Regulation and the Second Law of Thermodynamics

stephen_hawkingAt first blush, one would not think that Barney Frank and Stephen Hawking would have anything in common.  The first is the Chairman of the House Financial Services Committee, and is currently conducting hearings on the regulatory reform of the financial markets.  The second is the noted University of Cambridge professor of theoretical physics and the author of the best selling book A Brief History of Time.

 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.

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The Apprentice

donald-trump2The National Law Journal recently reported that the law firm of Howrey & Simon has adopted an innovative training program for new associates.  Newly hired lawyers will serve a two year “apprenticeship” prior to being fully integrated into the law firm.  This program will reduce the number and the compensation of the law school graduates hired by the firm, and it is part of Howrey’s overall program to eliminate “lockstep” salary increases for its associates.

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.

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Grossman on Governance

wall-streetNadelle Grossman has two new corporate law papers on SSRN.  The first, entitled “Turning a Short-Term Fling into a Long-Term Commitment: Board Duties in a New Era,” deals with the timely topic of corporate leaders making strategic decisions based on short-term profits without regard to long-term risk.  As a solution, she proposes changes in the legal duties owed by corporate directors.  Here is the abstract:

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. 

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