However, in my mind both men are associated with the Second Law of Thermodynamics.  This law of physics states that the entropy of an isolated system always increases over time.  Stephen Hawking described it in more comprehensible terms in A Brief History of Time:

It is a common experience that disorder will increase if things are left to themselves.  . . .  In any closed system disorder, or entropy, always increases with time.

 Therefore, when I think of Hawking, I think of someone who can explain the Second Law of Thermodynamics.  When I think of Barney Frank, I think of someone who is desperately trying to avoid its operation.

I would contend that all forms of market regulation follow the Second Law of Thermodynamics.  In each case, a comprehensive statutory scheme is enacted as law, it imposes a closed system of rules on market actors, and over time the scheme inexorably breaks down.  Federal securities regulation, which began with the Securities Act of 1933 and the Securities Exchange Act of 1934, provides the perfect case history of this principle in action.

The federal securities laws were designed to force companies selling their securities to the public to make certain basic disclosures about their finances and business prospects to the potential purchasers of these securities.  The policy goal was to even the playing field so that the buyers of the securities had at least some of the information that the sellers possessed, and the buyers could then make an informed purchase decision.  Federal law therefore created a system of regulation to ensure that specific documents were prepared, and disclosed to the public, before securities transactions were allowed to take place.

This regulatory scheme was imposed on the world as it existed in 1933.  This was a world where the fastest form of communication for a written text was the United States mail.  It was also a world where all information was compiled and stored in a document-centric format: if you sought a particular piece of information you had to search for it by reading through an entire book or a report.  This was also a world where the types of securities sold to the public were comprised mostly of the vanilla variety of stocks and bonds that buyers (and sellers) knew and understood.

 We live today in a very different world.  Technology has changed.  A written text can be sent anywhere in the world instantaneously via the internet.  In addition, information is stored very differently in the digital age.  We enter search terms into Google and Lexis, thereby allowing us to extract specific nuggets of information directly, without having to read through an entire book or document to find them.

 The markets where securities are bought and sold have also changed dramatically.  Virtually anything can be “securitized” and turned into a product that can be traded over the market – from the right to receive future mortgage payments to the risk that the same mortgage holders will default on those payments.   Financial institutions were initially forced to confine their trading to a single line of business: whether securities trading, banking, or insurance.  Over time, however, these rules were relaxed and firms became “financial supermarkets” that were allowed to take on multiple market risks at the same time.  The same company can now take the simultaneous risk that the securities it underwrites will not sell, that the loans it makes will not be repaid, and that its cash flow will not be sufficient to meet its obligations to policyholders.  A single company can survive one bad bet; it cannot survive losing all three.

 These changes in information technology and market behavior all occurred at the same time that economists were radically changing their theories about the way that prices for securities are determined by the market.  The SEC has long embraced the Efficient Capital Markets Hypothesis, which holds that the price of a financial asset reflects all available information that is relevant to its value.  If this theory holds true, then it is proper for regulators to focus their attention on ensuring that companies quickly and accurately disclose new information relevant to their future prospects.  However, behavioral economists have come to the conclusion that investors are often swayed by irrational factors unconnected to objective data about the company, such as an unjustified optimism that a past price rise will continue into the future (the “bubble” effect).  New theories of evolutionary economics posit that investors adopt trading practices in a process of trial and error, keeping strategies that work and dropping strategies that cease to create profit.  The implication is that investment decisions are neither purely rational nor purely irrational, and that the SEC’s single-minded pursuit of information disclosure can never foreclose the possibility of future market bubbles and meltdowns.

It has become plain that the original regulatory scheme of 1933 is beyond the point where minor patching will work anymore, and is probably beyond the point where even serious repair can rescue the original model.  Entropy has overtaken federal securities regulation.  Some might argue that this fact demonstrates that any attempt to regulate the financial markets is ultimately futile.  However, I believe that our experience with securities regulation merely proves that every regulatory scheme has a natural lifespan.

 Our current model for the regulation of financial markets has reached the end of its useful life.  The world we live in has changed to such an extent that the original model should be discarded and a new regulatory scheme embraced.  While it may not be feasible to replace all of our current market regulators, at a minimum those regulatory bodies should be consolidated and given a new mission.

 If financial institutions are going to be allowed to operate in multiple market sectors, then the focus of our financial regulation should be on systemic risk (the risk that conditions across several different market sectors will lead large financial institutions to fail).  In addition, the content of financial regulation should be determined less by the characteristics of the financial product being sold (securities for the SEC, commodities futures for the CFTC, loans for the Treasury Department and the Federal Reserve) and more on the financial stability of companies that sell financial products.  This would entail the enforcement of minimum capital requirements and prohibitions on excessive leverage so that the managers of large financial institutions do not bet the company’s very existence on risky trading strategies.  Finally, the mission of our financial regulators needs to shift away from policing whether sellers have disclosed information and focus on the needs of the public as the consumers of a product.  Are buyers being given a variety of choices?  Does the information being made available allow consumers to make meaningful comparisons between products?  A new Consumer Financial Protection Agency could be created to undertake this last task.

 What I have described are the very premises that underlie the Obama Administration’s proposals to reform financial regulation.  Barney Frank and the House Financial Services Committee have been holding hearings on these ideas.  You can read more about the Administration’s proposals in this report from the Brookings Institution.  I agree with the report’s author that these measures are sensible and overdue.

However, politics always gets in the way.  Each existing financial regulator is jealously guarding its own turf, to ensure that a new system of market regulation does not diminish its authority.  Powerful congressmen, who possess their power due to their seniority on the committees that oversee different segments of the market, do not want to see the old system of regulation abolished.  And financial institutions that have learned how to operate around and between the interstices of multiple regulatory bodies do not want a comprehensive reform that eliminates or even blurs these lines of demarcation.

As a result, any legislation enacting these reform proposals will probably be significantly watered down and the original 1933 model of securities regulation is likely to persist.  According to the Second Law of Thermodynamics, leaving the original model of regulation to itself will result in increasing disorder in the financial markets.  Someone once said that “you can’t fight the laws of physics.”  I think it was either Stephen Hawking or Barney Frank.

Lawyers in Howrey’s apprenticeship program will be paid significantly less than the going rate for first year associates at other large law firms.  During their first year, the new associates will take firm sponsored classes on legal writing and gain practical experience by working on pro bono matters.  During their second year, the associates in the program will spend several months “embedded” at client sites where their work will be charged at a reduced billing rate.  The law firm’s managing partner compared the apprenticeship program to the training programs typically employed in the medical and accounting professions.

 The Howrey program provides an opportunity to reconsider the entire continuum of legal education: a process that begins with undergraduate instruction, continues through law school, and is perpetuated by continuing legal education requirements.  From time to time, each stage in the continuum comes under scrutiny, as Rick Esenberg’s post on Reengineering Law School illustrates.  In my opinion, the continuum should be viewed holistically when we evaluate whether we are succeeding at training competent and ethical members of the legal profession.  Law schools, law firms and the state bar all need to cooperate in order to ensure that there are no gaps in the preparation that new lawyers receive as they start their careers.  As a member of the Wisconsin Legal Education Commission in 1996, I argued in favor of a program of mandatory skills-based CLE instruction for recent bar admittees.  Many of our students are undoubtedly pleased that the State Bar chose not to implement this particular Commission recommendation.

 Given my predisposition in favor of practical training, I should be supportive of the Howrey apprenticeship model.  Instead, I find myself troubled.  In particular, I am wary of the idea of embedding future corporate lawyers within a client’s legal department for any significant period of time.

 Corporate lawyers play a vital role as “gatekeepers” in the area of economic regulation.  The role of outside legal counsel is not just to provide the advice necessary to implement the client’s business plan, but also to guide the client (sometimes gently and sometimes more forcefully) away from tactics that stray too far into the “grey areas” of  prohibited conduct under securities or antitrust law.  Lawyers who fail to take this gatekeeper role seriously, and who unquestioningly advance the client’s interests, risk possible disciplinary action or even criminal charges.

It is worth recalling that, during the 1990s, accounting firms evolved away from their traditional role as financial monitors and towards more lucrative “client consulting” practices.  This inattention to the gatekeeper responsibilities of their own profession led to several high-profile corporate meltdowns.  Today the accounting profession is subjected to unprecedented regulation via the Sarbanes-Oxley Act.  Among other things, Sarbanes-Oxley forces accounting firms to rotate the lead auditors that they assign to their clients.  The purpose of this provision is to reduce the risk that a long time relationship between a particular auditor and a particular client might eventually jeopardize the auditor’s objectivity.

 My concern is that Howrey’s embedded lawyers may be tempted to internalize the client’s perspective, in a way that hampers the future objectivity of these young professionals.  While the details of the law firm’s program are unclear, it would make sense for Howrey to try and perpetuate the relationships that are formed between its apprentices and its clients when it assigns future legal work to associates.  This could lead to a close and career long association between an apprentice and a particular client.  It seems odd to me in this post-Sarbanes-Oxley world that a law firm would seek to mimic the very lack of separation that accounting firms previously fostered between individual accountants and particular clients.

It was this close association that created a culture where auditors acquiesced in the client’s view of how the company’s financial results should be presented, rather than pushing the client to adopt a more defensible presentation.  Outside legal counsel face pressures from clients as well, in this case to rubber stamp the non-financial disclosures in a company’s annual reports and other securities filings.  Will former apprentices prove too pliable when pushed to sign off on the preferred disclosure language of companies where they were once embedded, and with whom they have a career-long association?  If so, our profession should not be surprised if Congress someday mandates that law firms rotate billing partners among their clients required to file public reports, much as accountants must now rotate lead auditors. 

 There are many ways in which the objectivity of corporate lawyers can be compromised.  Outside counsel is often asked to serve on the board of directors of the client corporation.  In some cases, law firms receive the client’s stock as compensation rather than cash.  Engaging in such practices does not necessarily compromise the objectivity of the lawyer, and neither of these examples directly contravenes the ethical rules for lawyers.  Nonetheless, many observers argue that these practices should be avoided because they tempt lawyers to too closely associate their client’s interests with their own, thereby abandoning their gatekeeper role.  It is interesting to consider whether the use of embedded apprenticeships as a training mechanism for corporate lawyers engenders a similar risk.

Nadelle Grossman

Corporate boards face significant pressure to make decisions that maximize profits in the short run. That pressure comes in part from executives who are financially rewarded for short-term profits despite the long-term risks associated with those profit-making activities. The current financial crisis, where executives at AIG and numerous other institutions ignored the long-term risks associated with their mortgage-backed securities investments, arose largely because those executives were compensated for the short-term profits generated by those investments despite their longer-term risks. Pressure on boards for short-term profits also comes from activist investors who seek to make quick money off of trading in stocks whose prices overly reflect short-term firm values.

Yet this excessive focus on producing short-term profits runs counter to the interests of non-short-termist investors and other corporate constituents, as well as our economy and society as a whole, in creating corporate enterprises that are profitable on an enduring basis. Once again, the current financial crisis provides a lens through which we can see the distressing impact — both to individual businesses as well as to the entire U.S community — of an excessive focus on short-term profits.

I propose a solution to address this problem of short-termism. Under my proposal, directors would be required to make decisions that are in the long-term best interest of stockholders and the corporation under their fiduciary duties. I explain in the article why I propose fixing the short-termism problem through fiduciary duties as well as how, practically, my proposal would be implemented.

This paper is forthcoming in the Michigan Journal of Law Reform. 

The second paper, entitled “Director Compliance with Elusive Fiduciary Duties in a Climate of Corporate Governance Reform,” addresses other aspects of the fiduciary duties of board members.  Here is the abstract:

Corporate governance has become a hot topic following accounting scandals at Enron, WorldCom and others, which led to colossal corporate collapses. In many of those cases, the boards were “asleep at the wheel,” failing to catch managers’ questionable accounting practices. The Sarbanes-Oxley Act of 2002 was the federal government’s attempt at fixing the holes in the corporate governance system exposed by the accounting scandals. Through a patchwork of disclosure requirements and conduct rules, Congress and the Securities and Exchange Commission have attempted to bring about an increase in board oversight of, and independence from, management. The stock exchanges have also jumped into the corporate governance arena, implementing new rules with similar objectives. This collective corporate governance reform has imposed a significant new layer of responsibilities and qualifications on directors of public companies. Yet, shareholders’ only avenue to enforce the new duties under these reforms is through state law fiduciary duties. My article demonstrates how state courts have started to enforce the governance mandates under the reforms through fiduciary duties. Specifically, in my article I examine the watershed Disney case and the duty to act in good faith, and identify how Delaware courts are poised to use this duty to enforce directors’ oversight responsibilities under the corporate governance reforms. My article takes a uniquely holistic view of these shifts in Delaware jurisprudence, explaining how they allow Delaware courts to more closely align the standard of conduct expected from directors with the standard of review that courts apply in determining liability. My article ultimately submits that by more closely aligning these two standards through the duty to act in good faith, the Delaware courts are able to reflect evolving shareholder expectations in fiduciary duty law, thereby making directors more responsive to the shareholders who elected them.

This paper has already been published at 12 Fordham Journal of Corporate and Financial Law 393 (2007).

Another fundamental area where the Marquette Law School faculty is also showing important contributions to the law is the production of scholarship that results in law review articles, book chapters, textbooks, etc.  We often present and discuss these works when they are still in progress in conferences around the country with our colleagues in our areas at other schools.  Still, to facilitate even further these very important discussions, the MULS Academic Programs Committee, led by Professor Chad Oldfather, has organized two sessions of an in-house Works-in-Progress Workshop for June and July.

The June session was a great success. A group of eight of us met this past Wednesday and presented our works-in-progress, from very rough to more completed drafts of scholarship, to our colleagues participating in the program. 

 In addition to the various presenters, Professor Paul Secunda also provided participants with helpful feedback. The topics and discussion on each of the drafts were fascinating and brought us on a beautiful journey throughout many different areas of the law.

Professor Phoebe Williams opened the day by presenting a paper on “Age Discrimination as a Barrier to the Provision of Health Care,” in which she analyzes the Age Discrimination Act of 1975 and advocates for the creation of appropriate data collection and research models to effectively identify and redress those instances where advanced age is illegitimately considered by health care providers.

Professor David Papke then followed with a paper on “Law, Legal Institutions, and the Criminalization of the Underclass,” which represents one of the chapters of  a planned book on the analysis of the relationship between legal institutions and the “underclass” in the United States.

Also related to Criminal Law, Professor Greg O’Meara presented a paper on habeas corpus review for state prisoners, in which he challenges the belief, almost taken for granted after passage of the Antiterrorism and Effective Death Penalty Act of 1996, that habeas claims are ineffective.  Professor O’Meara’s paper will be part of the Conference on Criminal Appeals, which has been organized by Professors O’Hear and Oldfather and will take place at Marquette Law School on June 15-16, 2009. The paper will also be published in a special symposium issue of the Marquette Law Review.

The Workshop continued with the presentation of Professor Vada Lindsey on the wrongs of the “Earned Income Tax Credit.”  In this paper, Professor Lindsey criticizes the effectiveness of the EITC, particularly insofar as it fails to encourage saving by the working poor.

Professor Lisa LaPlante followed with a presentation that brought us to a different dimension of the law: international law. In her current project, starting from the analysis of the conviction of former Peruvian President Fujimori, Professor LaPlante considers the issue of criminal accountability for wars on terror and human rights violations by heads of state.

Professor Nadelle Grossman then brought all of us back to our classrooms by discussing her current research project: how traditional law school teaching, which is based primarily on case law, fails in preparing students for transactional practice. In her paper, Professor Grossman highlights the gap between the reality of legal practice and law school teaching, criticizes the lack of valuable materials for teaching transactional law and practice, and calls upon law school curricula to bridge this very important gap.

Next, Professor Michael O’Hear presented a draft of his article “Appellate Review of Sentence Explanations: Learning from the Wisconsin and Federal Experience,” which he will also present at the Criminal Appeals Conference and which will be published in the symposium issue of the Marquette Law Review. In his paper, Professor O’Hear proposes a set of principles to guide the appellate review of sentence explanations in jurisdictions, such as Wisconsin, that lack mandatory sentencing guidelines.

I then concluded the day with a presentation on “The Case for a Fair and Balanced Protection of Geographical Indications of Origin,” which addresses the reasons why we should protect these “new” types of intellectual property (which refer to names such as Prosciutto di Parma, Chianti, Bordeaux, Budwar Bier, or Idaho Potatoes) and the limitations that should apply to these rights. Unfortunately, I had no time to provide tastes of the many (good quality) food and drinks I mention in my paper!

Thank you again, Professor Oldfather, for organizing such a great day of legal discourse and intellectual exchange at Marquette Law School.

The first case, State v. Henley, 2008AP697, presents an interesting issue regarding the authority of the courts of appeal, or the supreme court, to grant a new trial to a criminal defendant in the interests of justice, without regard to the passing of the time for appeal.  As Judges Vergeront, Lundsten, and Bridge explained in their certification of the questions in the case,

This case is significant because the circuit court has granted a form of relief that does not appear to have been recognized previously in Wisconsin law. There is no authority cited by the parties, and none that we know of, that expressly permits a circuit court to grant a new trial in the interest of justice after the time for direct appeal under WIS. STAT. RULE 809.30 has passed. If such a remedy is available, it has implications for finality of criminal convictions and for the interplay with other forms of postconviction relief, such as WIS. STAT. § 974.06. However, availability of this remedy would also improve the ability of courts to consider unusual circumstances and do what justice requires in individual cases. These competing concerns are implicated in the entire series of legal issues discussed in this certification.

The issues in the next case, State v. Carroll, 2007AP1378, surround whether police violated the defendant’s rights in obtaining photographic evidence from his cell phone. 

The next case, Ehlinger v. Hauser, 2007AP477, arose from a business dispute regarding a disability buyout provision that was invoked after one of the principals in the shared business developed Parkinson’s disease. The court of appeals determined that the buyout provisions were unenforceable but that the circuit court properly exercised its discretion in determing that the shared business could pay the litigation expenses of the party who had been seeking the dissolution.  Both parties are dissatisfied with the outcome in the court of appeals, so the case includes a petition and a cross-petition.

In the next case, State v. Arends, 2008AP52, the court has been asked to clarify certain procedural questions presented by section 980.09 of the Wisconsin statutes, regarding committment of a sexually violent person. 

In the next case, State v. Fischer, 2007AP1898, also criminal, the court of appeals affirmed a circuit court order to exclude the testimony of a defense expert regarding his blood alcohol level, when the defense expert relied in part on results of a preliminary breath test (results that are not admissible at an OWI trial). The petition asks the court to decide whether the exclusion of the expert testimony violated Fischer’s constitutional or statutory rights.

Finally, in the last case, State v. Artic, 2008AP880, the Petitioner argues that that police officers’ alleged violations of his rights (invasion of the curtilage, manufacture of exigent circumstances, and forced entry) were not sufficiently attenuated from the consent to search.  Further, he argues that, per se, the fruits of a search or seizure are inadmissible if police created the exigent circumstances (fear of destruction of evidence) by knocking and announcing before entry.

The current crisis exposes the fragility of markets generally. They are built on mutual reciprocity, and as more opportunism from trusted intermediaries is exposed, the weaker our faith in other market actors becomes. Both Francis Fukuyama’s work on trust and Robert Putnam’s on the “social capital” it reflects bode ill for our economy. Putnam describes a southern Italy mired in corruption and fraud, and a northern Italy whose economic success is built on its long history of civic associations and mutual endeavor. Can anyone doubt that our economy is exposed (with each passing day) as more Sicilian in its “winners’” casual acceptance of fraud, more Russian in its oligarchic tendencies, more Brazilian in its inequality? After the Madoff scandal, what are investors to do–personally spot-check their broker’s office and assure that trades are actually being made?

There is a bunch of other interesting stuff in this post, but I think I’ll just end with my favorite part.  In discussing the “worship of wealth,” Pasquale quotes from the blog of former fund manager John Bogle:

At a party given by a billionaire on Shelter Island, the late Kurt Vonnegut informs his pal, the author Joseph Heller, that their host, a hedge fund manager, had made more money in a single day than Heller had earned from his wildly popular novel Catch 22 over its whole history. Heller responds, “Yes, but I have something he will never have . . . Enough.”

She points us to this story from the New York Times Deal Book:

The possibility of a bankruptcy filing at Tribune Company is an embarrassing development for Samuel Zell, the real-estate mogul who took the media company private last December.

But it is likely that Tribune’s employees — or, more specifically, the employees’ stock-ownership plan — would take the first hit.

Because of the unusual structure of Tribune’s $8 billion buyout, Tribune’s employee stock-ownership plan holds 100 percent of Tribune’s common equity, regulatory filings show. Common stockholders are generally the first to take a loss in a bankruptcy restructuring, and they usually recover next to nothing.

Mr. Zell, by contrast, supplied mostly debt in the complex transaction, putting him higher in line to get paid. His $315 million investment in the Tribune deal consisted of a $225 million promissory note; the rest was for warrants to buy about 40 percent of Tribune’s stock in the future.

Great, another self-centered corporate CEO looking out for himself and screwing the employees of his company. I guess we should be thankful that at least he is not asking for a bail out.

More about this story here.

Cross posted at Workplace Prof Blog.

According to the Risk and Governance Blog:

The Laborers’ International Union of North America and the International Brotherhood of Teamsters are filing new proposals that seek compensation reforms at companies that participate in the U.S. Treasury Department’s bailout program.

In the supporting statement for these 2009 resolutions, the labor funds argue that the pay restrictions in the Treasury’s Troubled Asset Relief Program (TARP) “fail to adequately address the serious shortcomings of many executive compensation plans.” Instead, the unions urge directors to adopt “more rigorous executive compensation reforms that we believe will significantly improve the pay-for-performance features of the Company’s plan and help restore investor confidence.”

According to the Associated Press, more than 110 financial firms have indicated that they likely will participate in the TARP’s Capital Purchase Program, under which the government has so far committed up to $250 billion to buy preferred stock. The labor funds have filed this resolution at JPMorgan Chase, KeyCorp, Bank of America, American Express, and SunTrust Banks, and plan to submit the proposal at more than 45 other firms.

The proposal calls for directors to adopt the following reforms:

* Limit annual incentive compensation to an amount not exceeding one times the senior executive’s annual salary;

* Require that a majority of long-term compensation be awarded in the form of performance-vested equity instruments;

* Freeze new stock option awards to senior executives, unless the options are indexed to peer group performance so that relative, not absolute, future stock price improvements are rewarded;

* Require senior executives to hold for the full term of their employment at least 75 percent of the shares of stock obtained through equity awards;

* Prohibit accelerated vesting for all unvested equity awards held by senior executives;

* Limit all senior executive severance payments to an amount no greater than one times the executive’s annual salary; and

* Freeze the accrual of retirement benefits under any supplemental executive retirement plan (SERP) for senior executives.

The labor unions urge directors to adopt all of these reforms unless barred by existing executive employment agreements.

In short, the bailout has presented an opportunity for unions to actively challenge excessive executive compensation. This is an example of how unions through their roles as shareholders are seeking to influence executive pay, voting for boards of directors, and other corporate governance issues.

Cross posted at Workplace Prof Blog.

So what should a new administration do to make businesses better appreciate, and protect themselves from, the long-term risks associated with their businesses?

Congress is currently attempting to address this through regulating the executive compensation practices of financial institutions that take advantage of the Treasury’s purchase of troubled assets (such as mortgage-backed securities) under the Troubled Asset Relief Program (TARP) established under the Emergency Economic Stabilization Act of 2008.  For example, these regulations prohibit the payment of compensation to top executives of financial institutions in which the Treasury obtains a meaningful debt or equity investment in connection with its purchase of troubled assets that rewards those executives for taking “unnecessary and excessive risks that threaten the value of the financial institution.”  But in my view, this only addressed one of the symptoms of the ailment of excessive risk-taking, and only in one industry.  To be sure, executive compensation practices are also a source of excessive risk taking, where executives are rewarded for the short-term benefits of their decisions notwithstanding their long-term value-destroying effects.  But perhaps more importantly, the stock market encourages risk-taking by rewarding investors with profits from short-term stock price swings notwithstanding the long-term risks of the decisions that created those swings.  Don’t get me wrong, I don’t blame investors for wanting to make profits.  Earning profits through investments in successful business enterprises is at the core of our capitalist system.  But our stock market should not encourage investors to make profits from short-term spikes in stock prices that are not lasting, much like executives should not be rewarded for making decisions that bring about those short-term spikes.

So how should the new administration go about fixing the problem? 

Perhaps the new administration should send a clear message to state legislatures and courts (who regulate the internal affairs of the business organizations organized in their states) that business managers must, as part of their fiduciary duties to their investors, make decisions that are aimed at enhancing long-term enterprise value rather than short-term profits.  (This is actually the subject of my forthcoming article.)  The new administration should also consider how to encourage investors to invest in enterprises that create lasting value and societal wealth, rather than in enterprises that simply provide short-term returns to their profit-seeking investors (such as hedge funds).  While some might view increased regulation in this area as dissonant with our system of capitalism, in my view, the goal would be to create a coherent and well thought out scheme of targeted regulations that could enhance how our capitalist system functions over the long-term.

The next President, members of Congress, and state legislators have a lot of work ahead of them to fix our corporate system so that U.S. businesses are encouraged to prosper and grow.  But I believe doing so is critical if we want our economy to be among the strongest in the world.

There’s a former Wall Street trader who is now a researcher at Cambridge University in the UK. His name is John Coates. What he told me was that when he ran a trading desk in Wall Street during the last dot com boom and bust, he found that his traders were exhibiting almost physical symptoms of mania. So they were punching the air. They were yelling. There was – not to put too fine a point on it – there was more pornography floating around in the office. This is of course is a very masculine, macho environment. But what John Coates also noticed was that the few women who were on the trading floor didn’t seem to be affected.

Looking into this, he discovered that this sort of behavior is actually really common in many male animals. What happens is, you have, say, two gorillas or two stags fighting each other. One of them wins. They get a surge of the hormone testosterone. It makes them aggressive. It makes them take risks. And that goes on for several days. And then one day, effectively they are suffering from testosterone poisoning. These traders are basically suffering from exactly the same symptoms as rutting stags.

Ari Shapiro, the NPR reporter then follows up with the next logical question, ”So we should put women in charge of Wall Street, is that what you’re saying?”  Mr. Harford replies, “Well, that’s a possibility, assuming that women want to be in charge in Wall Street, yeah.”  This, of course, leads to the question of who actually wants to be in charge of this mess.  But, in fact, some limited studies demonstrate that when women serve on corporate boards, the companies do better.  See Conglomerate for more on this conversation. 

So, the lesson for my pension fund advisors -– I hope you have a mix of men and women making investment decisions and I also hope you are investing in companies with a mix of men and women on the board.  (I also hope that my next quarterly statement is an improvement!)

Cross-posted at Indisputably.

Much has been made of the greed and speculative fervor that gripped the investment professionals on Wall Street. Clearly bets were being made with borrowed money that risked the very existence of institutions that are necessary to preserve the liquidity of capital in our markets. Expanding the oversight of the Treasury Department, increasing the transparency of transactions that involve derivatives and hedge funds, and re-examining accounting rules may all be necessary components of a plan to avoid such risk-taking in the future, but they will not be sufficient in and of themselves. From personal experience in the boardroom, I can vouch that nothing deters executive approval of speculative investment strategies as much as the prospect of a potential civil lawsuit if the deal goes sour.

Federal judges have been antagonistic towards plaintiff’s litigation alleging securities fraud for decades. The Supreme Court has deliberately sought to reduce frivolous lawsuits by interpreting the reach of Rule 10b-5 in ways that limit meritorious suits as well. Cases such as Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S. Ct. 2799 (2007), and Stoneridge Investment Partners LLC v. Scientific Atlanta, Inc., 128 S. Ct. 761 (2008), are but the latest examples of this judicial attitude. And of course Congress has acted as well to limit private suits through the Private Securities Litigation Reform Act of 1995 (passed over President Clinton’s veto) and the Securities Litigation Uniform Standards Act of 1998.

The hostility of federal judges towards frivolous lawsuits is easy to understand. The judge can observe firsthand the cost that an unwarranted claim of securities fraud imposes on the corporate defendant and its executives. However, federal judges do not observe firsthand, and therefore undervalue, the deterrent effect that the possibility of a securities fraud lawsuit (even an unwarranted one) has on the willingness of market actors to engage in speculative behavior. The restrictions on private litigation over the last decade or so have substantially reduced this deterrent, and have undoubtedly contributed to risky boardroom decisions. These restrictions have also greatly reduced the ability of a corporate lawyer to act as a “gatekeeper” and police the quality of executive decision-making. When corporate executives are discussing risky financial strategies, speculation is often replaced by prudence after the lawyer asks how the executives would defend their decision if challenged in court.

President Clinton was roundly criticized as beholden to the plaintiffs’ bar when he vetoed the Private Securities Litigation Reform Act. The next President should reflect upon whether Bill Clinton was correct to do so, and whether private securities litigation plays an important role in deterring excessive risk-taking in the markets. Our nation’s ability to avoid a future financial crisis may depend on it.

Up to 10,000 staff at the New York office of the bankrupt investment bank Lehman Brothers will share a bonus pool set aside for them that is worth $2.5bn (£1.4bn), Barclays Bank, which is buying the business, confirmed last night.

The revelation sparked fury among the workers’ former colleagues, Lehman’s 5,000 staff based in London, who currently have no idea how long they will go on receiving even their basic salaries, let alone any bonus payments. It also prompted a renewed backlash over the compensation culture in global finance, with critics claiming that many bankers receive pay and rewards that bore no relation to the job they had done.

A spokesman for Barclays said the $2.5bn bonus pool in New York had been set aside before Lehman Brothers filed for chapter 11 bankruptcy in the United States a week ago. Barclays has agreed that the fund should continue to be ring-fenced now it has taken control of Lehman’s US business, a deal agreed by American bankruptcy courts over the weekend.

I’m really at a loss of words. One can see the cupidity inherent in the current American system through this example alone. And also the need for direct oversight of executive compensation, as companies have shown an inability to provide any meaningful limits on such payments.

The Christian Science Monitor agrees:

Wall Street badly needs a culture change at the top. Its leaders must come to view themselves as stewards of institutions for the long term, not as temporary operators of vehicles proficient at finding new ways to throw off wealth, with everything else – including impact on the public interest – a mere detail. Institutional stewardship will mean, in practice, forgoing some opportunities for making a killing when the downside of a bet gone bad may be to jeopardize a franchise . . . .

The most objectionable aspect of CEO compensation isn’t primarily the unfairness of the few at the top taking more than their appropriate share, nor that CEOs could cash in their personal gains based on ephemeral financial value, nor even the absurdity of massive “golden parachutes” paid out in cases of failure. The worst affront to the national interest is that these compensation arrangements created incentives for CEOs to “roll the dice” in search of the biggest possible scores for the company (and, not coincidentally, themselves), with too little regard for the downside risk if they bet wrong. And with no appreciation for the potentially dangerous consequences of such gambles, in the aggregate, for the economic security of the American people.

Hat Tip: folo

Cross posted at Workplace Prof Blog.

As several heavy hitters in the financial world have come under pressure or have gone bankrupt in the past couple of months because of the subprime mortgage and lending crisis that has battered investment firms and banks, the employer “stock drop” cases that proliferated in the post-Enron Corp. and post-WorldCom Inc. age are on the rise.

Although the Employee Retirement Income Security Act claims raised in these stock drop cases have not been identical, there are two central claims that arise in these cases. The first claim typically raised is that the plan fiduciaries breached their duties by offering company stock as a plan investment option when the stock was an imprudent or unwise investment. The second claim focuses on the disclosure obligations of the plan fiduciaries and often alleges that the fiduciaries breached their duties by not telling plan participants of financial matters of the plan sponsor that made the sponsor’s stock an imprudent investment.

Among firms that recently have been hit with stock drop lawsuits are Lehman Brothers Holdings Inc., American International Group Inc. (AIG), Bear Stearns, Wachovia Corp., UBS, IndyMac Bank, and Fifth Third Bancorp.

I have written abut this type of stock drop litigation before. The issues at the forefront are how ERISA is overtaking securities law as the litigation vehicle of choice by plaintiffs who suffer stock losses and how these cases almost never make it to trial because the firms being sued are forced to settle if certification of the class is granted by the court.

Given the financial pain being felt by everyone these days, and with little hope of an end being in sight, I would suspect courts to cut down on certification of these classes or for a movement by the corporate lobby to amend ERISA to cut down on these types of suits.

Cross posted on Workplace Prof Blog.

Professor Grossman’s thesis has profound implications for the direction of corporate law.  At least since Berle and Means published The Modern Corporation and Private Property in 1932, the classic challenge for corporate governance has been viewed as the need to align the interests of management with the long-term interest of shareholders.  For over seventy years, developments in executive compensation, shareholder proxy voting, and director fiduciary duties have been directed towards this end.  However, the growing influence of “short-termers” with short investment horizons on the process of management decision-making has upset the classical assumption that shareholders will instinctively press management to advance a longer view of the corporate interest. 

Perhaps, in the future, the challenge of the corporate law will be viewed differently.  Advocates of reform might seek to uncover legal mechanisms that would better align the interests of institutional investors with the interests of private shareholders who hold their stock for the longer term. Alternatively, the goal of corporate law might be to develop ways to protect management from the pressures being applied by short-termers.  We may find that the insulation of management from shareholder influence is not the source of the problem in corporate governance, as Berle and Means proposed so long ago; it might turn out to be the solution.