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

Executive comp

The Economist's lead editorial this week blasts executive compensation and urges increased shareholder activism:

This one-way trend in top executives' pay has rightly raised eyebrows, on both sides of the Atlantic. The supply of good bosses may be short, but can it be that short, even during an economic slowdown and stockmarket slump?

This is the right question, as I explained in a prior post, from which the following remarks are adapted.

How much you get paid depends in large part on the thickness of the market for your services. In a thick market, wages tend to be low because there are many potential employees – all more or less fungible – competing for jobs. In a thin market, however, wages tend to be high because many employers are competing to hire a small number of eligible workers. The market for burger flippers is very thick. The market for law professors is relatively thick. The market for CEOs of Fortune 500 companies is thin. I’d guess the number of people who have what it takes to run a Fortune 500 company isn’t much larger than the number of people who can run a NBA fast break. Hence, its not surprising that corporate CEOs make Shaq-like dollars. Its just supply and demand, folks.

Having said that, however, the Economist does have a point. Although I don't have the citations at the tip of my fingers, I have seen a couple of recent studies to suggest that boards erroneously believe the CEO market is thinner than it actually is, which tends to artificially inflate CEO salaries. Boards tend to want proven track records (picking an unproven CEO who tanks is bad for the board’s reputation), which limits the pool through the “Experience Required” phenomenon. Boards also tend to pick CEO candidates who resemble the prevailing demographics of the directors, which further artificially limits the pool. Hence, the Economist doubtless is right -- the supply of potential good bosses is not as short as directors believe.

The problem is that neither solution the Economist considers is desirable. The Economist is surely right that we don't want to direct government regulation of executive comp -- in particular, as I've said before, we definitely don't want to imitate Germany by criminalizing excess compensation. On the other hand, as I've also argued before, shareholder activism is hardly a panacea for the ills of corporate governance. Shareholder activism is not a solution but a problem. The only solution I can come up with is the imperfect one of independent directors incentivized to monitor executive compensation. It's not perfect, but its better than the alternatives.

Also noteworthy is the following huge whopper in the Economist's editorial: "Few public companies today in either America or Europe have a majority of independent directors." I don't know about Eurpose, but as to the US the statement is flat wrong. According to the NACD's latest survey of public corporations, 61% of US corporations had a majority of independent directors (29% had a board that was more than 75% comprised of independent directors). These are 2001 figures. Given the emphasis on director independence in the NYSE's listing standards and Sarbanes-Oxley, moreover, the figure is almost certainly higher now than it was in 2001. Once the new NYSE and NASDAQ listing standards kick in, moreover, almost all listed companies will have to have a majority of independent directors.

Does Martha Stewart have a 1st Amendment Right to Lie?

Slate's Explainer column weighs in on Martha Stewart's argument that Count 9 of her indictment should be dismissed, inter alia, because it violates her due process and free speech rights. (Link via The Volokh Conspiracy.) Regular readers know that this has been a topic of some interest in this space, including exchanges with O'Sullivan, Smith, and Yin. Our discussion did not focus on the free speech issues, of course, because we were focusing on the prudential and securities fraud questions.

My beef with the Explainer's analysis is that it assumes a factual predicate -- that Stewart lied -- that I doubt can be supported. In my view, what Stewart did simply is not insider trading. Hence, when she denied committing insider trading, she told the truth. In any event, my friend and colleague Eugene Volokh takes the Explainer to task, demonstrating that the Explainer's analysis contains a number of fairly basic errors. Eugene knows the free speech and due process issues far better than I do, so I defer to his assessment that Count 9 could withstand scrutiny on those issues. (I note that Prof. Yin reached the same conclusion.) I continue to believe, however, that Count 9 fails to state a claim for securities fraud and that the whole indictment should not have been brought as a prudential matter. (And, as I've noted before, the judge in her civil case seems to agree!)

Download my overview of insider trading law here.

The endowment effect

Greg Goelzhauser of the Law and Economics blog has a very interesting post on the endowment effect, which I think is generally regarded as the best-established example of behavioral economics. On reading his post, however, I was left with a question, arising out of the example he chose:

It's Good vs. Evil, #5 vs. #2, Law and Economics Blog vs. Discourse.net (in terms of institutional affiliation), it's the biggest game of the year: Florida State vs. Miami in Tallahassee this Saturday. Thankfully, I will be in attendance to cheer on the Seminoles. What I'm equally thankful for is that I didn't have to pay much for the tickets (about the price of a nice dinner), despite the selling of tickets from anywhere between 200 and 600 dollars. I certainly was not willing to pay this price for a ticket, but now that I have one I am also not willing to sell it at those prices.

I gather Florida State is his alma mater and that he's pumped for the game. If so, his unwillingness to part with the ticket might be an example of Arrow's observation "that interpersonal comparison of utilities has no meaning and, in fact, that there is no meaning relevant to welfare comparisons in the measurability of individual utility." Kenneth Arrow, Social Choice and Individual Values 9 (1963). My sense of the endowment effect literature is that it usually focuses on low cost objects of no particular value to the holder (coffee mugs in the classic experiment), so as to eliminate the problem of interpersonal comparisons of utility. In contrast, Greg may simply subjectively value the ticket at a price higher than the market equlibrium. The lesson may be that there are multiple reasons why subjective WTA and WTP valuations may differ in a given setting, of which the endowment effect is only one possibility. Having said that, the post is well-worth reading as an introduction to the endowment effect.

UPDATE: Greg continues the discussion with a very helpful response. I was particularly stuck by his citation of endowment effect studies where the subjects in fact placed a high personal value on the asset in question. (Query, however, why are the WTA and WTP values placed on hunting rights so much higher for duck hunters than goose hunters? Does duck hunting provide that much more utility?) The studies he cites also raise a further question about endowment effect research, which is the reliability of survey data. Asking people what their WTA and WTP prices are may not be as reliable as observing actual transactions. On the other hand, it may well be useful to survey people who are actually in the business in question rather than staging experiments using undergraduates. The best evidence would come from transactions in actual markets, of course, but that's probably the hardest data to get. Interestingly, the Economist reported a while back on work by U of Md. economist John List:

Instead of using callow students, he went to a real market with traders of varying degrees of experience: a sports-card exchange, one of many such, where Americans trade pictures of their favourite athletes. There, traders dealing in hundreds of cards mix with browsers who might buy only one.

List's paper is available here. In it, he finds:

[W]ithin the group of subjects who have intense trading experience (dealers and experienced nondealers), I find that the endowment effect becomes negligible. ... I find that market experience significantly attenuates the endowment effect. ... These results provide initial evidence consistent with the notion that market experience eliminates market anomalies.

(See also the discussion at Marginal Revolution.)

As Artie Johnson used to say, "very interesting." The take-home policymaking lesson would seem to be that the endowment effect could cause a market failure justifying regulatory intervention, but that some care is necessary before reaching that conclusion. The regulator ought to be confident that (a) the endowment effect is really present; (b) as a result of the endowment effect, an inefficient outcome is proving sticky; (c) that market experience cannot remove the anomaly; and (d) there is a superior regulatory solution.

Stock options versus restricted stock

In a Washington Post op-ed, Intel's Andrew Grove and Reed Hundt explain why Intel is not going to follow Microsoft's lead and switch from stock options to restricted stock grants:

What about restricted stock? Would it not be a better deal for investors? Not at all. With restricted stock it's possible for employees to gain while stockholders lose. Here's an example. An employee may be granted a share of restricted stock when the stock is publicly traded for $10 per share. When the vesting period ends, usually after one to five years, the employee will make money no matter what has happened to the stock price. For example, if during that time, the stock price drops to $9 per share, the employee is ahead by that same $9, but anyone else who bought stock on the open market would have lost $1 per share in value. This is why critics have called restricted stock "pay for pulse." The granting of restricted stock puts greater emphasis on longevity and tenure than on owner-like motivations.

I have seen this argument before, but have never understood it. It seems to assume that the employee got got the restricted stock for free. As one otherwise useful article on the choice between stock options and restricted stock grants put it: "employees granted stock have not paid for it, while shareholders have." This is clearly wrong. The employee and employer exchanged value -- labor for compensation. The total compensation paid logically should not depend on the form of the consideration (ignoring transaction costs and taxes). Assume the employee's labor is fairly compensated at a rate of $100 per day. The employee could elect to work for a company that pays only cash salaries and receive $100 cash. Or the employee could go to work for a company that pays compensation in the form of both cash and restricted stock. This company is not going to pay the employee $100 cash per day. Instead, it will pay the employee $90 cash and give the employee the $10 share of restricted stock. If the employee takes the second job, the employee has an incentive to do whatever is possible to keep the stock price abpve $10. Otherwise, the employee would have been better off working for the all cash employer. Or am I missing something?

Mike O'Sullivan @ Corp Law Blog also weighs in with criticism of Grove and Hundt:

I also think [their] characterization of restricted stock as "pay for pulse" is unfair. By requiring an employee to stay at the company during the vesting period, restricted stock helps the company retain employees. As such, it can have the same beneficial effect as long-term incentive plans, deferred compensation plans and, yes, stock options. Restricted stock vesting doesn't have to be tied just to retention -- Microsoft's new restricted stock program, for instance, requires its top 600 or so executives to meet certain performance goals before their restricted stock vests. Hardly "pay for pulse." At the same time, options can offer "reward for pulse," as macro events such as interest rates, currency values and GDP growth can increase (or decrease) stock prices independent of any improvement (or failures) at an individual company. In other words, a rising tide can lift all boats, even the ones that are about to sink.

My sense is that one size does not fit all. At some firms and in some economic conditions, options may make more sense. At others, especially in the recent market, grants make more sense.

Coors reincorporates in Delaware

According to the The Denver Business Journal Coors has reincorporated in Delaware (moving from Colorado) via a downstream merger with a wholly owned subsidiary:

"This change will be beneficial to the company and its shareholders through obtaining the benefits of Delaware's comprehensive, widely used and extensively interpreted corporate law," said Peter Coors, chairman, in a statement.

The proposal received strong (80%) shareholder support. The proxy statement listed three reasons for the move:

Through its General Corporation Law of the State of Delaware (DGCL), the state has especially flexible and comprehensive corporate laws. Because of those laws, 60 percent of Fortune 500 companies are incorporated in the state.

Delaware has a special court, the Court of Chancery, that deals exclusively with corporate legal cases. Most states, including Colorado, don't have such a business-oriented court.

Reincorporating from Colorado to Delaware also may make it easier to attract future board members since such candidates should already be familiar with Delaware corporate law.

In other words, the company perceives Delaware law as racing (or, at least, rising) to the top. Next week I'm off to a conference at Vanderbilt law school to comment on a paper attacking the race to the top hypothesis. I'll be posting more on this topic then. In the meanwhile, my article The Creeping Federalization of Corporate Law has my most recent defense of the race to the top hypothesis.

Martha wins a round

Reuters is reporting that the judge in Martha Stewart's civil securities fraud case has refused to stay discovery in the civil case. This is a win for Martha because most of the prosecution witnesses in the criminal case are also potential witnesses in the civil case. With this ruling, Martha's lawyers should be able to depose them on the civil side, which will also be useful on the criminal side. In addition, the judge handed Martha a PR win by noting from the bench that:

"I read this indictment. I tell you something ... we have seen a lot more serious obstruction cases. This is not the strongest obstruction case I have ever seen. This is not John Gotti," the judge said, according to a transcript of the pretrial hearing, referring to the notorious Mafia figure.

The judge, John Sprizzo, according to Reuters, is a former prosecutor. My take on all this is here and here.

A tad more on faculty retreats

My friend Mark Sargent, the outstanding dean of the Villanova law school, sends this response to my earlier post on faculty routs ... oops ... I mean retreats :

As a dean I make the following pledges: 1. I will never, never, never hold a faculty retreat. I would sooner open my veins with a rusty can opener. 2. "Mission" and "Vision" statements are worse than bunk. They are emblematic of the worst qualities of higher education today. I will never make my colleagues write one, unless the ABA makes me (which it did). You may quote me.

Now that's my kind of dean. I had forgotten that the ABA insists on a mission statement. It is not to me clear why the ABA does so. At bottom, virtually all of the ABA's rules are about cartelization of legal education. And since any idiot can crib a mission statement, it's not clear how that rule advances the ABA's cartel. Oh well, ours is not to reason why, ours is just to draft fluff.

More Martha

With respect to my post the other day about Martha Stewart's indictment, an astute reader emails to ask whether I'm talking about the "infamous Count 9 of the criminal complaint instead of to the overall obstruction charges that form the basis for the rest of the complaint"? I'm only talking about count 9. I agree with the reader's assessment of that count. He writes:

If you were thinking only of Count 9's charge that by publicly proclaiming her innocence, she was engaging in criminal securities fraud, I agree with you. In fact, even if she is, indeed, guilty, something bothers me if the government is allowed to publicly make allegations against her but she is not allowed to publicly deny them.

Meanwhile, Tung Yin of the Yin Blog has a very interesting post providing a good deal of detail on the legal merits of the obstruction of justice charge. I don't dispute his assessment that what Martha did could be criminal (in a hyper-technical sense, IMHO), but I still don't get why it is criminal as a matter of sound public policy or, especially, why as a prudential matter a prosectutor should have brought Count 9. I agree entirely with the first reader's assessment that it is unfair to let the government fling allegations, which they end up deciding not to charge somebody with, and then let the government prosecute that person for having denied the allegations the government decided it couldn't prove. Why isn't that just whacked?

Turning to the obstruction counts, however, I'm also skeptical of them as a prudential matter. It also seems to me that aggressive prosecutorial use of 18 U.S.C. sec. 1001 undercuts the requirement that the government prove guilt beyond a reasonable doubt. Granted the 5th amendment only gives you a right to remain silent, but shouldn't you be allowed to tell the cops "I didn't do it" without getting hauled up on charges later -- especially if they end up deciding not to charge you with the underlying crime? I mean, I can't tell you the number of times I've told a cop I didn't see the stop sign. [Ed: After reading Prof. Yin's helpful follow-up post, I added the underlined sentence for further clarification.]

I should note that Prof. Yin, to say the least, seems receptive to the prudential component of my argument:

Now, all that's left is to wonder, should the alleged lie in the actual case with the actual circumstances be a crime? And if so, is it really worth prosecuting? That's a totally different question, and certainly I can see arguments to be made that Stewart's alleged false statement really isn't worth the government's attention and time -- but for her celebrity status.

Exactly, if the defendant wasn't Martha Stewart (and if we hadn't already had Enron and so on), this case never happens. My friend Tom Smith makes this point quite pithily:

Steve Bainbridge is right on about Martha Stewart. He is perhaps too polite to add, however, that the ill-defined insider trading laws are perfect tools for ambitious prosecutors who want to go on scalp-hunting expeditions. Is Martha the most egregious insider trader in Manhattan these days? Hardly. But she is a high profile celeb with a reportedly obnoxious personality that the press would love to see fall. The Bonfire of the Vanities with the feds roasting their marshmellows on the flames.

Harsh, but true. (Download my overview of insider trading law here.)