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

More on behavioral economics

The new Law and Economics Blog criticizes my post Behavioral Economic Analysis of Law:

An uninformed reader would be greatly mislead in reading Professor Bainbridge's broad based criticism of legal decision theory, backed by what is simply a critique of one of its applications. Moreover, he largely ignores the descriptive power of legal decision theory by mentioning only one of its potential normative implications. To be fair, the blogosphere does not lend itself to comprehensive critiques. Professor Bainbridge may have good reasons in support of his seemingly over-broad introductory criticism. That the blogosphere is so situated, though, only speaks to why we should be careful when engaging in such a critique.

As to the complaint that I did not provide a "comprehensive critique," it would have been nice if the blogger had acknowledged that I included the following at the end of my post:

You can read an even more extended version of my argument, with application to the longstanding debate over mandatory disclosure in securities regulation, in my article Mandatory Disclosure: A Behavioral Analysis, 68 University of Cincinnati Law Review 1023 (2000).

If we're going to "be careful when engaging in ... a critique," let's include all the relevant facts.

Anyway, as for the complaint that I mention "only one of its [i.e., behavioral economics'] potential normative implications," the policymaking normative implications of behavioral economics strike me, at least, as the key question. In my article, I provide an example of one scholar who used generic behavioral economics claims to justify a prohibition of investor waivers of their rights under the securities laws, without showing that the various cognitive errors cited actually affect investor behavior in the context at hand. Behavioral economics, of course, can be relevant to legal issues other than policymaking. It might, for example, help lawyers and academics get a better handle on negotiations. Nothing in my post denies that. But my post was intended principally to suggest a limitation on the use of behavioral economics as a normative policymaking tool. If that wasn't clear enough, my bad; but, personally, I think it was clear enough.

UPDATE: Greg Goelzhauser of the Law and Economics blog responds here. Admittedly, I got a little testy in responding to his initial post. (In my defense, I hadn't had my morning coffee yet, although that's not much of an excuse, I admit.) But I stand by my substantive point that people are already using behavioral economics to make normative policy recommendations and that I am skeptical of doing so for the reasons developed in both the post and the article.

BusinessPundit on business ethics

The BusinessPundit has an interesting post on business ethics:

If the only way you can stay in business is by lying, cheating, and manipulating your books, then you are a lousy capitalist and you will eventually get what is coming to you. Business schools need to step up and teach students more business philosophy. They need to know that they should play fair even when government regulators aren't looking, because otherwise earnings, stock price increases, or contract wins are meaningless. How can anyone be proud of their business accomplishments if they cheated?

Its not clear to me that ethics education at the post-graduate level can help all that much. Values and ethics education needs to start a lot earlier than that to take, I suspect: "Raise up a child in the way he should go. And when he is old he will not depart from it." On the other hand, it can't hurt.

One virtue of values and ethics education is suggested by the distinction between virtue and principle ethics. Principle ethics are most attractive to those who are tempted to propose a rule as a solution to a problem. In a principle-dominated ethical system, the moral life consists mainly of complying with society’s mandated code of conduct. In contrast, virtue ethics reject codes of conduct in favor of context-based judgment. In a virtues-based ethical system, the moral life consists mainly of the habitual private exercise of truthfulness, courage, justice, mercy, and the other virtues. Ideally, values-based education becomes one of those intermediating institutions that build what George Weigel calls “a citizenry regulating itself from within according to a shared public ‘language of good and evil.’”

In the wake of the Enron scandal, Congress and the SEC opted for a principle ethics-based approach. They mandated a host of new legal ethics rules. I supported these rules, but for reasons I’ve outlined in two recent law review articles (here and here) I doubt whether they’ll work in the absence of the sort of business and legal professionals who are capable of regulating themselves because they have internalized norms of honesty and justice.

Who was the Greatest US Supreme Justice? A Corporate/Securities Law Perspective

I was recently given a copy of Bernard Schwartz's entertaining book, A Book of Legal Lists, which includes lists of both the 10 greatest and 10 worst US supreme court justices. Those chapters reminded me of an article I wrote with my friend (and, regretably, former colleague) Mitu Gulati a few years ago, in which we had occasion to make an objective empirical evaluation of greatness on the part of modern supreme court justices.

As a proxy for the importance of cases decided by the Supreme Court, we looked at opinions that found their way into the casebooks. Specifically, we looked at thirty-eight currently used case books on Corporations, Business Associations, Securities Regulation, and Corporate Finance. For each casebook, we counted the number of securities and corporate opinions by the various Supreme Court justices. If the same case appeared in two casebooks, it was counted twice, and so on. We assumed more important cases would appear in more casebooks and that greatness would translate into a justice being assigned the most important (and most often reproduced) cases.

The table reveals a dramatic dominance effect for the late Justice Lewis Powell, both in terms of his overall number of securities and corporate cases in casebooks and his per year entry rate. In terms of total cases, Powell has sixty-one and only two other justices have more than 20 (White (22) and Blackmun (21); Marshall comes next closest with 19). A similar skew is present in the per year entry rates. Powell has an average of four securities or corporate cases entering the casebooks per year. The next closest number is 1.25. Finally, note that these are only comparisons for only those justices who have securities or corporate cases in the casebooks. Most have none. So, for our purposes, Lewis Powell ranks as the Greatest Supreme Court Justice. Your mileage, of course, may vary.

An alternate to the expertise/greatness hypothesis might be that Powell was simply a superior casebook opinion writer. While we did not test this alternate hypothesis, anecdotal evidence suggests that Powell did not having anything close to the same level of influence in other areas. He was an excellent opinion writer and among the more influential justices of his time. But his clear dominance was limited to the business areas. See Richard A. Posner, Cardozo: A Study in Reputation (1990) (commenting on Powell’s skill at opinion writing and comparing the influence levels of a set of different justices); Montgomery N. Koma, Measuring the Influence of Supreme Court Justices, 27 J. Legal Stud. 333 (1998) (ranking the justices according to influence levels as measured by citations).

Guttman v. Huang: Del VC Strine on audit committee due care standards

In recent years, increasing regulatory attention has been devoted to the role of the audit committee. In 1999, the major stock exchanges adopted new listing standards (after being prodded by then-SEC Chairman Arthur Levitt in a classic example of how the SEC uses (arguably, abuses) its �raised eyebrow� power) toughening the rules on audit committees. See generally 64 Fed. Reg. 71, 529 (Dec. 21,1999). Likewise, the SEC adopted new disclosure requirements, most notably requiring an annual Audit Committee Report in the proxy statement. Regulation S-K item 306; Schedule 14-A item 7(d)(3). Sarbanes-Oxley and the accompanying stock exchange listing standard amendments further ratcheted up the burdens on audit committees.

A (relatively) new Delaware chancery court opinion by Vice Chancellor Leo Strine sheds light on the state corporation law fallout from these developments. Guttman v. Huang, 823 A.2d 492 (Del. Ch. 2003). Strine is a very smart fellow, with a strong academic bent, who has written a number of important decisions of late. His opinion in Guttman is the best recent summary of the rules of audit committee liability. Because this is a very long post, I have dumped the legal analysis in the Extended Post below. (One of the main reasons for starting this blog was to provide an outlet for scholarly analysis of problems to which I don't want to devote an entire law review article. This is a very good example of just what I had in mind.)

Generally, corporate directors and officers owe their firm and its shareholders three basic fiduciary duties: care, loyalty, and good faith. See, e.g., Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 361 (Del. 1993). Of these, the duty of care is most relevant for present purposes. The duty of care requires corporate directors to exercise �that amount of care which ordinarily careful and prudent men would use in similar circumstances.� Graham v. Allis-Chalmers Mfg. Co., 188 A.2d 125, 130 (Del.1963). Central to the duty of care is an obligation for directors and officers to avail themselves, �prior to making a business decision, of all material information reasonably available to them.� Aronson v. Lewis, 473 A.2d 805, 811 (Del. 1984); see also Smith v. Van Gorkom, 488 A.2d 858, 872 (Del. 1985). Where the directors have so informed themselves, however, judicial review of their decisions and actions is precluded by the duty of care�s chief corollary�the business judgment rule. [NB: In addition to an informed decision, there are a number of other preconditions that must be satisfied in order for the business judgment to insulate a board�s decisions or actions from judicial review. See generally Stephen M. Bainbridge, Corporation Law and Economics 270-83 (2002) (discussing preconditions).]

The business judgment rule, of course, is a presumption that the directors or officers of a corporation acted on an informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the company. Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984). �While it is often stated that corporate directors and officers will be liable for negligence in carrying out their corporate duties, all seem agreed that such a statement is misleading. . . . Whatever the terminology, the fact is that liability is rarely imposed upon corporate directors or officers simply for bad judgment and this reluctance to impose liability for unsuccessful business decisions has been doctrinally labeled the business judgment rule.� Joy v. North, 692 F.2d 880, 885 (2d Cir. 1982). See also Kamin v. American Express Co., 383 N.Y.S.2d 807 (Sup.Ct.1976), aff�d, 387 N.Y.S.2d 993 (App. div.1976) (holding that the duty of care �does not mean that a director is chargeable with ordinary negligence for having made an improper decision, or having acted imprudently�); Bayer v. Beran, 49 N.Y.S.2d 2, 6 (Sup. Ct. 1944) (stating that �although the concept of �responsibility� is firmly fixed in the law, it is only in a most unusual and extraordinary case that directors are held liable for negligence in the absence of fraud, or improper motive, or personal interest�).

In the leading In re Caremark Int�l case, then-Delaware Chancellor William Allen opined that the directors� duty of care includes an affirmative obligation to ensure �that appropriate information will come to its attention in a timely manner as a matter of ordinary operations.� In re Caremark Int�l Inc. Deriv. Litig., 698 A.2d 959, 970 (Del. Ch. 1996). Yet, it is critical to recognize the distinction drawn by Chancellor Allen between allegations involving lack of oversight by directors and mere inadequate oversight. The business judgment rule is relevant only where directors have actually exercised business judgment; in other words, there rule provides no protection where directors have made no decision at all. See, e.g., Aronson v. Lewis, 473 A.2d 805, 813 (Del. 1984) (stating that �the business judgment rule operates only in the context of director action�).

In Caremark, the corporation had no program whatsoever of internal controls to ensure that the corporation complied with key federal statutes governing its operations. When the corporation ran afoul of one of those statutes and was obliged to pay a substantial fine, a derivative suit was brought against the directors. In reviewing the merits of that claim for purposes of evaluating the settlement, Chancellor Allen noted that decisions made deep in the interior of an enterprise by relatively junior employees can have devastating consequences for the firm. Allen also noted two concurrent regulatory trends. On one hand, federal law increasingly uses criminal sanctions to ensure corporate compliance with various regulatory regimes. On the other, the federal criminal sentencing guidelines mitigate sanctions where the corporate defendant had law compliance programs in place. In light of these considerations, Allen rejected the defendants� argument that �a corporate board has no responsibility to assure that appropriate information and reporting systems are established by management . . . .� Caremark, 698 A.2d at 969-70. Instead, as we have seen, he imposed an affirmative obligation for management and the board to implement systems of internal control. Because the Caremark directors had failed to take any action, the business judgment rule did not insulate them from (potential) liability for this failure. Instead, the duty of care controlled.

Where the board and management have established systems of internal control, however, the business judgment rule becomes the relevant standard of review. [NB: Indeed, it may be plausibly argued that the business judgment rule would insulate directors from liability even if the board considered the issue and then affirmatively decided not to adopt a system of internal controls relevant to the issue at hand. In theory, after all, a decision not to act does not differ from a decision to take action. In Caremark, moreover, Chancellor Allen made clear that directors who act in good faith through proper procedures are not liable even if, in retrospect, they made the wrong decision. Caremark, 698 A.2d at 967-68. The business judgment rule, as typically formulated, would seem to protect directors who rationally adopt either a minimal compliance program or even no program at all after weighing the costs against the benefits. Bainbridge, supra, at 296.

Hence, when reviewing how the directors have exercised their oversight function through an extant system of internal controls�as opposed to entirely failing even to create such a system�the standard of review becomes one that a plaintiff-shareholder can satisfy only with great difficulty. Plaintiff must show the traditional grounds on which the business judgment rule is set aside: fraud, illegality, or self-dealing.

Vice Chancellor Strine�s decision in Guttman v. Huang seems to blur this important distinction. In that decision, Vice Chancellor Strine opined that:

[T]he Caremark opinion articulates a standard for liability for failures of oversight that requires a showing that the directors breached their duty of loyalty by failing to attend to their duties in good faith. Put otherwise, the decision premises liability on a showing that the directors were conscious of the fact that they were not doing their jobs.

823 A.2d at 506. Guttman thus seems to establish a single standard of liability for cases involving negligent oversight through an extant system of internal controls and for failures to exercise oversight by failing to create such a system. If so, in my view, Guttman blurs a doctrinal distinction I regard as critical to understanding Caremark. (The two standards perhaps can be reconciled by arguing that directors who are �conscious of the fact that they were not doing their jobs� have �abdicated their functions,� which is not protected by the business judgment rule. Aronson v. Lewis, 473 A.2d 805, 813 (Del. 1984).)

Fortunately, even if Guttman is correct, the standard remains one which a derivative suit shareholder-plaintiff can satisfy only with great difficulty. Vice Chancellor Strine approvingly quoted a key passage from Chancellor Allen�s Caremark opinion:

Generally where a claim of directorial liability for corporate loss is predicated upon ignorance of liability creating activities within the corporation ... in my opinion only a sustained or systematic failure of the board to exercise oversight�such as an utter failure to attempt to assure a reasonable information and reporting system exists�will establish the lack of good faith that is a necessary condition to liability. Such a test of liability�lack of good faith as evidenced by sustained or systematic failure of a director to exercise reasonable oversight�is quite high. But, a demanding test of liability in the oversight context is probably beneficial to stockholders as a class, as it is in the board decision context, since it makes board service by qualified persons more likely, while continuing to act as a stimulus to good faith performance of duty by such directors.

Caremark, 698 A.2d at 971 (emphasis supplied), quoted in Guttman v. Huang, 823 A.2d 492, 506 (Del. Ch. 2003). Hence, the Vice Chancellor indicated that a Caremark claim must plead facts showing that, inter alia, �that the company lacked an audit committee, that the company had an audit committee that met only sporadically and devoted patently inadequate time to its work, or that the audit committee had clear notice of serious accounting irregularities and simply chose to ignore them or, even worse, to encourage their continuation.� Guttman, 823 A.2d at 507.

The bottom line thus seems to be that audit committees still receive substantial protection. Mere negligence still shpu;d not result in liability. Instead, a systemic breakdown in oversight or conscious disregard of clear problems is required. In my view, however, Vice Chancellor Strine would have done better to make clearer that the business judgment rule still applies in full force to an audit committee�s oversight functions. I have written a law review article entitled The Business Judgment Rule as Abstention Doctrine, forthcoming in the Vanderbilt Law Review, in which I explain in detail why courts generally should abstain from reviewing board decisions. In my view, those arguments carry over in full force to review of how an audit committee carries out its functions.

In brief, there is the problem of judging by hindsight. Decisionmakers tend to assign an erroneously high probability of occurrence to a probabilistic event simply because it ended up occurring. Christine Jolls et al., A Behavioral Approach to Law and Economics, 50 Stan. L. Rev. 1471, 1523 (1998). If a jury knows that the plaintiff was injured, the jury will be biased in favor of imposing negligence liability even if, viewed ex ante, there was a very low probability that such an injury would occur and that taking precautions against such an injury was not cost effective. Even where duty of care cases are tried without a jury, as in Delaware, judges who know with the benefit of hindsight that a business decision turned out badly likewise could be biased towards finding a breach of the duty of care. Cf. Chris Guthrie et al., Inside the Judicial Mind, 86 Cornell L. Rev. 777, 799-805 (2001) (discussing empirical evidence that judicial decisionmaking is tainted by the hindsight bias). Hence, there is a substantial risk that judges will be unable to distinguish between competent and negligent management because bad outcomes often will be regarded, ex post, as having been foreseeable and, therefore, preventable ex ante.

Second, business decisions are frequently complex and made under conditions of uncertainty. Accordingly, bounded rationality and information asymmetries counsel judicial abstention from reviewing board decisions. Judges likely have less general business expertise than directors. They also have less information about the specifics of the particular firm in question. To be sure, the old adage that �judges are not business experts� cannot be a complete explanation for the business judgment rule. Yet, many old adages have more than a grain of truth. So too does this one. 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 na�ve would assume that these markets perfectly constrain director decisionmaking. It would be equally na�ve, 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.

Finally, judicial review could interfere with�or even destroy�the internal team governance structures that regulate board behavior. Research on relational teams �which are what boards and board committees are � shows that they are not only hard to monitor, but that they also are hard to discipline. Stephen M. Bainbridge, Why a Board? Group Decision Making in Corporate Governance, 55 Vand. L. Rev. 1, 49 (2002). Instead of external review, relational teams are best monitored by a combination of mutual motivation, peer pressure, and internal monitoring. As I have explained elsewhere in more detail, however, judicial review might well destroy the interpersonal relationships that foster these forms of internal board governance. Id. at 49-50.

In sum, Guttman is an interesting development, but one the Delaware courts should promptly clarify as incorporating the classic business judgment rule. The justifications for the business judgment rule apply in full force to the present setting.

Board size: Is there an optimum?

In the extensive commentary on the NYSE’s governance problems, a point I have not seen discussed very much is the sheer size of the NYSE board.

Board sizes vary widely. But most public corporation boards are much smaller than the NYSE’s 27 members. A 1999 survey by the National Association of Corporate Directors (NACD) found that slightly less than half of corporate boards had seven to nine members, with the remaining boards scattered evenly on either side of that range.

Is there an optimal board size? One meta-analysis of studies of board size in particular found a statistically significant correlation between increased board size and improved financial performance. Dan R. Dalton, Number of Directors and Financial Performance: A Meta-Analysis, 42 Acad. Mgmt. J. 674, 676 (1999). Given the potential influence of confounding variables, however, it does not seem safe to draw firm conclusions from that survey. Other studies, moreover, are to the contrary. See, e.g., Sanjai Bhagat & Bernard Black, The Uncertain Relationship Between Board Composition and Firm Performance, 54 Bus. Law. 921, 941-42 (1999) (summarizing studies); Theodore Eisenberg et al., Larger Board Size and Decreasing Firm Value in Small Firms, 48 J. Fin. Econ. 35, 36 (1998) (finding a significant negative correlation between board size and firm profitability in small and medium Finnish firms).

Up to a certain point, large boards can have a number of benefits. Larger size may facilitate the board’s resource-gathering function, since a larger number of directors will usually translate into more interlocking relationships with other organizations that may be useful in providing resources such as customers, clients, credit, and supplies. Larger boards with diverse interlocks are also likely to include a greater number of specialists—such as investment bankers or attorneys—who bring special expertise to the table.

On the other hand, a number of considerations suggest that small boards may be preferable. Large boards tend to be contentious and fragmented, which would reduces their ability collectively to monitor and discipline senior management. In such cases, the senior managers can affirmatively take advantage of the board through “coalition building, selective channeling of information, and ‘dividing and conquering.’ ” Jeffrey A. Alexander et al., Leadership Instability in Hospitals: The Influence of Board-CEO Relations and Organizational Growth and Decline, 38 Admin. Sci. Q. 74, 79 (1993). There seems to be plenty of evidence of this phenomenon at the NYSE under Grasso.

The social loafing phenomenon also suggests an upper limit on efficient group size. In a famous 1913 study which measured how hard subjects pulled a rope, members of two-person teams pulled to only ninety-three percent of their individual capacity, members of trios pulled to only eighty-five percent, and members of groups of eight pulled to only forty-nine percent. See David A. Kravitz & Barbara Martin, Ringelmann Rediscovered: The Original Article, 50 J. Personality & Soc. Psychol. 936, 938 (1986). This phenomenon is partially attributable to the difficulty of coordinating group effort as size increases. (Too many cooks spoil the soup.) Social loafing is also attributable, however, to the difficulty of motivating members of a group where identification and/or measurement of individual productivity are difficult—i.e., where the group functions as a production team. As group size grows, for example, the number of nonparticipants (loafers) likely increases. In addition, larger boards may inhibit the formation of the sorts of close-knit relationships by which groups constrain agency costs.

On balance, my guess is that 27 is way too big for optimal board functioning. A Korn/Ferry survey of corporate directors found: "According to respondents, the optimal board size is two inside directors and eight outside." So add this to the list of necessary NYSE reforms.

What is the appropriate motivation for director nominees?

Over at TheCorporateCounsel.net Blog, Broc poses the titular question, and comments:

One aspect of boardroom reform that has not been fully explored is what should be an acceptable motivation for someone who seeks to serve as a director. Historically, directors have agreed to serve principally for the prestige and clublike atmosphere. Some have done it for the money - although this is unlikely the case for those directors that earn big dollars as officers at other companies.

At the recent BRT Roundtable on Corporate Governance, Fannie Mae CEO Franklin Raines explained that he joined Pfizer's board to enhance his ability to be an innovator - which in turn would benefit his employer. This is an honest and understandable answer - but does it serve the needs of Pfizer's shareholders to whom he now owes fiduciary duties?

Personally, I think you want directors motivated by precisely what motivated Raines -- i.e., healthy self-interest. In The Wealth of Nations, Adam Smith famously remarked:

It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages. [Book I, Chap.2.]

[In the course of conducting business, a business person generally] neither intends to promote the public interest, nor knows how much he is promoting it. [Instead, the business person] intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good. [Book IV, Chap. 2.]

Of course, Smith also famously railed against joint stock companies, which we now know to be error, but even mighty Homer nods.

Independent directors are not a panacea for the ills of corporate governance, as I have argued elsewhere, but independent directors motivated by a healthy concern for the self-interest do have considerable incentives to actively monitor management and to discipline poor managers. If the company fails on their watch, for example, the independent directors’ reputation and thus their future employability is likely to suffer. Those incentives are not perfect, of course, as demonstrated by the failures of independent directors at Enron and its ilk. But no motivation besides self-interest is more likely to elicit whatever benefits director independence can provide.

The fallout from Grasso? How about more worthless disclosure?

How will public corporations respond to the Grasso imbroglio? The New York Times speculates:

Directors of big companies, already under pressure to demonstrate independence from management, are now worried that they will be blamed for failing to explain not only how much but how they pay chief executives. ...

When companies send proxy statements to shareholders early next year, [Tom Wamberg, chief executive of Clark Consulting] said, they will be noticeably thicker, because directors feel compelled to spell out the terms of the deals they have struck with company officers.

"Our advice to our clients is overcommunicate, overexplain," Mr. Wamberg said. "For each required disclosure, what could have been four paragraphs is going to be eight paragraphs."

Wamberg's prediction strikes me as just about right. Risk averse lawyers will not want to be blamed by their clients if the firm gets bad PR for inadequate disclosure, let alone getting sued (successfully or not). Risk averse directors would rather provide excess disclosure than risk the sort of harm to their reputation that the NYSE's directors are currently experiencing. But is extra disclosure a good thing?

A rational shareholder will expend the effort to make an informed decision only if the expected benefits of doing so outweigh its costs. Given the length and complexity of SEC disclosure documents, the opportunity cost entailed in becoming informed before voting is quite high and very apparent. Moreover, most shareholders' holdings are too small to have any significant effect on the vote's outcome. Accordingly, shareholders assign a relatively low value to the expected benefits of careful consideration. (For a discussion of why rational apathy is a good thing, see HERE.)

The SEC has consistently ignored these textbook principles, insisting that shareholders want more and better disclosure of executive compensation. Ultimately, however, more comprehensible information doesn't help and greater volumes of information only makes the situation worse. For most shareholders, the investment of time and effort necessary to make informed voting decisions remains a game that is not worth playing. What then will shareholders do with the enhanced disclosure they will be getting post-Grasso? They will do what they always do with corporate disclosure: ignore it and simply vote for management's director slate and management compensation proposals.

Some believe that this shareholder passivity model no longer holds true in light of the growing importance of institutional investors. To be sure, institutional investors are an increasingly important force in the stock markets and, moreover, some institutions are playing a more active role in corporate governance. At the same time, however, the passivity model undoubtedly remains applicable even to most institutional investors. Participating in corporate governance is not a cost-less endeavor. Just as with any other shareholder, institutional investors must expend resources to make informed decisions. Most institutional investors therefore will probably seek to free-ride on the efforts of the few who are willing to expend such resources. As is typical of free-riding situations, this means that virtually no one will make informed decisions.

In sum, shareholders will want boards to make cost-effective disclosures. They will not want the board to spend a dollar on disclosure unless the shareholders get back at least $1.01 worth of additional value in the form of more informed decisions, greater accountability, and additional transparency. My guess is that Wamberg is right, and that many corporations will be spending a lot more on disclosure than the value the shareholders will get back.

Random stock traders and the ECMH; with a review of Malkiel’s Random Walk

An article in Nature claims: "Stock market traders show signs of zero intelligence." It reports on research by J. Doyne Farmer, of the Santa Fe Institute, which purports to find that "that economic decision-making is so varied and complex that it is hard to distinguish it from random choices." They set up a theoretical model that assumes "traders place orders at random rather than on the basis of shrewd calculation and observation of economic trends." The results of running that model replicate many of the statistical features of a real world stock market (the London Stock Exchange in the period 1998-2000). Not being a fan of theoretical modeling, I find this result less persuasive than if it were backed by actual empirical data on ivestor behavior. (Link via Tyler at Marginal Revolution.)

The efficient capital markets hypothesis has long claimed that stock price movements are random. But in the ECMH model randomness refers not to trader behavior but to the proposition that stock price movements are serially independent. Randomness does not mean that the stock market is like throwing darts at a dart board. Stock prices go up on good news and down on bad news. If a company announces a major oil find, all other things being equal, the stock price will go up. Randomness simply means that stock price movements are serially independent: future changes in price are independent of past changes. In other words, investors can not profit by using past prices to predict future prices. Randomness in the ECMH thus is not inconsistent with the proposition that stock market actors are informed rational self-maximizers. In contrast, Nature claims that Farmer's research is inconsistent with that proposition: "by dispensing with even a restricted form of rationality, the new model is daring"

Like Tyler, I think Nature overstates the extent to which the standard ECMH model requires hard assumptions of rationality on the part of investors. Much recent work has been done on incorporating insights from noise theory and behavioral finance into the ECMH. (See also HERE.) Most economists simply do not believe in the extreme version of the ECMH that Nature lays out (as the Nature article itself acknowledges). To this extent, the article is arguing against a strawman. Instead, most economists and economically-minded lawyers who still adhere to ECMH now fall back on the old rule that "it takes a theory to beat a theory." In this view, the ECMH is a first approximation that does a better job of predicting market behavior than any other theory out there. When a theory comes along that generates profitable trading strategies inconsistent with ECMH that will be the day that the ECMH has been disproved. But this study is not that theory.

For more information on the ECMH, as well as a review of the best book ever written on using finance theory as an investment guide, see the extended post.

In RANDOM WALK DOWN WALL STREET, Burton Malkiel sets out the basics of modern corporate financial theory in a way accessible to the law reader. As a teacher of corporate finance to law students, I have recommended this book to my students for over 10 years. Numerous alumni have told me that was the best advise they got in law school (a sad commentary on American legal education, but that's another story).

Two basic theories are expounded here. First, modern portfolio theory (MPT), which elucidates the relationship between risk and diversification. Because investors are risk averse, they must be paid for bearing risk, which is done through a higher expected rate of return. As such, we speak of a risk premium: the difference in the rate of return paid on a risky investment and the rate of return on a risk-free investment. In the real world, we measure the risk premium associated with a particular investment by subtracting the short-term Treasury bill interest rate from the risky investment's rate of return. The risk premium, however, will only reflect certain risks. MPT differentiates between two types of risk: unsystematic and systematic. Unsystematic risk might be regarded as firm-specific risk: The risk that the CEO will have a heart attack; the risk that the firm's workers will go out on strike; the risk that the plant will burn down. These are all firm-specific risks. Systematic risk might be regarded as market risk: risks that affect all firms to one degree or another: changes in market interest rates; election results; recessions; and so forth. MPT acknowledges that risk and return are related: investors will demand a higher rate of return from riskier investments. In other words, a corporation issuing junk bonds must pay a higher rate of return than a company issuing investment grade bonds. Yet, portfolio theory claims that issuers of securities need not compensate investors for unsystematic risk. In other words, investors will not demand a risk premium to reflect firm-specific risks. Why? There is a mathematical proof, which relates to variance and standard deviation, but Malkiel explains it in a way that is quite intuitive. Investors can eliminate unsystematic risk by diversifying their portfolio. Diversification eliminates unsystematic risk, because things tend to come out in the wash. One firm's plant burns down, but another hit oil. Thus, even though the actual rate of return earned on a particular investment is likely to diverge from the expected return, the actual return on a well-diversified portfolio is less likely to diverge from the expected return. Bottom line? If you hold a nondiversified portfolio (say all Internet stocks), you are bearing risks for which the market will not compensate you. You may do well for a while, but it will eventually catch up to you (as it has recently for tech stocks).

The second pillar of Malkiel's analysis is the efficient capital markets theory (ECMH). The fundamental thesis of the ECMH is that, in an efficient market, current prices always and fully reflect all relevant information about the commodities being traded. In other words, in an efficient market, commodities are never overpriced or underpriced: the current price will be an accurate reflection of the market's consensus as to the commodity's value. Of course, there is no real world condition like this, but the securities markets are widely believed to be close to this ideal. There are three forms of ECMH, each of which has relevance for investors: **Weak form: All information concerning historical prices is fully reflected in the current price. Price changes in securities are serially independent or random. What do I mean by "random"? Suppose the company makes a major oil find. Do I mean that we can't predict whether the stock will go up or down? No: obviously stock prices generally go up on good news and down on bad news. What randomness means is that investors can not profit by using past prices to predict future prices. If the Weak Form of the hypothesis is true, technical analysis (a/k/a charting)-the attempt to predict future prices by looking at the past history of stock prices-can not be a profitable trading strategy over time. And, indeed, empirical studies have demonstrated that securities prices do move randomly and, moreover, have shown that charting is not a long-term profitable trading strategy. ** Semi-Strong Form: Current prices incorporate not only all historical information but also all current public information. As such, investors can not expect to profit from studying available information because the market will have already incorporated the information accurately into the price. As Malkiel demonstrates, this version of the ECMH also has been well established by empirical studies. Implication: if you spend time and effort studying stocks and companies, you are wasting your time. If you pay somebody to do it for you, you are wasting your money. ** Strong Form holds that prices incorporate all information, publicly available or not. This version must be (and is) false, or insider trading would not be profitable.

In the last section of RANDOM WALK, Malkiel distills all this theory into an eminently practical life-cycle guide to investing. As one may infer, it has two basic principles. First, diversification. Second, no one systematically earns positive abnormal returns from trading in securities; in other words, over time nobody outperforms the market. Mutual funds may outperform the market in 1 year, but they may falter in another. Once adjustment is made for risks, every reputable empirical study finds that mutual funds generally don't outperform the market over time. Malkiel's recommendation: put your money into no-load passively managed index mutual funds. You will see lots of anonymous reviews of RANDOM WALK claiming Malkiel is wrong. Odds are, most of those folks are have either been misled by the long bull market or, even more likely, are brokers or other market professionals who make a living selling active portfolio management. In sum, buy it, read it, believe it, and practice it.