torts of an agent. The two key issues, of course, will be master/servant (a.k.a. employer/employee) versus independent contractor; and scope of the employment. As to the former, here’s an Aussie lawyer discussing the issue:

Also of relevance is the music video to Depeche Mode’s 1984(?) single “Master and Servant”:

New Corporate Governance Reviewed

Brett McDonnell has posted a review of my new book, The New Corporate Governance in Theory and Practice. Here’s the abstract:

The New Corporate Governance in Theory and Practice, a new book by Stephen Bainbridge, pulls together the leading arguments for director primacy that Bainbridge has made in a series of articles. In his core argument, Bainbridge uses theoretical work by Kenneth Arrow to explain the attractions of the separation of ownership and control with a centralized hierarchy headed by a board of directors. Bainbridge posits that achieving an optimal tradeoff between authority and accountability is the central problem of corporate law. He uses a key passage from Arrow to argue that in making this tradeoff, lawmakers should always make a presumption in favoring of preserving managerial authority. This paper examines Bainbridge’s argument, and shows that he does not succeed in justifying this presumption. Arrow’s argument does persuasively show why rules that lead to constant review of all board decisions would effectively eliminate board authority, and that this would be unattractive. However, none of the major pro-accountability reform proposals currently in play comes even close to eliminating board authority. Arrow’s argument is not able to tell us whether reform in favor of somewhat more accountability at the expense of some, but far from a total, loss in authority is a good idea or not. That is, Bainbridge’s use of Arrow does not help us determine the wisdom of current reform proposals. Bainbridge’s attempt to use Arrow thus falls far short of his target. Bainbridge has other, less original, arguments which supplement his core argument for board authority. This paper considers the leading supplementary arguments as well, and also finds them wanting. The paper ultimately moves beyond a critique of Bainbridge to argue more affirmatively for greater accountability for boards.

Although Brett’s review is critical (and very much so in spots), I think it’s a fair review that offers a number of constructive criticisms. In the end, we’ll just have to agree to disagree.

Here’s a few quotes I especially liked (go read the paper if you want the negative ones):

• “Bainbridge makes a great advance in framing the debate over corporate governance as a tradeoff between authority and accountability, and he does an excellent job in extolling the benefits that authority brings.” I like this because my project has been designed from the outset to counter what I regard as the over-emphasis on ageny costs and accountability in the academic corporate governance literature. Accountabilty alone cannot be the goal of corporate governance. Authority matters too.
• “I do not disagree much with Bainbridge’s descriptive claim that shareholders have very little power—most corporate decisionmaking power is indeed vested in the board.”
• “Bainbridge’s normative defense of board authority is the leading academic defense available for the basic contours of American corporate law. The two leading academic alternatives to Bainbridge—contractarianism and shareholder primacy—do not explain American corporate law as well.” I never thought so either, which is why director primacy was needed.
• “The contractarian law and economics tradition of scholars such as Romano and Easterbrook and Fischel does explain and defend much of corporate law. However, as I have noted elsewhere, that tradition does not do a great job of explaining why board authority is so hard-wired into our corporate law.” Hence, director primacy.

I’ll be interested to see people’s reactions. I plan to reply to Brett’s main criticisms in depth in a later post.

Quality Circles in Education

Gordon Smith offers up a long blog post on his plans to use quality circles in his business associations class. I’m fascinated by his plans, because I did a lot of research on quality circles and other forms of participatory management back in the late 1990s, and came away a skeptic. Go read Gordon’s post and then come back.

In my article, Privately Ordered Participatory Management: An Organizational Failures Analysis, I wrote that: Quality circles commonly consist of a small group of employees (typically under 15) meeting on a regular basis on company time to discuss problems in their work environment. The emphasis is on productivity and product quality.  Members of a given quality circle usually come from a single department, in contrast to the plant or firm-wide committees typical of QWL. Employee enrollment in a quality circle program is usually voluntary, with participation by 25% of a plant’s work force being typical.

Unlike QWL’s broad jurisdictional purview, discussions within quality circles are typically limited to production processes. A common task is the design of workplace procedures. Recall that under Taylorism, management developed standardized work procedures and enforced employee compliance with them. At NUMMI (GM’s joint venture with Toyota), quality circle-like groups of workers designed their own standardized procedures. As one worker explained, “we all work out the objectively best way to do the job, and everyone does it that way.”

Quality circles are often associated with so-called Total Quality Management, perhaps the best known management fad of the last decade. In fact, however, TQM’s proponents usually draw a sharp distinction between the employee involvement aspects of TQM, which involve the use of cross-functional problem-solving teams, and quality circles. Despite their insistence on these denominational distinctions, TQM teams and quality circles are sufficiently similar to justify treating them as variations on the same theme.

Quality circles have undergone many changes in recent years. One important trend is the demise of permanent quality circles and their replacement by temporary problem-solving teams.  An important sub-set of quality circles has evolved in the direction of self-directed work teams, which are discussed below. In such cases, participation in the circle is usually mandatory and typically involves the entire work force.

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Quality circles are quite explicitly directed at gathering input from line employees about production processes. At Otis Specialty Paper, Inc., for example, ad hoc circles are convened to solve production problems and provide input on changes in the production process.  Recall also the NUMMI example in which quality circles were used to design standardized work procedures.

Interestingly, Gordon plans to use them as a two-way flow of information.

Many features of quality circles confirm their information gathering function. Quality circle training focuses on training both individuals and groups to process and communicate information.  Once implemented, quality circles (like problem-solving QWLs) encourage employees to communicate more freely with supervisors.  In at least some firms, management also reviews meeting minutes or directly observes meetings.

Interestingly, management-initiated quality circles solve more problems and solve them faster than employee-initiated circles.  This suggests that circles are most useful when put to management-intended purposes. At the same time, however, manager-dominated quality circles are not as successful as those in which managers play a less dominant role.  This evidence supports my hypothesis: if the point of quality circles is to give management access to employee-held information, that purpose is negated when managers take over.

I will be interested to see reports from Gordon on the extent to which he led the discussion, versus simply listening. It might be interesting for Gordon to experiment in the future with allowing the QC to meet outside his presence, with someone taking detailed minutes he (and the class?) could review later.

The information gathering function is especially explicit in TQM, which places great emphasis on collecting data and solving problems.  The goal is continuous learning about and improvement of the production process.  Quality circles are an integral part of this management style. Under TQM, quality circles are sometimes divided into two types. One is the “steering arm,” which identifies the organization’s main problems. The other is the “diagnostic team,” which tries to find solutions to the identified problem. In both cases, teams are composed of those “people who can provide access to the data necessary for testing potential solutions and who are critical to implementing the solutions developed.” Once the teams are formed, three techniques are used to extract production information from the team members: Brainstorming is used to generate lists of ideas, with a strong emphasis on creative thinking. Flowcharts of the production process are drafted by team members to help eliminate inefficient steps in the process. Cause and effect diagrams are used to match problems to the probable causes.

What information asymetrically held by students is Gordon trying to extract from the class via the quality circle? Why is that information impacted in such a way that makes a quality circle the best way of extracting it? The post identifies the following benefits:

Quality circles give constructive criticism of your teaching when you can do something about it.
Quality circles let you counter students’ criticisms.
Quality circles let you explain where you’re coming from.
Quality circles help with diversity issues.
Quality circles give you a mechanism for criticizing your students.
Quality circles give students a sense of ownership of the class.

For experienced teachers, it seems unlikely that you need a quality circle to get a handle on these issues. Plus, the academic literature on quality circles doesn’t suggest any reason to think they would be particularly adept mechanisms at resolving most of these issues.

As my hypothesis predicts, however, quality circles do not devolve real decisionmaking power to employees. To the contrary, the managerial literature on quality circles strongly emphasizes the need for management to retain ultimate decisionmaking control.  After discussing a problem, a quality circle may make recommendations to management, but typically has no power to direct that the recommendation be implemented.  In contrast, management retains a considerable degree of control over the quality circle itself; management readily can punish quality circles that tackle the wrong problems or make poor recommendations.  As one critic of quality circles observed, they provide “an ideal structure for controlling decision making while management’s power to implement decisions is maintained.”

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Employees who work together acquire at low cost information about one another, which is not readily available to managers.  In cases in which this information asymmetry is especially pronounced, traditional Taylorist monitoring structures may be rendered wholly ineffectual. If such employees can be motivated to monitor one another, however, peer pressure may substitute for managerial monitoring. Some forms of participatory management, most noticeably self-directed work teams, are well-suited for creating substantial peer pressure.

As with self-monitoring, peer pressure takes advantage of widely-shared traits among U.S. workers. The Families and Work Institute’s survey is again instructive. Thirty percent of the respondents defined success as earning the respect or recognition of their supervisors and peers.  Such employees are likely to engage in self-monitoring, but are also vulnerable to peer pressure. Indeed, as to such employees, the peer pressure generated by operational participation programs should prove a powerful motivating force.

This prediction is borne out by Guillermo Grenier’s well-known case study of a quality circle program in which workers were given responsibility for making discipline decisions with respect to their fellow employees. “Although this responsibility was largely illusory,” as my hypothesis predicts, it proved an effective means of generating peer pressure for greater productivity.  Workers were required to provide written evaluations of their fellow team members, which were used to determine raises.  The circles also identified and openly discussed individual employees who had problems constituting “counterproductive behavior.”

Because the firm’s workers had some of the forms of decisionmaking power, while ultimate authority remained in management’s hands, the quality circles studied by Grenier closely resembled self-directed work teams. As such, Grenier’s work points towards an explanation of the ambivalent empirical data relating to quality circles. Studies of employee attitudes find that quality circles positively affect program-specific attitudes (such as the perception of influence), but also find a negative impact on general employee attitudes (such as job satisfaction and organizational commitment).  About half of the studies of the effect of quality circles on firm productivity find positive effects, but half find no effect.  Many favorable studies could not show causal links between participation and productivity.  Only one study tried to measure changes in product quality resulting from a quality circle program; it found no effect.

Although the effectiveness of quality circles remains open to question as a matter of solid empirical data, there is a growing body of anecdotal evidence suggesting that long-term quality circles generally are not successful.  Estimates of the failure rates for quality circles range from a low of one-third to a high of 60%.  Whatever the cause of these failures, a question on which we shall speculate in a moment, quality circles arguably have flopped as a management tool.  According to some observers, they are an unstable organizational structure waiting to self-destruct.

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[Q]uality circles fail because they lack a monitoring component or put no teeth into team members’ ability to monitor one another.  In such cases, quality circles can only serve information transmission purposes. We have known at least since Taylor’s time that informational asymmetries about production processes arise precisely because workers have strong incentives to withhold information from management that might prevent shirking or otherwise be used to the workers’ disadvantage. As noted above, this was the rationale for Taylorism’s emphasis on discouraging workers from thinking about their job or its place in the production process. Quality circles may not offer sufficient incentives to overcome the strong bias against voluntary disclosure of information asymmetrically held by workers.  Quality circles therefore ought to be subject to displacement by programs that can both more effectively resolve informational asymmetries and provide enhanced monitoring mechanisms to prevent shirking, which is precisely what my analysis suggests self-directed work teams have done.

Gordon (and Eric Orts on whose work the idea is based) seem focused solely on information gathering and transmission; specifically, two-directional feedback about how the class is going. To the extent quality circles have any utility in the classroom, it would seem useful to direct them mainly at trying to get a handle on how well students are learning the material.

Count me an interested skeptic

Bad PowerPoint Advice

I’m a big believer in PowerPoint and an avid consumer of PowerPoint advice. Unfortunately, much PowerPoint advice ... well, to be frank, sucks. Case in point: I recently read an author who suggests the following algorithim: “Find out the age of the oldest person in your audience. Divide by 2 and that’s your optimal font size.” That might be good advice if you’re giving a talk to senior citizens, but when your audience consists of law students in their 20s, you really don;t want to use 10-12 point fonts!