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

Rumsfeld Brings Kaizen to the DoD

In reading Donald Rumsfeld's op-ed A 21st-Century DoD in today's WSJ (sub. req'd), I concluded that Rumsfeld's vision is informed more by management theory than military science:

Today, President Bush will sign into law landmark legislation that will help bring the Defense Department out of the industrial age, and into the information age. ...

[The bill] will provide civilian managers in the department with 21st-century management tools. ...

This legislation is an important step forward on the road to transforming the department. ... But this is only a step. Transforming is not an event. There is no moment at which the DoD moves from being untransformed to being "transformed." We will need to be continuously looking for ways to improve both the military and civilian sides of the department.

In business school-speak, the 21st century management tool Rumsfeld describes in the highlighted passages is known as "continuous improvement," the best known example of which is Toyota's famed kaizen process. Continuous improvement is based on the theories espoused by early 20th century theorist W. Edward Deming (so much for "21st century tools"!), who stressed the need for a constant cycle of research, design, production, and marketing, with continuous interaction among each function, so as to improve quality and customer satisfaction.

As someone for whom corporate governance is my vocation and military history a strong avocational interest, I am deeply skeptical of bringing business school management theories to bear on national security (see, e.g., the troubles Robert McNamara's "Whiz Kids" got us into). But I am especially skeptical about continuous improvement - Kaizening - of the military side.

In my article Privately Ordered Participatory Management: An Organizational Failures Analysis, which critiques kaizening, TQM, and other types of employee involvement, I quoted a worker at NUMMI (the Toyota-GM joint venture), who said:“Kaizening is supposed to be creative, but I mean how many times can you sit there and Kaizen a job after you’ve done it for four and one-half years? ... [J]ust keep me in a job and I’ll do it the way you want me to do it.” Hence, as I've explained in this space before, while kaizening works well as an engineering process, it's not at all clear that it makes an effective human resources tool (at least on the US).

The NUMMI worker quoted in the preceding paragraph is expressing an unconscious desire for formalization of her job—i.e., the creation of stable written rules, procedures, and instructions. For many workers, formalization is attractive because it reduces role conflicts and ambiguity, which increases work satisfaction and reduces feelings of alienation and stress.

Workers with a taste for formalization gravitate towards hierarchical workplaces. I documented this tendency in my article Corporate Decisionmaking and the Moral Rights of Employees: Participatory Management and Natural Law, where I explained that:

A recent study of transportation firms found that long-term use of employee involvement initiatives increased stress and decreased employee fulfillment—exactly contrary to the encyclicals’ expectations. A study of “empowered” employees versus a control group of unempowered employees within a single insurance company found no statistical difference between the two groups on such productivity-related issues as motivation or even on some job satisfaction measurements. Only about half of the participants in [one] case study were willing to change jobs in order to get more participation and that rate declined rapidly if doing so would require longer hours or lower pay. In unionized plants, rank and file workers have often resisted collective bargaining agreements that included employee involvement. In firms adopting self-directed work teams, ten to twenty percent of employees will resist the change because they prefer a mundane job to the greater responsibility and higher expectations associated with team membership. Other studies have found even higher rates of resistance: Participation rates in voluntary participatory management programs range from a low of 33% to a high of 68% of the eligible workforce. Conversely, a study of nonparticipating employees found interest in volunteering for employee involvement programs ranged from a low of 15% to a high of 63%. Anecdotal evidence suggests that firms using participatory management techniques are expending considerable effort in selecting employees who are psychologically equipped to work under those conditions, which is precisely what one would expect if some workers are not temperamentally suited for participatory workplaces. The existence of differing tastes among workers is similarly suggested by evidence that workforce demographics are correlated with the effectiveness of participatory management.

Why do such workers prefer hierarchy? Some are simply being economically rational. Behavioral patterns that are learned over many years, and reinforced by past rewards, are exceedingly difficult to change. As such, many firms will experience a path dependent resistance to participatory management. Introduction of participatory management within a firm typically entails substantial change, which will threaten vested interests in the workforce. Self-directed work teams threaten the seniority—and even the jobs—of foremen and other supervisory employees. Surviving supervisors are thrust into new positions as “team consultants” rather than bosses, with new and demanding responsibilities. Gain-sharing, pay for skills, and team-based compensation all threaten traditional seniority-based compensation. Training may be resisted by some workers: the old dogs who don’t want to learn new tricks. The job rotation and stress on “continuous improvement” characteristic of self-directed work teams will threaten those workers who prefer a more mundane set of job responsibilities.

How does all this relate to Rumsfeld? Could there be a more hierarchical or formalized workplace than the military? My experience growing up as an Army brat exposed me to a constant stream of formalized rules and regulations. I doubt it has changed all that much.

As we have seen, workers with a taste for formalization and hierarchy do not respond well to the demands of continuous improvement. Instead, workplaces dominated by such cultures tend to respond better to the management equivalents of Stephen Jay Gould's theory of punctuated equilibrium - such as management by exception. Under such approaches, periodic reviews are undertaken when circumstances have changed dramatically. These reviews result in adoption of new sets of rules. The review is then followed by a period of stability in which the rules are, at most, tweaked ever so slightly. Instead of continuous improvement, we see episodic improvement, which is less threatening to workers with a strong taste for fomalization and hierarchy.

I don't doubt that the end of the Cold War and 9/11 ushered in the need for a periodic review of our nation's military forces and strategy. I suspect we need an expeditionary force of the sort Max Boot so well described in The Savage Wars of Peace. I just doubt that the military will do well adjusting to Rumsfeld's demand for continuous improvement. Indeed, the many well-publicized examples of conflict between Rumsfeld and the brass look to me quite a lot like the sorts of conflicts I described in the excerpt above.

One solution is to let Rumsfeld just blow the place up and start over from scratch. But a good manager doesn't do that. A good manager manages to his/her people, not to the latest business school theory. Understanding your workers' tastes is the essential first step in making decisions about how workplaces are structured. I hope Rumsfeld has done that, but somehow I doubt it.

UPDATE: CE Petit who is both a really smart business (copyright) lawyer and former USAF officer has an excellent follow-up post in which he describes some of the management theories to which he was subjected during his military career and ponders about Rumsfeld's possible motivations.

Employees, Pay, and Risk

I've been thinking a lot today about employee compensation. Yesterday's LA Times had a long article on Wal-Mart, the gist of which is that Wal-Mart's employees should be unionized and paid a lot more. One of the article's key points is that Wal-Mart's low pay has ripple effects, driving down the pay and benefits of unionized grocery store workers at Safeway and Albertson's. The subject came up again when I surfed over to CalPundit, where guest blogger Barbara Maynard, the chief spokesperson for UFCW Locals 770 and 1442, the grocery store unions on strike here in the Southland, asks:

Would you rather that these 70,000 middle class jobs become poverty level jobs filled by workers who have to turn to the taxpayer for healthcare and food stamps? That’s what the companies are proposing because that’s what Wal-Mart has. The CEOs of these three companies are just trying to keep up with the Waltons. Their combined operating profits have gone up 91% in the past five years...but Wal-Mart’s have gone up even more. Good lord — when is enough enough? At what price profits??? [Ed.: My emphasis]

I think unions serve important social and economic functions, as I've explained before, but when I hear actual union leaders talk I am reminded of an old Peanuts cartoon in which Linus says: "I love Mankind, its people I can't stand!" It's a lot easier to think positive thoughts about unions at the level of economic theory than when watching them work in practice.

Anyway, I was thinking about whether I wanted to write up Maynard's and CalPundit's comments, when I discovered a post by Rob at Business Pundit that provides a powerful answer to Maynard's question(to be clear, Rob's post didn't say anything about either the Times article or the CalPundit post):

What people don't accept is that some people make almost nothing while the company they work for makes a huge profit. The question seems to be that if a company is profitable, why should all the money go to the shareholders? Why not give some to the employees who are barely getting by? I think I have an answer to this, based on my own recent experience - the profits belong to those who take the risk, not those who do the work....

I am in the process of starting a company. ... I am the one who, by doing this, is on the hook for 300K if it fails. I am the one who may lose my house and file bankruptcy if it doesn't work. This could ruin my life. Why would I take such a risk? Because if things go well, I will have significantly more money than I do now. ... The people who will work for me aren't taking a risk. If we can't make it, they will simply move on to another job. They won't owe a bank huge sums of money, they won't have lost tens of thousands of dollars of their own hard-earned cash.

Gordon Smith at Venturpreneur followed up with a great post putting fleshing out Rob's framework with some economic theory:

Instead of asking who is entitled to the profits, let's ask who is most likely to maximize profits? (After all, from a societal standpoint, maximizing the residual claim maximizes value creation, and we generally like value creation.) On the one hand, anyone who has a claim to the profits will want to maximize them. On the other hand, the only person who has a chance of success is the person who controls the firm. Here is a kernel of insight: profits attach to residual control. ...

Well, maybe I failed to mention that people can exercise residual control only by "purchasing" the right (not necessarily from another person, but by exposing oneself to substantial personal loss). This is where the notion of risk comes into the picture. If control were cheap, everyone would want it (which, of course, would cause the price rise ... so that was a silly game, wasn't it?). Residual control is expensive relative to other forms of participation in the firm.

Requiring entrepreneurs to take this step of puchasing residual control acts as a defense against adverse selection: people who know that they have limited competence would not be willing to purchase residual control because the costs of failure are too high.

As I explained in my article, In Defense of the Shareholder Wealth Maximization Norm, maximizing the value of the residual claim is just as important for established public companies as it is for the startups Rob and Gordon are discussing. In sum, Ms. Maynard is asking the wrong question. It's not "at what price profit" but "at what price not making a profit?" Take away the profit motivation and Ms. Maynard's union members won't be dealing with higher health benefit costs, they'll be out of a job.

Ribstein on mutual funds

My friend Univ. of Illinois law professor Larry Ribstein (who also put together the BusFilm web site on business movies) has an op-ed in draft on the mutual fund scandal, in which he argues:

Investors care mainly about fund returns. Market timing and late trading by large investors are significant only to the extent that they might affect expected returns, as by indicating mismanagement. But then it seems enough that investors know about the fund’s policies so they can decide whether to, for example, hire their own professional portfolio managers, invest in exchange traded funds whose prices are constantly updated, or buy low-fee index funds whose managers lack incentives to make deals with big investors.

Although at first glance Larry seems to be making the same "much ado about nothing" argument recently advanced by Alex Tabarrok, Larry does acknowledge the need for limited regulatory intervention; indeed, he seems to agree with my points that (a) no new laws are needed but (b) we do need to enforce the laws on the books:

There does seem to be a problem here. Special favors to large investors allow them to make discount purchases or premium sales of fund shares, siphoning $5 billion a year for “market timing” and $400 million for late trading from small investors, in addition to “liquidity” costs of portfolio rebalancing. ...

In short, [however,] the problems with mutual funds do not require a federal solution. Congress and the SEC have had their chance for 60 years. It’s time to give markets and state law a chance.

i agree with the thrust of Larry's case against new regulation, but disagree insofar as Larry seems unwilling to apply the federal laws that are already on the books. As I understand it, the mutual funds in trouble all had policies against late trading and market timing. The prospectuses by which they sold those funds described those policies (I pulled some of my fund prospectuses and they all have fairly detailed statements of such policies, although none of the fund companies in which I'm invested have been implicated -- yet). Hence, as I suggested in my original post, we not only have a problem of self dealing, we also have fraud. So while I'm all in favor of markets and state fiduciary duty law being used as constraints on the fund industry, I also think that the fraudsters can and should be punished under Securities Exchange Act Rule 10b-5 and the relevant Investment Company Act provisions. UPDATE: Larry emailed me:

To clarify [that] I don't suggest not enforcing current disclosure laws. My article asks whether disclosure alone is enough ("Beyond disclosure, the potential solutions become murky . . . "). Also, I'm curious what you think about my suggestion in my followup post that all we have in most of these cases is bad business judgment.

I don't know that I would call fraud bad business judgment. Anyway, as I understand the facts, at some of these funds the managers have had a financial stake in the entities allowed to do market timing, which would be self dealing.

Slate’s Coverage of the Martha Stewart Trial

Henry Blodget, a former securities analyst, is going to be covering the Martha Stewart trial for Slate (go here). The first entry bodes well, at least for the potential amusement value. Regular readers know I've been blogging in defense of Martha, even though I don't like her TV persona very much (okay, you got me, I don't like it at all). I plan to use Blodget as a major resource for blogging the trial. As you await future posts (breathlessly, no doubt), you can check out my prior posts here.

Why the insider trading prohibition is mandatory rather than just a default rule

I recently received the following email from a fellow corporate law professor:

Steve: I'm teaching insider trading to my corporations class today. I use your casebook, and I just read through your Insider Trading book. I like your summary of the property rights rationale for insider trading regulation, and I'm with you 100% right up to the end. But, if you want to treat insider information as a property right like trade secrets, how do you deal with the fact that insider trading liability is not waivable by the corporation-- i.e., the party with the entitlement?

It seems, following the property rights theory, that inside information should be a right of the corporation in the first instance, but it should be up to the firm after that to decide whether they want to allow insiders to use it (just as firms can, I presume, allow insiders to use trade secrets). Part of the answer here might involve the desirability of federal enforcement of insider trading. But couldn't the information be a property right with federal enforcement? That is, the firm ought to be able to opt-out of enforcement actions. They can't, of course. But doesn't that hurt the property rights theory? Maybe we just have to throw up our hands and go with the public choice explanation at this point (SEC won't allow corps to waive b/c they want to keep enforcing these cases)?

It's a great question. I answered with an excerpt from my article "Insider Trading under the Restatement of the Law Governing Lawyers," 19 Journal of Corporation Law 1 (1993). In this article I argued (1) that the rule of legal ethics actually authorize insider trading (I know that sounds nuts, I was surprised too when I realized it) and (2) that the rules should be changed to forbid lawyers from using confidential client information to make inside trading profits. In the excerpt that follows, I deal with the question of whether the prohibition should be a default rule that the client and lawyer are free to change or a mandatory rule. I conclude that it should be a mandatory rule (albeit somewhat tentatively, I must admit).

Alex Tabarrok on the mutual fund scandal

Few blogs are consistently as thought-provoking as Marginal Revolution. I am an unabashed fan. Every once in a great while, however, the thoughts they provoke are those of utter astonishment. So it was with Alex Tabarrok's post The Mutual Fund Scandal - much ado about nothing. In the following table, the text of Alex's post is in the left-hand column, my comments are on the right.

Alex Tabarrok	Steve Bainbridge
Let's take it for granted that insiders have used the peculiar pricing practices of the mutual fund industry to transfer some profits from buyers. According to some accounts, hundreds of millions of dollars have been transferred in this way ....	1. It's important to make clear that the scandal is not just self dealing by insiders. A big part of the scandal relates to mutual fund companies allowing certain investors to engage in market timing trades and late trading. These mutual fund companies all had policies against such trading, which were stated in their prospectuses. As such, we not only have self dealing, we also have discrimination among investors and securities fraud. 2. The gist of what is to come is signaled by the dismissal of siphoning of hundreds of millions of dollars as the transfer of "some profits."
But remember mutual fund buyers get quarterly statements showing their returns net of all chicanery. Is it so hard to believe that buyers make their decisions based upon their actual returns? A mutual fund that performs poorly is a mutual fund that performs poorly regardless of whether this was due to bad investment decisions, high expense ratios, or a slick transferring of funds. A few investors might buy and then accept any return as a matter of luck but the marginal investor can and does move funds around easily (what market is more contestable?) - not to mention the institutional investors.	Alex seems to be assuming zero transaction costs. In fact, the transaction costs of switching mutual funds can be significant. Many funds charge back-end load fees (a.k.a. exit fees or deferred sales charges) of 3-7% when investors pull their money out. Many more fund charge front-end load fees that reportedly run "5.75% for equity funds, [albeit] less for bond funds, and [which] are simply deducted from the amount being invested." In addition, many investors hold their mutual funds through brokerage accounts, which is another potential source of fees. As such, the transaction costs of switching may well be significant. (Alex's co-blogger Tyler Cowen likewise has suggested that mutual fund investments are sticky. I doubt whether mutual funds are quite as sticky as Tyler seemed to think, for reasons explained here, but that doesn't mean I think the mutual fund market is a zero transaction cost environment.) Because there are non-trivial transaction costs to switching funds, investors should care why a fund is under-performing. A fund that has a bad quarter because they got unlucky with a couple of big positions presents a very different problem than a fund that has a bad quarter because insiders have been self dealing and letting favored investors violate stated policies. The latter fund is much more of a long-term threat to investor wealth than the former. If you don't know why the fund is underperforming, however, you can't distinguish between the two. The last observation suggests that self dealing by insiders at a few funds could have negative externalities for the industry as a whole. If investors cannot distinguish between underperformance caused by a run of bad luck and self dealing, they may begin to perceive the whole industry as a lemons market. Assume there are two classes of investors. One class believes the magnitude of the harm posed by insider self dealing justifies restricting such self dealing. Accordingly, this class is willing to pay higher fees to funds who promise not to allow self dealing. The other class is willing to allow self dealing by managers of its funds, so long as those funds charge lower legal fees. An unscrupulous fund will try to maximize its income by attracting investors in the first class while secretly self dealing. Investors in the first class will be aware of this phenomenon, but the high detection and enforcement costs associated with self dealing make it almost impossible for them to distinguish between honest and dishonest funds. A prohibition of self dealing enforced by public law enforcement agencies makes these investors better off, but makes the second class worse off. If one believes that most investors fall into the first class, however, a prohibition of insider trading would be efficient (so long as one is willing to use the Kaldor-Hicks definition of efficiency.) Hence, a prohibition of self dealing may have advantages for the industry as a whole, by giving credibility to their promises not to allow self dealing and thus reducing agency costs. UPDATE: As Leaderlog observes, "non-transparency is usually synonymous with rent-seeking."
As a result, it makes little difference whether the managers get their return through the above-board expense ratio or the under-handed exploitation of stale pricing. Sure, there may be some exploitation at the margin but this is akin to banks that charge fees for "free checking" or restaurants that include a gratuity in their bill. It's annoying and the occasional consumer may be dunned but once consumer and competitor responses are taken into account the net transfer is small.	This is the part that really surprised me. If Alex is right, then generations of corporate lawyers have wasted their time worrying about the duty of loyalty and generations of economists have wasted their time worrying about agency costs. So long as markets are liquid, we apparently don't need either prohibitions of self dealing or institutional constraints on agency costs such as hostile takeovers. Investors can fully protect themselves by switching out of underperforming funds. Of course, if I'm right about the transaction cost and transparency points above, maybe that isn't true. (I also think Alex is too glib about the "net transfer" from self dealing.) In any event, I think it is instructive that corporate law long has drawn a distinction between bad management and self dealing. At first blush, you might think that the agency costs associated with bad management and self dealing differ in degree but not in kind. Both reduce shareholder wealth. Both are forms of shirking, at least in the broad sense that term is used by agency cost economists. On closer examination, however, self dealing in fact differs in kind, not just in degree, from bad management. Managerial decisions typically are collective actions of the board or top management team as a whole. In making such decisions, the board and/or management is constrained to exercise reasonable care by a combination of external market forces and internal team governance structures. In contrast, self dealing transactions rarely implicate the entire board or management team. To the contrary, they often involve misconduct by a single director or even a mid-level employee. Those who intentionally self deal, moreover, likely also actively seek to conceal their defalcations. Given the potential gains of self dealing in an organization characterized by a separation of ownership and control, legal liability thus is a necessary deterrent against such misconduct.
If you doubt the above, assume that we eliminate all under-handed practices. Do you think that consumers will now earn higher returns? Or, do you think, that other fees will rise to make up the difference? I predict the latter.	Here is where we come back to the point that the problem is not just self dealing but also securities fraud. Even if Alex is right that investors would (should?) view self dealing and disclosed fees as interchangeable, it is not clear that they would view fraud and fees as interchangeable. (Anyway, another aspect of Alex's argument puzzles me. Because fees benefit the fund management firm, while self dealing benefits individual managers, even if investors don't care about self dealing, fund management firms should.) We also come back to the points about the transaction costs of switching funds and the risk that a lemons market will emerge. If investors care whether their funds lie about things like market timing and late trading by favored investors, honest firms could attract investors by promising to prevent such trading. In order to work, however, such promises must have credibility. Investors will demand that fund management provide a credible promise—a bond—that guarantees that the fund will abide by its stated policies. Law can facilitate private ordering by providing such a bond. Candidly, I am somewhat skeptical that one needs the full panoply of disclosure and procedural rules imposed by U.S. securities law in order to provide such a bond (see here). At the very least, however, facilitating the making of credible commitments requires an antifraud rule (like present Rule 10b-5) and enforcement regime.
The only danger is that in their haste to make political hay the politicians will end up passing some dumb law that makes everyone worse off.	Here we are in complete agreement. Regular readers know I am a skeptic of much recent corporate governance reform legislation and regulation. At the same time, however, I think that current laws against self dealing and fraud ought to be enforced with vigor. I would have thought Alex would too.

But, as they say, decide for yourself.

Why do Restaurant IPOs Perform So Badly?

According to yesterday's WSJ (sub. req'd), there have been 75 restaurant chain IPOs in the last ten years. Overall, the sector has gained only 2% from their initial offering price, which is staggering given the evidence that IPOs generally are way underpriced. The sector's results become even more surprising, however, when you strip out the two success stories -- PF Chang China Bistro and Krispy Kreme Doughnuts. If you remove them from the data set, the sector as a whole lost 20%. On top of this data, moreover, one might note the anecdotal results from such high-profile flame-outs as Boston Chicken and Planet Hollywood. Granted, the restaurant game is a perilous one, as most restaurants fail in their first year. Restaurant IPOs, however, involve chains that are reasonably well-established and geographically diversified. The failure of any one location (or even several) should not take down the whole chain. Also, of course, the restaurant business was particularly hard hit by the combination of the recession and 9/11. Yet, it seems that restaurant IPOs were not doing all that well even before the stock market bubble burst. So I don't have a good theory for why this sector underperforms. (Ideas, anyone?) All I know for sure is that it's a sector I would avoid.

Securities Lawyers as Gate-Keepers and the Economic Incentives of Modern Legal Practice

Securities Litigation Watch blogged on a talk by Columbia University law professor John Coffee at which Coffee advanced his argument that outside legal counsel should take on an auditor-like role in certifying the accuracy of the client's financial disclosures. Mike O'Sullivan at Corp Law Blog picked up on that post, linking the report about Coffee's talk to Coffee's recent law review article The Attorney as Gatekeeper: An Agenda for the SEC, 103 Columbia Law Review 1293 (2003). Mike does a typically excellent job of explaining why Coffee's proposal should "die a quick death and be quietly buried in the academic legal writing cemetery." Ouch.

I don't disagree with anything Mike said, but my take on the problem would start by thinking about incentives. Some might say I am too cynical about my fellow lawyers, but I can't help thinking that people respond to incentives (and cognitive biases). And, as I see it, the incentives of lawyers are such that they would not do a very good job at the task Coffee wants to assign them. The remainder of this post is derived from my article, The Tournament at the Intersection of Business and Legal Ethics. (You might also be interested in Managerialism, Legal Ethics, and Sarbanes-Oxley Section 307.)