Ideoblog

Jurisdictional competition, regulatory arbitrage, and duck liver

As the civilized world knows by now, Chicago has finally abandoned its stupid ban on foie gras. Today I want to reflect on what lies behind that move.

In the first place, Chicago had to compete as an international city. The current Mayor Daley is arguably the first and certainly the best at that game in Chicago's history. Despite having gorged myself for a year on New York’s wonderful restaurants, I conclude that New York restaurants arguably are to Chicago restaurants what New York architecture is to Chicago architecture. There’s a lot of very high quality and interesting stuff in both categories in NY, but Chicago is closer to the cutting edge. That attracts the high end of the travel biz, and Daley knows this. He understood that these days the high end traveler can go to NY as easily as Capone went to Cicero.

Chicago's tourist boom won’t continue if Chicago’s going to go all provincial. Daley comes from the same background as his grain-fed colleagues on the city council, but he’s way more tuned to Chicago’s competitive challenges. So duck liver becomes another case study, to go with corporate law and same sex marriage, in my growing file of examples of jurisdictional competition driving the law.

Even before the ban's repeal, Chicago chefs played a little regulatory arbitrage, according to Raymond Sokolov’s article on "foie gras freedom" in today’s WSJ. One chef was “running a "duckeasy" on the model of Prohibition speakeasies. He gave foie gras away and “overcharged for the salad underneath.” Others just flouted the ban: “Hot Doug” Sohn “served a hot dog laced with foie gras and named after the edict's sponsor, Alderman Joe Moore.” He paid the fine and got tons of free publicity.

Now, for the animal rights crowd, you should know: I respect your right to love animals; comments on this blog are moderated; and we have many jurisdictions in which your views can be heard, and they all have jurisdictional limits.

Let me suggest Evanston.

The loophole legend

The supposed Pulitzer-Prize fodder over at the WSJ about the Bear Stearns collapse includes what is now being called the “loophole legend”:

The hurried deal had a loophole that could give angry Bear Stearns investors powerful leverage to seek a higher price: J.P. Morgan had pledged to finance Bear Stearns's trades for a year -- even if shareholders rejected the deal. Unfortunately for the drama of the story,

I discussed this legend-in-the-making at the time the transaction was unfolding.

But John Carney over at Dealbreaker points out yet again that this legend “probably isn’t true.” In fact, JP Morgan needed the durable guarantee to send a very strong signal that would stop the run on Bear. Indeed, the WSJ story supports this take, since it emphasizes that previous efforts to shore up confidence didn’t work.

(Carney also asks whether JP Morgan would have been willing to pay 750 million more over a mistake.  Actually, yes, given the difficulty of proving that the parties' actual intent deviated from the words of a very heavily lawyered document.)

Carney adds that no one has been willing to support the legend on the record, and it was not in Bear Stearns' proxy statement description of the transaction. As Carney says: “The omission of the loophole legend suggests that the executives at Bear Stearns and JP Morgan weren't as comfortable telling that particular tale in a forum where they could be held to account for their veracity.”

Carney is suggesting that Pulitzer-seeking journalists are not similarly “held to account” in repeating without qualification off-the-record speculation for purposes of dramatising a story even after significant doubts about the speculation had developed. But at least in this web-enabled world we do end up with something like the whole story.

The marriage law market hits NY

Last week I wrote about the California marriage decision as an example of the market for law in action. I pointed out that now that California had joined Massachusetts, "[t]his puts economic pressure on other states (e.g., NY), which among other things risk losing productive taxpayers to competitive states."

Now the other shoe has dropped – NY has responded to this pressure by deciding to recognize foreign same-sex marriages, thus becoming the only state that recognizes foreign but not domestic same sex marriages.

Obviously this isn’t the end of the process – both the California and NY decisions will be challenged politically and legally. People and firms will participate in this process not only by voting but also by deciding where to locate. Note that the NY decision was precipitated by an issue of health care benefits -- something that is of more than passing interest not only to the couples but to their employers.

As I pointed out last week, the law market is a messy process. But it’s also arguably a better way to generate a social consensus on same sex marriage than to have the federal government abruptly declare a winner through a statute, constitutional amendment or Supreme Court decision.

New on SSRN: Uncorporating the Large Firm

This is a significant revision of a paper I’ve been talking about for awhile – the role of partnership governance in managing large firms. The previous version was The Rise of the Uncorporation, posted last summer (that’s now the working title of a book I’m working on that will cover the whole uncorporation area). Here’s the new abstract:

This article examines private equity firms as an example of partnership-type, or uncorporate, structures in the governance of large firms. Other examples include publicly traded partnerships, real estate investment trusts, hedge funds and venture capital funds. These firms can be seen as an alternative to the corporate form in dealing with the central problem of aligning managers` and owners` interests. In the standard corporate form, shareholders monitor powerful managers by voting on directors and corporate transactions, suing for breach of fiduciary duty and selling control. These mechanisms deal with managerial agency costs by relying on other agents, including auditors, class action lawyers, judges, independent directors and shareholder intermediaries such as mutual and pension funds. Uncorporations substitute other devices for corporate-type monitoring, including more closely tying managers` economic well-being to the firm`s fortunes and greater assurance of distributions to owners. Continued concerns with managerial agency costs, the inadequacy of regulatory responses such as the Sarbanes-Oxley Act, changing costs and benefits of public ownership, leverage and capital lock-in all contribute to the rise of uncorporate structures in large firms. Political considerations may, however, constrain these developments.

Bottom line: partnerships and the like are not just for closely held firms anymore.

Alternative bottom line: maybe it’s finally time to stop calling that course “corporations.”

Airlines still not hedging oil

Four years ago I started wondering why airlines weren’t hedging oil.

I noted that “[w]ithout hedging, the airlines are actually speculating on the price of oil, since they know they're going to be buyers. Since they probably don't have inside information on where oil prices are headed, this would seem to be questionable.”

A year later I was still wondering, noting that Southwest had saved $155 million by capping 86% of its fuel expenses at the equivalent of just $26 a barrel of crude oil. At that time, oil was around $50/barrel. I guessed it might have to do with the fact that “much of the industry is operating in bankruptcy?”

But the industry is out of bankruptcy, oil prices are still soaring, and Southwest is still the only hedger. Today the WSJ’s George Anders wonders,

With oil near $130 a barrel, why does Southwest Airlines stand alone in the airline industry in its aggressive use of hedging to keep fuel costs under control? Southwest has locked in more than 70% of its jet-fuel requirements this year at a price equivalent to $51 a barrel for crude oil. By contrast, other big carriers have hedged 30% or less of their fuel needs this year. Those carriers generally expect to pay the equivalent of $85 to $100 per barrel of oil under their hedging programs.

Anders cites some explanations by David Carter, who has studied hedging by Southwest (case study) and the US airline industry. The industry study, from back in 2002, concludes that hedging jet fuel can be valuable, but that non-hedgers may not be acting act suboptimally. That would seem to be harder to stomach six years later. 

For today's column, Carter suggests that it's "psychologically hard to switch strategies when prices are moving against you" and that airlines are stymied by frequent management changes.  Southwest's treasurer Scott Topping claims they're able to move decisively because they have a small group making decisions.

I have some other explanations:

• Fear of fiduciary liability for hedging mistakes. And it cuts both ways -- the "psychological" problem Carter refers to may be a fear of making their previous decision not to hedge look bad.
• Managers are paid and judged by what the rest of the industry is doing, so they stay in lock-step.
• Creditors may be wary about financing hedging only to see executives misspending hedging profits while they hold the bag for losses. See Tufano, Agency Costs of Corporate Risk Management.
• Derivatives can be scary because they reduce transparency (e.g., Enron).
• SOX could be rearing its ugly head. Hedging might entail extensive disclosures, and potentially huge individual liability for certifying financials that omit something. As I’ve argued often, SOX penalizes risk-taking. Of course it's also risky not to hedge in this environment, but at least managers won't go to jail or face personal liability for failing to hedge, particularly if they can point to competing executives doing the same thing.

Fear and group-think don’t make for lovely business strategy, but these seem to be the elements of our current business environment.

There may be a solution.  In my Rise of the Uncorporation (new version out shortly) I suggest that the tighter discipline of what I call “uncorporations” – firms that operate under partnership-type incentives and discipline – may help solve agency problems, including problems associated with using derivatives. These controls may make it easier for creditors and others to trust managers' decisions regarding derivatives.

Anders concludes his WSJ article by noting that "[hedging] has been a big enough boon [for Southwest] that other airlines should ask why they missed out." And we should ask what kind of institutional perversity might be causing this failure.

Discussing universal health care at shareholder meetings

Per the NYT, the SEC has decided that companies must allow shareholders to vote on a proposal for universal health insurance coverage – yet another shift in position on the types of shareholder proposals firms must allow.

This sort of proposal was allowed in NYCERS v. Dole Food Co., Inc. 795 F. Supp. 95 (SDNY), dismissed as moot, 969 F.2d 1430 (2d. Cir. 1992). The issue makes for a great law school hypothetical on the shareholder proposal rule. Health care is, of course, quite significant for most firms, so it’s arguably not just a matter of general social policy, one of the exclusions under the shareholder proposal rule. That would also take it out of “ordinary business.” Of course universal health care is beyond a company’s power to effectuate, but each company can take a lobbying position on this issue. But a company’s lobbying position would seem to get back to ordinary business. . . .

A better approach would seem to be common sense. Look, folks, this is no more a part of a shareholders’ meeting than the Iraq war, right? But the whole business of shareholder proposals doesn’t really lend itself to common sense.

Perhaps an even better approach is to eliminate the issue of whether a corporation needs to subsidize shareholder proposals by making them dirt cheap – e.g., through an internet chatroom type arrangement. The SEC is moving in this direction, but there are many logistical issues.

The best approach of all, which I’ve advocated all along, is simply to get the SEC out of the business of reviewing shareholder proposals. What gets discussed at a shareholder meeting should be a matter of state law and, if enabled by state law, the company’s charter. The domain of the securities laws stops at accurately disclosing the company’s rules.

Sure, this would mean that companies would have a selfish incentive not to allow discussion of socially important matters. But they are, after all, private companies, aren’t they?

Update: Bainbridge suggests that "[c]ourts should ask whether a reasonable shareholder of this issuer would regard the proposal as having material economic importance for the value of his shares.." Otherwise, he says, forcing the corporation to discuss this is

a species of private eminent domain by which the federal government allows a small minority to appropriate someone else’s property—the company is a legal person, after all, and it is the company’s proxy statement at issue—for use as a soap-box to disseminate their views.

I'm sympathetic with the conclusion, but if we're going to get all constitutional about it, I think the appropriate analysis is forced speech under the First/14th amendment, and I'm not sure reifying the corporation is the right approach. See my Corporate Governance Speech and the First Amendment, 43 U. Kans. L. Rev. 163 (1994) (with Butler), a chapter in our Constitution and the Corporation.

As for Steve's proposed rule, I wish it were that simple. Though I side with Steve, opponents would argue over what a "reasonable shareholder" would want. Since people are going to disagree, it's important to get the institutional framework right. As I've said, it's a state law issue.

Dealbreaker wisely comments:

The capture of so many arms of our government--party machinery, congressional committees, regulatory agencies--by lobbyists for special interests is well-known, and is viewed by many as a serious threat to democratic legitimacy. Probably the beset that can be said is that competition between special interests often act as a kind of check-and-balance mechanism. These shareholder proposals about universal health are also likely to be captured by special interests, especially labor unions acting through labor dominated pension funds. Handing control of corporate lobbying efforts over to these interests could remove the check-and-balance aspect of corporate lobbying.

John Cusack goes to War

John Cusack, who’s made some great movies, including the memorably funny Grosse Point Blank in which he played a hit man, plays another hit man in War, Inc. The big difference is that this time he has bigger ambitions than just being funny (HT Bainbridge):

“There’s a great tradition of films and filmmakers taking on aristocracies,” Cusack said. “There used to be kings and queens and presidents, and now there are CEOs and shareholders and board members.”

Rather than merely making art, Cusack “wants to start a conversation.”

To some extent, this is another in a very long line of films, chronicled in my Wall Street and Vine in which I said (as summarized last week):

film artists . . . are not so much anti-business as anti-capitalist. They have that attitude because they believe the capitalists constrain creative expression – particularly in film, in which expression takes wads of money. In other words, anti-capitalism in film is a product of artists' resentment.

But Cusack's film seems to be less than that, because it's not a conventional commercial film but rather a vanity film.  As the WSJ’s reliable Joe Morgenstern summarizes:

The setting is Turaqistan, a fictional stand-in for Iraq where the troops and military might of a vast corporation called Tamerlane -- read Halliburton -- are engaged, Hauser tells us, in "the first war ever to be 100-per-cent outsourced to private enterprise." While it might be a worthy subject for the Stanley Kubrick of "Dr. Strangelove," privatized war is too important to be left to the amateur absurdists at work here. . . . .Surrounded by sententiousness and self-preening, Marisa Tomei manages to play a skeptical journalist with easy charm, but her efforts are doomed by the movie's ceaseless barrage of dumb bombs.

Every artist seeks to connect with his or her audience (why else engage in expression rather than pure thought?). At its deepest level art brings out something that the viewer or listener didn’t know was there. At its shallowest level – the vanity level at which War, Inc. seems to have been created – the artist is playing to the audience’s attitude. The artist is hoping the audience will respond as to a warm bath, comforted by the fact that a famous filmmaker shares their views. Yes, this will “start a conversation,” because the legitimized and emboldened audience will shout at the similarly inclined: "see, I told you! War is all about capitalism!"

At least the anti-capitalist resentment of the typical screen artist has to please an audience. Here we seem to have the self-indulgent drivel of a former comedian who wants to make a point.

By the way, while the film tries to channel Dr. Strangelove, it might have done better to try to also be funny. That film (which admittedly doesn’t wear very well) at least kept war and capitalism almost separate. (You know, capitalists actually don’t like war – it gets in the way of business).

I say almost, because Dr. Strangelove did have something to say about capitalism:

Group Capt. Lionel Mandrake: Colonel... that Coca-Cola machine. I want you to shoot the lock off it. There may be some change in there.

Colonel "Bat" Guano: That's private property.

Group Capt. Lionel Mandrake: Colonel! Can you possibly imagine what is going to happen to you, your frame, outlook, way of life, and everything, when they learn that you have obstructed a telephone call to the President of the United States? Can you imagine? Shoot it off! Shoot! With a gun! That's what the bullets are for, you twit!

Colonel "Bat" Guano: Okay. I'm gonna get your money for ya. But if you don't get the President of the United States on that phone, you know what's gonna happen to you?

Group Capt. Lionel Mandrake: What?

Colonel "Bat" Guano: You're gonna have to answer to the Coca-Cola company.

Guano couldn't drop his petty obsession with capitalism even in the face of nuclear war. Apparently Cusack didn't get the joke.

Pileggi on uncorporations on the Harvard corporate blog

Francis Pileggi has added LLCs to the Harvard corporate blog's portfolio in a helpful post.  As he says:

The Delaware Chancery Court recently issued its opinion in Fisk Ventures, LLC v. Segal, which I predict will be cited often by scholars and practitioners alike as part of the ongoing discussion about the difference between applying fiduciary duty concepts to LLCs–or not–as compared with the conventional application of those duties in the corporate context.

I agree, in my own post on the case, in which I conclude that "Chancellor Chandler [has] made it clear that the contract controls uncorporations in Delaware."

I plan to add my own uncorporate post to the Harvard blog in the coming weeks. At some point maybe they'll have to change their name!

Hot off the press: Butler and Ribstein on insurance

Insurance is currently regulated by the states, and they've made a mess of it.  The federal government is closing in.  Henry Butler & I have an answer -- model insurance regulation on corporate governance.  The paper is A Single-License Approach to Regulating Insurance. Here's the abstract:

State regulation of insurance companies has been criticized for many years because of the burden imposed on insurers by having to comply with the laws of many jurisdictions. These higher costs are passed on to consumers. The problems with the current regulatory structure are prompting calls for increased federal regulation of insurance. However, all proposals to federalize insurance regulation create opportunities for abuse at the hands of the federal government and fail to utilize the benefits of a federal system. This article shows how many of the problems of the current system can be addressed without resorting to a large scale intrusion of federal regulators into insurance markets. The proposed solution calls for minimal federal intervention to provide for jurisdictional competition between states that would be allowed to charter insurers that could operate nationally with only the single license granted by the charter. This single-license approach addresses the most salient concerns of proponents of federal optional chartering. It also has the potential for triggering competition and innovation in insurance products and rates while preserving a meaningful role for state regulation.

And, yes, our proposal includes safeguards to deal with concerns about a potential "race to the bottom" in consumer protections and solvency regulation.   

Springer on corporate crime

Jerry Springer addressing Northwestern Law graduates:

Springer . . . . warned students they would face ethical dilemmas throughout their lives. "Think of the ethical questions you will have to deal with," he said. "Will you work with a corporate client who perhaps is polluting? Will you walk into a senior partner's office after having been asked to prepare a memorandum in support of this client's case and say, 'I'm sorry, sir or madam, I have to find another place to work?'"

I doubt he asked students whether they would consider representing individuals accused of crimes. Of course I'm talking about politically correct criminals such as rapists, murderers, as distinguished from really bad types like Lay and Skilling.