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

The LA Strikes and the Economic Analysis of Unions

The LA grocery strike is getting to be a real pain. I rely on our neighborhood Ralph's for staples. Oddly enough, it also houses the only branch of my bank in our neighborhood. My problem is that, contrary to what I bet you suspect, I will not cross picket lines. Why not?

First, I come from a long line of union members. Second, Catholic Social Teaching emphasizes that workers have a natural right both to form unions and to strike. As I read the relevant encyclicals and pastoral letters, this teaching is not a matter of prudential judgment, but rather an authoritative teaching to which faithful Catholics must give religious assent. Finally, unions potentially are an important way of minimizing transaction costs.

Labor contracts are subject to moral hazard problems on both sides. Workers shirk—providing less effort than that to which they have agreed. Owners behave opportunistically—providing fewer rewards than promised. Preventing such shirking is one of the principal functions, in economic terms, of any labor relations system. Hence, at least among lawyer-economists in the transaction costs branch of law and economics, the once widely-held view that unions exist to capture monopoly rents for workers in the form of higher wages and superior benefits has given way to an understanding that unions play an important role in reducing transactions costs by constraining strategic behavior by management. Because workers value job security, firms can obtain lower labor costs if they can credibly promise to refrain from opportunistic conduct. One way of bonding that promise is to sign a collective bargaining agreement with a union. Collective bargaining transforms the decisionmaking process from unconstrained management prerogative to limited managerial discretion bounded by claims of right sounding under the agreement. The seniority system, with its ports of entry, internal promotion ladders, and protection from lay-offs, offers job security. Union monitoring helps ensure compliance by the firm with its contractual obligations. Grievance procedures allow for dispute resolution. Collective bargaining thus becomes a burden on the enterprise, in that it raises the transaction costs associated with decisionmaking processes and limits management discretion. Yet, because that burden serves to make the firm’s promises to its employees more credible, it is one rational managers would accept. (Putting the theory into practice, of course, has been a problem. Unions have been plagued by internal agency costs and been a source of social costs.) For a more detailed explanation see my articles Employee Involvement in Workplace Governance Post-Collective Bargaining and Corporate Decisionmaking and the Moral Rights of Employees.

Update re decisionmaking heuristics: One of my colleagues dropped by the office this afternoon to object that, whatever merit my arguments may have, I have not made a case for refusing to cross all picket lines. Good point. Neither efficiency or morality compels the result that every strike is worth respecting. My rule against crossing crossing picket lines, however, is economically justified as a transaction cost minimizing decisionmaking heuristic. Bounded rationality is a neo institutional economics concept capturing the idea that we all have inherently limited memories, computational skills, and other mental tools. These limitations become a significant constraint on decisionmaking under conditions of complexity and uncertainty. Under those conditions, we can reduce decisionmaking costs by adopting a heuristic -- a rule of thumb -- for making judgments. Yes, the rule of the thumb inevitably produces errors, but the benefit in time and effort saved may outweigh error costs. A rule of thumb of not crossing any picket line saves me the time and effort necessary to figure out whether a given strike is morally and economically justified.

Delaware’s Predictability Redux

Several days ago, I blawgged on the role that predictability played in Delaware's dominance of the market for corporate charters. A reader's email question suggests another example of how Delaware law is significantly more predictable than, say, California.

Most corporations these days have poison pills (about two-thirds, according to this report). Yet, the validity of poison pills under California law is uncertain. As the reader's email noted:

The leading treatise on California corporate law states that [a flip-in poison] pill “appears to be violative” of section 203 of the California Corporate Code. [Citing Harold Marsh's treatise.]

I've researched this issue at some length and have been unable to find any significant guidance in either the case law or secondary literature. As far as I can tell, there is no definitive answer. In contrast, Delaware's law on poison pills is well-developed. We know that standard pills are ok in theory (although the Delaware courts reserve the right to invalidate them if used for improper purposes) and that dead hand and no hand pills are invalid. (See generally my article Dead Hand and No Hand Pills: Precommitment Strategies in Corporate Law.) Yet again, so much for the indeterminacy hypothesis. Relative to California law, Delaware's substantial body of precedent provides a high degree of certainty. Given the importance of poison pills these days, this is an excellent example of why a rational planner would prefer Delaware to California even none of the other considerations we've been discussing came into play.

Dow 10000, Psychology, and the ECMH

PoliBlog has an insightful post on the possible economic and political impact that would follow from the Dow getting back above 10,000:

While I am hardly saying that if the Dow hits 10k or more (and stays there) that that guarantees any particular outcome in the 2004 elections, can anyone argue that it wouldn’t help President Bush? Can anyone make the argument that a falling or stagnant stock market doesn’t help the Democrats? The election will turn on multiple factors, and the economy is always one them. So, good economic news, especially good economic news that is widely disseminated and fairly easily understood, certainly helps the party in power.

The problem is that it is not clear the Dow will stay above 10,000 in the near term. The WSJ (sub. req'd) is reporting on how 10,000 has emerged as a psychological barrier:

It sounds odd to some rationalists, but the Dow Jones Industrial Average has had a problem with the number 10000 .... Whenever the Dow has reached the 10000 level, it has run out of steam, sooner or later. The blue chips first surpassed 10000 in 1999, and eventually got as high as 11722.98 before succumbing to a bear market and falling back. Since that fizzle, the Dow industrials have moved past the milestone again and again. In all, they have surged above 10000 a total of 18 times, based on the average's closing value, only to lose momentum and fall below again on a later day. It makes no rational sense that a big round number like that should be a barrier, and yet...

As a quasi-rationalist, how can I square this evidence with my general belief in the efficient capital markets hypothesis (ECMH)? Easy.

ECMH's fundamental thesis 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 over- or under-priced. The current price is an accurate reflection of the market's consensus as to the commodity's value. A hard rationalist version of the ECMH would claim that investor psychology is irrelevant. The hard rationalist version, however, is almost certainly wrong. Research in cognitive psychology suggests that investor idiosyncrasies do not always cancel one another out. Instead, investors sometimes act like a herd all running in the same direction, which can produce pricing errors. Large speculative bubbles that appear out of nowhere and crash without apparent reason are the most visible form of this phenomenon.

There is considerable evidence that markets adapt to investor irrationality over time, however. If investor irrationality produces pricing errors, it becomes possible to profit by taking advantage of them. At one time, for example, the capital markets showed a systematic bias against small cap firms. As a result, it was possible to earn abnormal returns by investing in a portfolio weighted towards small caps. Over time, many investors did so, including a substantial number of mutual funds that specialized in small cap investing. As a result, the small cap anomaly gradually faded to the point at which it was no longer possible to systematically beat the market by investing in them. Interestingly, however, the Dow 10,000 barrier has elicited a market adaptation that -- at least in the short run -- is likely to reinforce investor irrationality:

In practical terms, short-term investors have learned to make money by speculating that the market will gyrate when it hits key psychological points. ... People use index futures and other devices to bet that stocks will sag as they hit a symbolic barrier.

These bets create downward pressure that reinforces investor skepticism. Fortunately, there is evidence that experienced traders can learn their way out of the irrational behavior patterns that lie at the bottom of so many market anomalies. Herd behavior, moreover, is a fairly fragile thing. Introduction of credible new information can have a cascade effect, in which market opinion changes almost instantaneously. Enough good economic news therefore should eventually overcome the psychological barrier and let the Dow get back above 10,000, just as the Dow eventually managed to stay above 1,000.

Today’s Shareholder Access Question

As part of this space's continuing series posts in response to the SEC's shareholder access proposal, today we tackle question A.2:

What would be the cost to companies if the Commission adopted proxy rules requiring companies to include security holder nominees in company proxy materials?

One likely cost will be a reduction in board effectiveness. In my article, Why a Board, I explained that the firm must be viewed as an institution—more precisely, as a set of institutions—rather than as a mere production function. Specifically, the firm consists of a set of production teams embedded within a hierarchical structure. At the apex of that hierarchy stands not an individual, but yet another team—the board of directors.

Teams are subject to unique cognitive biases, such as groupthink, and unique sources of agency costs, such as social loafing. With respect to the exercise of critical evaluative judgment, however, teams have clear advantages over autonomous individuals. Not only do teams outperform average individuals in a given sample, there is considerable (albeit contested) evidence that the process of group interaction has synergistic effects allowing teams to outperform even the best decision makers in the sample.

The election of a securityholder representative will disrupt the delicate internal dynamics that make boards successful. If the SEC could figure out a way to limit the proposal to situations in which the board is clearly dysfunctional, this might be less of a concern. The SEC proposal does not do so. The securityholder right would could be triggered by passage of a shareholder proposal the board declines to adopt, for example, as the SEC is considering. [Ed.: See update]

The effect of a securityholder right to elect board members will be analogous to that of cumulative voting. Whether cumulative voting is desirable for a given firm will therefore vary. Firms whose top management team requires advice from diverse sources might benefit from cumulative voting, although the high probability of adversarial relations between that team and minority shareholder interests suggests that board representation of the latter likely would prove unavailing in this regard. Firms requiring skeptical outsider viewpoints to prevent groupthink likewise might benefit from cumulative voting. Again, however, the likelihood that cumulative voting results in affectional conflict rather than cognitive conflict leaves one doubtful as to whether those benefits will be realized.

The likelihood of disruption in effective board processes is confirmed by the experience of German firms with codetermination. German managers sometimes deprive the supervisory board of information, because they do not want the supervisory board’s employee members to learn it. Alternatively, the board’s real work is done in committees or de facto rump caucuses from which employee representatives are excluded. As a result, while codetermination raises the costs of decisionmaking, it seemingly does not have a positive effect on substantive decisionmaking. (See my article Privately Ordered Participatory Management: An Organizational Failures Analysis.)

The effects of electing a securityholder representive therefore will not be better governance. It will be an increase in affectational conflict (as opposed to the more useful cognitive conflict). It will be a reduction in the trust-based relationships that causes horizontal monitoring within the board to provide effective constraints on agency costs. It will be the use of pre-meeting caucuses and a reduction in information flows to the board. The cost of the proposal therefore will be less effective governance.

Vanderbilt Conference: Comments on Bebchuk and Cohen Firms’ Decisions Where to Incorporate

A perennial topic in academic corporate law is whether the evolution of state corporate law is better described as a race to the top or a race to the bottom. According to the "race to the bottom" hypothesis, states compete in granting corporate charters. After all, the more charters (certificates of incorporation) the state grants, the more franchise and other taxes it collects. Because it is corporate managers who decide on the state of incorporation, states compete by adopting statutes allowing corporate managers to exploit shareholders.

Many legal scholars reject the race to the bottom hypothesis. According to a standard account, investors will not purchase, or at least not pay as much for, securities of firms incorporated in states that cater too excessively to management. Lenders will not make loans to such firms without compensation for the risks posed by management's lack of accountability. As a result, those firms' cost of capital will rise, while their earnings will fall. Among other things, such firms thereby become more vulnerable to a hostile takeover and subsequent management purges. Corporate managers therefore have strong incentives to incorporate the business in a state offering rules preferred by investors. Competition for corporate charters thus should deter states from adopting excessively pro management statutes. The bulk of the empirical research appears to bear out this view of state competition, suggesting that efficient solutions to corporate law problems win out over time.

Lucian Bebchuk and Alma Cohen have made an important recent contribution to the debate in an empirical paper entitled Firms’ Decisions Where to Incorporate. Bebchuk and Cohen claim two key empirical findings:

[First, their] study has … produced findings that cast substantial doubt on the proposition that there is a vigorous competition among states over corporate charters. ... The overwhelming majority of non-Delaware companies are simply incorporated in the states where their headquarters are based.

[Second, their] findings indicate that the incorporation market rewards states that amass antitakeover statutes. ... At one end of the spectrum, states with no antitakeover statutes, such as California, do poorly and retain a relatively small fraction of the companies located in them. At the other end of the spectrum, states that amass most or all standard antitakeover statutes are the ones most successful both in retaining in-state companies and in attracting out-of-state companies.

In other words, the market for state competition in corporate charters is not perfect, and (2) agency costs affect management decisionmaking. Neither result will surprise any informed observer of the corporation law scene. The question is what, if anything, does confirming those points prove? Bebchuk clearly intends it to be one more nail in Delaware’s coffin. Does it succeed in slaying the race to the top beast?

Former SEC Commissioner Laura Unger on Expensing Stock Options

Interesting TCS interview with former SEC Commissioner Unger on stock options. Highlights:

I think the average investor doesn't really understand financial statements. But most investors do understand a narrative that describes what compensation plan for a particular company and whether it includes stock options....

What I think is important to the analyst community or to the analyst generally, is the dilutive effect of options that are exercised. ... By dilution I mean the impact on the number of shares that are outstanding and the impact on existing shareholders that an exercise of options resulting in more shares outstanding has on holdings and the market in general. I can speak from first-hand experience on this because I'm on the board of a software company that issues broad-based stock option plans. The majority of shareholders, the institutional shareholders, care about the dilutive affect of the option grants, not the impact on the bottom-line financials.

Today’s bonus corporate governance ruminations

1. What would the SEC do if Delaware amended DGCL § 141 to provide that for three year director terms, rather than the current 1 year default. It would make the SEC's shareholder access proposal a lot less disruptive. (Note that in a classified board there still is an annual election, even though each director's individual term will be 3 years. I'm suggesting that there only be an election every three years.)
2. If shareholder activism is such a great thing, why aren't there mutual funds that specialize in activism? Granted there is a free rider/public good problem, but it is still a little puzzling.
3. If the SEC's shareholder access proposal goes through, why would we need rule 14a-8? If shareholders are that worked up about something at a firm, let them try to elect a director under the new proposed access regime. Update: As Gordon Smith points out, a "too easy" answer is that the SEC wants to use Ryle 14a-8 as a trigger for shareholder access to director nominations. But other triggers could be devised that would not depend on 14a-8.
4. Will the SEC be satisfied with getting the shareholder access proposal through or is the real agenda federalization of corporation law? Regular readers will know that I am not a fan of the current process of creeping federalization of corporate law.

Today’s Shareholder Access Question: Why Not Rule 14a-8 Too?

On Wednesday, I began a new series of posts in response to the SEC's shareholder access proposal. As you will doubtless recall, my first post dealt with the relationship between state law and proposed Rule 14a-11. As you will also doubtless recall, the SEC release states:

If state law permits companies incorporated in that state to prohibit security holder nominations through provisions in companies' articles of incorporation or bylaws, the proposed procedure would not be available to security holders of a company that had included validly such a provision in its governing instruments.

Today, instead of answering another SEC question, I wish to pose a question to the SEC (just over 1% of my hits come from the sec.gov domain, so I know you're listening!): Why not allow corporations to opt out of Rule 14a-8 too? (For the benefit of the uninitiated, Rule 14a-8 is the shareholder proposal rule. There's a good guide here.)

The shareholder proposal rule has become an increasingly costly mechanism for social activists, unions, and public pension fund managers to hijack the corporate proxy statement as a soapbox for multiple proposals that often have little to do with shareholder welfare. Granted, there is increasing use of the rule for what purport to be governance governance, but query how much governance bang we're getting for our buck. If it makes sense to let firms opt out of Rule 14a-11, there is no good reason to forbid them from doing so with respect to Rule 14a-8. (I need to come back to this issue to develop the case for an opt-out from Rule 14a-8 in more detail, but I thought I'd at least get it on the table now. Maybe one of my fellow corporate law/governance bloggers will want to run with it?)