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

Kaizen as human resources tool

Business Week offers up an interesting article on Toyota's Kaizen (continuous improvement) process. (Link via Business Pundit.)

[Toyota] executives created the doctrine of kaizen, or continuous improvement. "They find a hole, and they plug it," says auto-industry consultant Maryann Keller. "They methodically study problems, and they solve them."

While kaizening works well as an engineering process, it's less clear that it makes an effective human resources tool, at least in the US. I wrote about kaizening, TQM, and other types of employee involvement in in my article Privately Ordered Participatory Management: An Organizational Failures Analysis, in which 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.” This worker seemingly would prefer a more structured environment. Studies of formalization—the creation of written rules, procedures, and instructions—suggest that it reduces role conflicts and ambiguity, which increases work satisfaction and reduces feelings of alienation and stress. Kaizening and other forms of employee involvement can trigger role stress because many employees lack the quasi-management skills—agenda building, conflict management, and problem solving—required for successful employee involvement. Alienation can result from the greater workload and negative changes in peer group relationships experienced by some participants in employee involvement. Not all employees respond well to formalization, of course. Many prefer a less structured and less hierarchical workplace. A good manager manages to his/her people, not to the latest management fad. Understanding your workers' tastes is the essential first step in making decisions about how workplaces are structured. All too many managers, however, manage to the latest fad rather than managing to the preferences of their people. I explain why in the post above.

The venturpreneur on corporate social responsibility

My friend Gordon Smith has a typically thoughtful post on corporate social responsibility. Money quote:

In my view, attempts to promote corporate social responsibility through corporate law are misguided because neither the profit maximization norm nor corporate structure account for the purported lack in corporate social responsibility. Instead, the culprits here are just that: culprits. Bad people. Like the poor, they will always be with us. And despite the best efforts of social reformers, law cannot fully anticipate nor fully prevent their activities. Indeed, I worry that one of the unfortunate consequences of attempting to provide a complete legal response to socially irresponsible behavior is that we may inadvertently encourage such behavior. Simply stated, detailed legislation may be imply that everything not regulated is moral.

Go read the whole thing, as they say.

Implications of the expectations effect for behavioral economics

The WSJ (sub. req'd) reports today on research into the so-called expectations effect:

British philosopher Bertrand Russell was only half joking when he described the powerful effect that the nationality of a scientist can have on lab rats. "Animals studied by Americans rush about frantically, with an incredible display of hustle and pep, and at last achieve the desired result by chance," he wrote in 1927. "Animals observed by Germans sit still and think, and at last evolve the solution out of their inner consciousness."

Seventy-six years on, scientists have documented the power of expectations, not only of lab researchers but also of teachers, athletic coaches, judges and work supervisors.

"Expectation becomes a self-fulfilling prophecy," says Robert Rosenthal, professor of psychology at the University of California, Riverside. "When teachers have been led to expect better intellectual performance from their students, they tend to get it. When coaches are led to expect better athletic performance from their athletes, they tend to get it. When behavioral researchers are led to expect a certain response from their research subjects, they tend to get it." [Ed.: Emphasis supplied.]

Expectation effects, also known as the Pygmalion effect, have been documented time and again (479 studies have found that teachers' expectations affect how students do, for instance).

The highlighted sentence is what caught my eye. Much recent legal scholarship has relied on the burgeoning school of behavioral economics. In turn, much behavioral economics research is based on psychology experiments using university students.

A longstanding critique of behavioral economics claims that many of these experimental situations are highly artificial, which raises doubts as to whether the results can generalized from the lab setting to real markets. The behavior of undergraduates swapping coffee mugs, for example, probably doesn’t tell us very much about the behavior of institutional investors buying IPO stocks in the primary capital market.

In contrast, the expectation effect suggests an even more powerful -- and fundamental -- critique of behavioral economics. If the experimental model is not well-designed to eliminate covert communication by the researcher, it seems, the researcher's expectations may be what is driving the result rather than any real cognitive bias on the part of the subjects. Consider the Journal's description of one experiment involving lab rats:

In one set of studies, 12 experimenters were each given five rats. Six experimenters were told that their rats were of a genetic strain that learned like long-tailed geniuses; the other six were told that their rats were dolts. The experimenters then spent five days training their rats to run a maze. From the first day, the rats identified as bright ran the maze better -- and kept getting better.

You can guess the punch line: all the rats belonged to the same strain. They differed only in the experimenters' expectations for them. In this case, the covert communication probably came from the way experimenters with "smart" rats acted: They felt more relaxed and enthusiastic as they worked with the rats, talked to them less (fewer outbursts of "you stupid rat!") and handled them more.

The effect is a very significant one:

The size of the expectation effect varies, but is always statistically significant, and sometimes big. For teachers, high expectations can raise student performance 30%. For rats, they can improve maze learning 65%.

What are we to make of all this? I don't think we should throw the baby out with the bath water. Behavioral economics is an important development every law and economics scholar should be prepared to grapple with. On the other hand, it is another reminder that behavioral economics cannot be used glibly. In the legal literature, one increasingly sees advocates of government intervention using behavioral economics to tell a variety of market failure stories. They jump glibly from positing the status quo bias, citing the coffee mug experiments, for example, to the conclusion that the government needs to shake up the status quo, without demonstrating that the bias is truly valid in the specific setting at hand. The expectation effect teaches that such a demonstration may prove even harder than I suspected. Interestingly, the Journal reports that a recognition of the power of the expectations effect is the reason studies of new therapies are done on a "double-blind" basis, so that not even the investigators know which patients received the active compound and which a dummy pill. Perhaps we should only trust those behavioral economic studies that mimic the double blind methodology.

The insider trading charge against Martha Stewart

With Martha Stewart about to sit down with Barbara Walters, I thought it might be an opportune moment to revisit the question of whether Martha Stewart actually committed insider trading (given the facts as we know them thus far).

As I'm sure you know by now, the SEC has charged Martha Stewart with illegal insider trading in ImClone, a biotech company run by her buddy Samuel Waksal. According to the SEC, in December 2001, Waksal learned that the FDA was going to hold up ImClone’s key Erbitux cancer drug. Waksal and a family member then dumped ImClone shares from their Merrill Lynch accounts. In violation of Merill Lynch policy, Stewart’s Merill Lynch broker told her the Waksals were selling. Stewart dumped her ImClone stock before the FDA announced its Erbitux decision, avoiding a 16% a drop.

The SEC thus is asking us to believe that Martha Stewart, TV show host, corporate president and directors, and multi-millionaire risked her reputation, livelihood, and fame to avoid losing the whopping sum of $45,673.

The SEC’s charges actually have very little to do with insider trading. Suppose Jane is the CEO of a big mining corporation. Jane learns the company has struck gold. Before the discovery is announced, Jane buys some more stock. That is classic insider trading. Now suppose Jane tells her friend Don the good news. Don buys stock, also pre-announcement. That is known as tipping. According to the U.S. Supreme Court, the tip will be illegal if Jane got a personal benefit from making the tip and Don knew (or should have known) that Jane’s tip violated her fiduciary duty to the company. A third kind of insider trading is called misappropriation. Suppose Jane’s company plans a hostile takeover of a second company. She tells her attorney Anne about the plan. Anne then buys stock in the target company. Anne has committed illegal insider trading based on misappropriated information. If Anne tips her friend Dave, that would be illegal too. The charges against Stewart don’t look anything like these examples. It is as though Jane’s broker thought her trade was unusual and told another client about it.

Martha Stewart pretty clearly didn’t know about the FDA’s Erbitux action. In fact, according to the SEC itself, after selling her ImClone stock, Stewart called Waksal and left the following message: “Martha Stewart—something is going on with ImClone and she wants to know what….” Although the SEC’s complaint makes much of the Stewart-Waksal friendship, the SEC nowhere alleges that Stewart had any advance knowledge of the problem with Erbitux.

In other words, Martha Stewart got a hot tip and she acted on it. So what? As a society, we care about insider trading because it is a form of theft. Information about the gold discovery belonged to Jane’s company, not to Jane. Information about the takeover bid belonged to the company, not to Anna. They stole that information from its owner and used it for personal gain. If the information leaked as a result, the company would be injured. But what information did Stewart steal and from whom? The SEC tells us she stole it not from ImClone but from Merrill Lynch, but does this look like theft as you know it? To be sure, the SEC may be able to make out the requisite theft in some hyper-technical sense but Stewart’s misconduct has very little to do with the historic reasons for policing insider trading.

Tellingly, the Justice Department’s criminal indictment does not charge Stewart with insider trading. Only the SEC’s civil complaint did so. Instead, the Justice Department went after Stewart for conspiring to obstruct justice by the great American pastime of lying to the cops. According to published reports, the U.S. Attorney decided going after Stewart would be an “unprecedented” expansion of insider trading law.

I don’t particularly like Martha Stewart’s public persona. Like a lot of people, I get a vicarious little thrill out of seeing the high and mighty brought low. But charging her with insider trading stretches that crime beyond where it was ever meant to go.

Mutual fund stickiness

A couple of days ago, Tyler Cowen opined that:

When you buy a new car, most dealers put you through hell. You have to fill out all sorts of paperwork, taking up half your day and locking you in psychologically to sticking around through protracted negotiations, based on deceit and lies. Most buyers don't leave and go elsewhere, in part because they know they can only expect to start all over again with the same. And as long as it is not too visible, you don't feel too bad about your initial investment decision.

I suspect we see the same kind of stickiness with mutual funds. Many investors will not be shocked by the recent revelations. But why bother switching to another fund? Once you get there, you can expect more of the same.

It's looking like mutual fund investments are not as sticky as Cowen predicted, at least according to this WSJ report (sub. req'd):

Investors withdrew $4.4 billion from mutual funds managed by Putnam Investments in the week ended Wednesday, even as they generally pumped money into stock and bond funds at other companies, according to calculations by AMG Data Services of Arcata, Calif. ... The withdrawals from Putnam funds are above and beyond the more than $4 billion that has been pulled from the Boston money manager by institutional investors, including state pension plans in Vermont, Rhode Island, Iowa and Pennsylvania. ... The withdrawals at Putnam ... are among the largest experienced by a fund complex in a single week, said Robert Adler, AMG president. "Investors are voting with their dollars," he said, and "they are making a strong statement" about Putnam in the wake of the federal and state charges.

NYSE Chief Reed announces NYSE governance proposal

Reed's proposed changes to the NYSE's corporate governance focus on creating a new 8 member board comprised of independent directors. From the NYT (reg. req'd):

In place of the 27-member board, Mr. Reed nominated eight people, including two current board members, to serve one-year terms. The exchange's board will be responsible for governance, compensation and internal controls, as well as for the supervision of regulation. It will be independent from the Big Board's management and from stock exchange members, member organizations and listed companies.

Madeline K. Albright, the former United States secretary of state, and Herbert M. Allison Jr., a former Merrill Lynch executive who is chairman of TIAA-CREF, the teachers pension fund, are the only current board members who Mr. Reed chose to retain. Other nominees are Euan D. Baird, the chairman of Rolls-Royce P.L.C.; Marshall N. Carter, the former chief executive of the State Street Corporation; Shirley Ann Jackson, president of the Rensselaer Polytechnic Institute; James S. McDonald, president and chief executive of Rockefeller & Company, the money management firm founded by the Rockefeller family; Robert B. Shapiro, former chairman of the Monsanto Company; and Sir Dennis Weatherstone, the former chairman of J.P. Morgan.

Reed's plan stinks. Granted, a smaller board comprised of independent directors is a good idea. Look at the list of nominees, however. Over half the board consists of ceremonial directors. There is only one representatives of a big institutional investor, which may not be a bad thing on the merits, but could make that key constituency group unhappy. None have relevant regulatory experience (as far as I can find out). Few, if any, have a deep knowledge of how the trading floor works. The Board of Directors therefore could end up depending on the new Board of Executives consisting of representatives of regulated firms.

In the long run, moreover, there still is an obvious conflict of interest arising out of specialist ownership of the Exchange. As long as that remains true, the Exchange still will be owned by the very people who it needs to investigate when there are concerns about trading ahead or front running. The nominally independent directors still will be elected to the specialists.

In some respects, that conflict of interest would be lessened if the Exchange were owned by public shareholders rather than the specialists. Yet, public ownership without splitting off the Exchange's regulatory function might just introduce a different set of conflicts. What if maximizing shareholder returns required the Exchange to overlook misconduct by specialists or others with floor trading privileges, for example?

The answer, it seems to me, is to follow the NASDAQ model. The NYSE’s roles as a regulator and a market should be separated. The regulatory functions could be assumed by the SEC, a new SRO, or maybe even the NASD (or some combination thereof). The market then could be spun off through an IPO. This solution addresses both the current governance problems and the longstanding conflicts inherent in the Exchange’s dual roles. The WSJ reported yesterday that SEC Chairman Donaldson reportedly is now considering imposing just such an approach on the Exchange. Tellingly, perhaps, the SEC's press release on Reed's plan concludes:

The Commission will continue to consider further market-wide reforms, including governance and regulatory reforms, in the coming months as it proceeds with its broad review of market structure issues. Additional reforms beyond the proposal put forth today will likely be considered.

Why instant messaging might kill the socratic method

This is a great story from a law student blog illustrating how technology will change the socratic method in law schools. Can you imagine what Prof. Kingsfield's students would have paid for this technology? Link via Scheherazade, who thinks this sort of team learning is a good thing. I think it could kill the socratic method, which I think I think would be a good thing.

SEC approves NYSE and NASDAQ director independence rules

The SEC has approved the NYSE and NASDAQ corporate governance listing standards, which strongly emphasize director independence. All listed companies now will need a majority of independent directors. Director independence is a good thing, most of the time, but mandatory one size fits all rules make little sense to me. Want more? See A Critique of the NYSE's Director Independence Listing Standards.