Ideoblog

Messing with bonuses and the contracts clause

David Zaring responds to a Posner question whether there is "any constitutional limitation on the federal government's abrogating a private contract, for example a contractual obligation to pay bonuses to employee of AIG?."  Per Zaring: 

the government can take any and all property it wants provided it offers due process. And the government abrogates private contracts all the time, contracts for involuntary servitude being but one example. Still, it's not as if these questions aren't close, or that the regular abrogration of contracts by the government wouldn't be a bad thing. I presume answering them would take constitutional theorists back to the Depression era cases, such as Home Building & Loan Ass'n v. Blaisdell

This is something I addressed in my article with Butler, The Contract Clause and the Corporation, 55 Brooklyn Law Review 767 (1989), reprinted in Property Rights in American History, vol. 6 (James W. Ely, Jr., ed., 1997), and part of Butler and my book, The Corporation and the Constitution. Here's an excerpt from the article (footnotes omitted):

The "contract clause"' of Article I, section 10 of the Constitution provides that "No State shall . . . pass any . . . Law impairing the Obligations of Contracts."' The constitutional history of the contract clause indicates that this clause was inserted to ensure a "regular course to the business of society"'in the wake of debtor relief under the Articles of Confederation.  By ensuring the stability of contracts, the contract clause increases the value of contracts, and thereby encourages private ordering. * * *

An important reason for special constitutional protection of contracts is to discourage state government officials from earning "rents"' by engineering wealth redistributions to interest groups. Because wealth redistribution is a zero-sum game, the rent-seeking expenditures invested in property transfers are unlikely to be outweighed by any positive results of the expenditures.  Although this is a general problem with government interference, it is a particular problem when the winners and losers from a potential wealth redistribution are clearly defined. This is the case when government action impairs contracts, thereby redistributing wealth from the parties who stand to gain, ex post, from further enforcement of the contract to those who stand to lose. * * *

There is another reason for believing that contract impairing legislation as a class is likely to be inefficient. A principal justification for legal regulation is that it substitutes for private ordering when private ordering is frustrated by transaction costs and other market imperfections. However, legislation that impairs contracts obviously frustrates rather than substitutes for private ordering. * * *

The article also notes that cases like Home Bldg. & L. Ass'n v. Blaisdell, which basically empower state governments to impair contracts when they need to, have eroded the Clause, but that nevertheless

the rationale underlying the contract clause remains at least as viable today as when the Constitution was adopted. Wealth redistributions engineered by rent-seeking lawmakers are at least as much, if not more, of a problem today than ever. Consequently, courts should look again to the contract clause as providing significant constitutional protection from the impairment of economic rights.

The bottom line is that there's not much left of categorical constitutional protection against contract impairment, and that it never applied to the federal government in any event.  But that doesn't mean that the courts should ignore the underlying principle.  

Possibly when confronted with an egregiously direct abrogation of a clear existing contract with slim public policy justification (e.g., the AIG bonus case) the courts will resurrect this protection through a limited application of due process.   Possible, but alas unlikely.

The end of big law?

Douglas McCollam, writing in today’s WSJ, notes the suffering of Big Law:

At bottom, what’s in question is the whole economic edifice of the modern American law firm. Like the pharaohs of old, big firms are enamored of constructing pyramids with an ever-widening base of associates and nonequity partners toiling on behalf of a narrowing band of equity partners at the top. Increasing a firm’s “leverage”—as expressed through the billable hour, one of the most pernicious creations in the annals of commerce—has been the key metric driving profitability at big law firms over the last generation. Numerous studies have documented the deleterious impact this model has had upon the legal profession and clients. To date, nothing has been able to kill it. It would be ironic indeed if the economic downturn that has cost lawyers so much ended up being the very thing that saved the legal profession from its own excess.

This is right as far as it goes. But it needs to go further. Even after the leverage bubble pops, there are still going to be big problems with big law. As I said earlier in the summer:

Where is the glue that is supposed to hold large firms together? Turns out maybe it was simply faith that the money would keep pouring in in large enough quantities to support the current business plan. Sounds a bit like a Ponzi scheme. The real problem is that large firms don’t really own anything but faith, which is fine for religion, but not much of a glue for a business.

In other words, the problem not just excessive leverage but the basic business model of big law firms. How does that get fixed? I’ve got an article in process addressing that. More later.

Wall Street should be more like a giant hedge fund

As long as it uncorporates. 

Coming soon: federal regulation of insurance?

As summarized by this Wiley Rein newsletter:

Federal regulation of insurance received unanimous support today from a panel of witnesses during today's Senate Banking Committee hearing titled "Regulatory Modernization: Perspectives on Insurance." * * *

Today's hearing was particularly interesting in several respects. First, it was the only insurance regulation hearing in recent memory where every witness favored some form of federal insurance regulation. This is unlikely to have happened by accident. More likely, it was specifically designed to send a signal of continuing movement in the insurance regulation debate toward a federal legislative resolution. * * *

All told, the panel testimony indicated that momentum for some federal regulation of insurance continues to grow, although quietly and under the radar. The Administration's White Paper noted that insurance regulatory reform was necessary either through a federal charter or effective state action. Given the pace of events on the Hill today, it seems that Congress may be growing impatient for state action—action which the states have had more than 100 years to take

Not so fast. Henry Butler and I have proposed a state-charter-based system that both mitigates the problems caused by 51 different regulators and can work. It’s worth consideration, unless you’re absolutely convinced that the federal government has all the answers.

Note that both consumer and industry groups seem to favor federal regulation. Do you think they will both be happy under the emerging federal regime?

The US and UK complain about nasty European hedge fund regulation

The WSJ discusses how the US and UK are lobbying Europe not to regulate foreign hedge funds out of European markets.

The U.S. and U.K. are lining up to change the European Union's proposed Alternative Investment Funds Directive, a sweeping bid to overhaul regulation of hedge funds, private equity and other alternative investment funds. In its current form, the directive would, among other things, place limits on how much debt funds can take on; require them to hold capital to cover potential losses and redemptions; and place strict disclosure requirements on private-equity portfolios. The directive would effectively apply to all funds and financial firms, including those based in the U.S., if they want to raise cash or provide services in Europe.

The US, meanwhile, is just seeking to impose registration and disclosure requirements (although this is bad enough).

The article continues:

The U.K., which already regulates hedge-fund managers, believes the European rules go too far and will drive funds out of Europe in what was described as a "weak form of protectionism" by Paul Myners, a U.K. government minister responsible for London's financial center. The stakes are high for Britain, where 80% of Europe's hedge funds are managed and which has a large private-equity industry. "It is perhaps easy for other European countries to make political capital out of demanding intrusive regulation of an industry of which they have little or no direct experience," Mr. Myners said in a recent speech to the fund industry.

Maybe this experience will teach US regulators that hedge fund regulation here is also all about regulating trade -- in our case, protecting banks and mutual funds from aggressive competitors, and corporate executives from activist funds and evil short-sellers.

Then again, maybe not.

Lambert reviews The Law Market

Thom Lambert's review of my and Erin O’Hara’s recent book is in the current issue of the Federalist Society’s Engage. My favorite part:

One of the most important metrics for evaluating the success of an academic work is the degree to which it sparks further questions. (Consider, for example, the scores of scholarly inquiries inspired by Ronald Coase’s articles The Nature of the Firm and The Problem of Social Cost.) Evaluated along this dimension, The Law Market must be deemed a smashing success. Among the many questions it inspires are: To what degree have law markets, like commodity markets, accommodated the needs and desires of niche groups? How have law markets “punished” suppliers of inferior products? By what precise mechanisms are judges, especially those who are not elected, motivated to honor parties’ choices of governing law? Can we better articulate substantive criteria for when courts should refuse to apply selected law? Inspired by The Law Market, I look forward to pondering those questions as I continue my own exploration of the law.

Love being compared to Coase. But there are other astute observations here as well. Go read the whole thing.

Digitizing casebooks: we're all rock stars now

Professor B, discussing a Law Blog story about Kindle DRM, comments:

Looking at the problem from the perspective of an author who royalties are a very large percentage of his annual income and an avid Kindle user, I'm totally okay with the the differences between real books and e-books. As it is, the used book market takes a huge chunk out of my annual royalties. The drop off from the first year of a new edition to the second can be as high as 30%, for example. I can't imagine the hit my royalties would take if e-books of my texts were available without strong DRM. But it seems safe to assume that anything remotely resembling an e-book Napster would be a disaster from my perspective. My assumption is that it would make the hit we currently take from the used book market look like chicken feed. The enormous amount of time and effort put into writing and updating the books simply would no longer be worth it.

Kinda reminds me of what I said four years ago about the effect on the music industry of digital music.  I observed that live and recorded performances were to some extent substitutes, so we should expect the prices of both to be falling in the digital era.  Yet live shows were getting more expensive.  Why?

Maybe because the shows are getting better because they're more important to artists’ careers. So that may be why the troubadour is returning. Will we see this effect in other areas -- a resurgence of live theatre? The big-time lecture tour, like the ones Dickens and Wilde used to do? I sure hope it doesn't mean that everybody in the intellectual property business will suddenly have to work for a living.

 Well, maybe we're all rock stars now.  I can't wait to see Prof B in a sequined vest.

Wall Street II

Forbes (via Dealbook) has some details on The Sequel: 

Michael Douglas at least will reprise his role as Gordon Gekko * * * He's just finished a prison sentence in the sequel, according to Deadlinehollywooddaily.com, while actor Shia LaBeouf will play a young trader engaged to Gekko's estranged daughter. The plot sees LaBeouf's character suspect that a stock-shorting hedge fund manager * * * is somehow responsible for the surprise suicide of his mentor. The trader then goes to ex-con Gekko for help seeking revenge on the villainous hedge fund chief.

Fox apparently wanted the steely psycho-killer from No Country for Old Men, Javier Bardem, to play the hedge fund manager (though there's some dispute about that), but he rejected it. The film's casting director notes that Gekko et al were seen as heroes in the go-go 80s, but now public perceptions of bankers and hedge fund managers have been shaped by Madoff.

So it seems that even Gordon Gekko is not evil enough to feed filmmakers' anti-capitalism these days.  And, oddly, hedge funds come off worst of all, despite the fact that they arguably had the least to do with our current mess. 

All this is consistent with my theory of anti-capitalism in film discussed in my Wall Street and Vine and Imagining Wall Street.  In others, it's a perception that is at least to some extent created by as well as used by films relating to business.

I'll be relating all this to the financial crisis in a talk at Michigan State in September.  Watch this space for more.

Punishing innocent executives: SOX's litigation time bomb goes off

I’ve written a lot about over-punishing corporate executives for mistakes in business judgment. This is bad, but there’s something even worse – punishing business executives even when they’re not accused of making a mistake.

This is the effect of SOX Section 304(a), which provides in part:

If an issuer is required to prepare an accounting restatement due to the material noncompliance of the issuer, as a result of misconduct, with any financial reporting requirement under the securities laws, the chief executive officer and chief financial officer of the issuer shall reimburse the issuer for-- (1) any bonus or other incentive-based or equity-based compensation received by that person from the issuer during the 12-month period following the first public issuance or filing with the Commission (whichever first occurs) of the financial document embodying such financial reporting requirement; and (2) any profits realized from the sale of securities of the issuer during that 12-month period.

As Butler and I said in our Sarbanes-Oxley Debacle:

An important effect of SOX is to put an increased burden of the risk of corporate fraud on monitors and gatekeepers such as auditors, lawyers, outside directors, and senior executives. This is true not only of the liability provisions discussed above, but also of provisions like section 304, which requires reimbursement of compensation and stock profits following accounting misstatements, regardless of whether the executive knew of the fraud and even if he exercised all reasonable care in monitoring and instituting controls. This is questionable policy. 

This provision hasn’t been used against an innocent executive until now. Bloomberg reports that the SEC is set to announce that it will demand that Maynard Jenkins, former CEO of CSK Auto Corp., forfeit compensation for a fraud perpetrated by others in the company.  The Bloomberg article (which also quotes me) says:

Demanding Jenkins forfeit compensation may up the ante for other companies facing potential restatements. “It raises the question of whether this will become a standard enforcement expectation any time there is a restatement,” said Philip Khinda, a former SEC enforcement attorney now in private practice at Steptoe & Johnson LLP in Washington.

One may wonder why this provision hasn’t been used until now. One possible reason is that new SEC Chair Mary Schapiro wants to show that the agency that could ignore Madoff should not be shuffled out of existence in the looming reorganization of financial agencies. At least it has some teeth, even if they get sunk into a wholly innocent executive (or Mark Cuban).

Another explanation is the one forecast in “The Sarbanes-Oxley Debacle”:

While the first major market correction will be painful for investors, SOX will surely turn it into a festival for trial lawyers. Such litigation on this scale should not be confused with shareholder protection. SOX has created a ticking litigation time bomb.

A festival for regulators, too.  So the downturn coupled with more aggressive regulators and an open-ended law like SOX should make for an interesting, if toxic, mix.

The Cuban case

Cuban has successfully rebuffed, at least temporarily, the SEC's effort to prosecute him for insider trading.  Here's Prof B's helpful discussion and analysis.

As the Professor says, "whether the SEC has authority to create a rule imposing misappropriation liability on the basis of an arms-length contractual duty of confidentiality--as opposed to a fiduciary duty-based duty of confidentiality--had not been tested until this case."

Indeed, I pointed out this ambiguity more than ten years ago in my article on the Supreme Court's O'Hagan case, Federalism and Insider Trading, 6 Supreme Court Economic Review, 123, 137-38 (1998) (footnotes omitted):

What kind of breach of duty to the information source constitutes actionable "misappropriation" under Section 10(b)? The uncertainty in this regard is revealed by the Chestman, Reed and Willis cases discussed above. In particular, it is not clear whether the misappropriation must be based on a hornbook-type fiduciary relationship as the court held in Chestman. Though O'Hagan repeatedly noted that misappropriation may arise out of abuse of fiduciary relationship, it did not explicitly require such a relationship. Since the Court's policy rationale stressed harm to the market from exploiting an information advantage rather than harm to the information source, the Court may extend liability beyond the fiduciary context. On the other hand, the Court, in responding to the argument that the misappropriation theory was too indefinite to provide a basis for criminal liability, noted that the theory involved breach of "a recognized duty." This counsels against extension beyond "hornbook" fiduciary relationships.

Prof B was one of several prominent profs who argued that you need a fiduciary relationship, not just a promise of confidentiality. As Prof B notes, the court's opinion actually rejected the amici's position (see fn 5). However, the court said that without a fiduciary relationship the SEC needs to show not only an agreement to keep confidential, but an agreement not to use the information.

For what it's worth, I question the Court's interpretation of the O'Hagan case.  First, since the O'Hagan duty is based on deception of the owner of the information, arguably a lie to the owner about the intent to keep the information confidential should be enough.

Second, nobody's really talking about a bona fide fiduciary relationship.  As I discussed in my Are Partners Fiduciaries, 2005 Illinois Law Review 209, a fiduciary duty is a duty of unselfishness that arises from delegation of control, not merely an expectation of confidentiality arising from a promise or relationship. 

Third, even if the promise is only confidentiality rather than specifically non-use, it may be possible to argue that trading alone outed the information and therefore breached confidentiality. Ironically, this invokes the efficiency-based theory against insider trading liability -- that it informs the market.

Finally, I would not that there's a significant practical difference between the amici's argument and the one the court accepted in Cuban's case.  The SEC need now only show that the agreement Cuban made implied non-use.  This may not be easy, but I submit it would have been much harder for the SEC to show a fiduciary-type duty.

All that said, as a matter of policy, I'm not in favor of federal liability in a case like this.  Indeed, this case illustrates the murkiness and questionable nature of hanging federal securities law liability on state law duties.  But that's a problem created by the Supreme Court's O'Hagan case, which is still the law.  And, anyway, doesn't the SEC have better things to do these days?

In other words, the Cuban court, the SEC, the amici and the Supreme Court are all wrong, but for different reasons. 

Email comments.

Additional thoughts:  Courts usually give the SEC and other federal agencies the benefit of the doubt on their interpretations of statutes.  Doesn't seem like the SEC got much benefit here.  Was the court thinking of the SEC's history with Cuban?