Ideoblog

The Jones v. Harris decision

The Supreme Court unanimously reversed and remanded Judge Easterbrook's decision in the Jones v. Harris mutual fund case, holding that the Gartenberg fiduciary standard applied to investment advisors.

The Court applied an under-all-the-circumstances substance-plus-procedure test, the implications of which will be keeping mutual funds and their lawyers busy for some time. The Court thereby sided with Judge Posner's dissent and rejected Judge Easterbrook's emphasis on disclosure, market competition and easy exit by investors which, as I have argued, support analogizing mutual funds to the sale of products rather than fiduciary relationships.

Although I'm dubious about the result on principle, my analysis of Jones acknowledged that

in this day and age the Supreme Court will side with Posner. Such a decision would be a symptom and signal of our sharp turn toward paternalism in everything from complex finance to corporate governance to the simplest products.

Justice Alito's opinion noted another important consideration that undoubtedly motivated the Court:

The debate between the Seventh Circuit panel and the dissent from the denial of rehearing regarding today's mutual fund market is a matter for Congress, not the courts.

Perhaps, but unfortunate given where Congress is headed these days.

The Carney firing

Foster Kamer reports that Henry Blodget fired John Carney of Business Insider this afternoon because of

disagreements between Blodget, publisher Julie Hansen, and Carney over how to best run Business Insider: Blodget wanted more sensational, pageview-grabbing posts and click-friendly features like galleries, while Carney wanted to put forth breaking news scoops that told a longer narrative.

Here's Felix Salmon and Bainbridge on the story."

It's ironic that this happened just after the Greg Reyes backdating conviction. As I have discussed,

The real backdating scandal is not the one that has been generally reported. It is, instead, the woeful inadequacy of mainstream business reporting compounded by prosecutorial misconduct.

In that post I also quoted the WSJ's Holman Jenkins as noting

the exemplary diligence and enterprise with which, way back when, certain reporters and editors uncovered the backdating phenomenon, and then the intellectual sluggishness with which they analyzed it.

They found an interesting story (one that fit well under the current interest in behavioral economics) and then got it fundamentally wrong by insisting on shoving it into a procrustean off-the-shelf narrative of executive "greed."

Indeed, for want of a single paragraph explaining why backdating could be (in the words of a recent academic paper) a case of optimum contracting between companies and employees, we might have avoided the waste and injustice of these misguided backdating prosecutions

But Carney was one of the few noted journalists (other than Jenkins) who saw the travesty of the backdating reporting and prosecutions. Here's a good example of his work, discussing the Reyes case.

Meanwhile, reporters who are financially ignorant but adept at sensationalizing business stories, notably including the NYT's Gretchen Morgenson (here's my archive of critiques of her wrongheaded and sometimes ridiculous reporting), chug on.

Carney is smart, educated and a great writer and reporter. Unless financial journalism has gone even further down the tubes than I fear, he'll be back. Unfortunately, so will the people and mentality that fired him, and the stupid stories that are helping to misguide financial policy.

The Reyes conviction

Tom Kirkendall, as usual, has the story of this very sad episode in the long-running tale of egregiously misguided government backdating prosecutions. Here's some background.

How clear must a fiduciary waiver be in NY and Delaware?

Peter Mahler reports on Pappas v. Tzolis, Mem. Dec., Index No. 601115/09 (Sup Ct NY County Mar. 3, 2010) involving a member who bought out the other two while secretly negotiating to sell the LLC's sole asset to an outside buyer, and then selling it six months after the buyout for a price much higher than he paid the former members.

The confusion in this case begins with the parties' choice of NY law in a Delaware LLC. I discuss the issue of what law to apply where the internal affairs doctrine result (here, Delaware) seems to conflict with a contractual choice of law clause (here NY) in my book with O'Hara, The Law Market, Chapter 6. We observe (at 128-29) that a Delaware court in Rosenmiller v. Bordes, 607 A. 2d 465, 468-69 (Del. Ch. 1991) applied Delaware law despite a N.J. choice of law clause in the shareholder agreement. We note that

[b]ecause the IAD is only a rule for enforcing contractual choice of law, it arguably should be interpreted like any other choice-of-law clause, consistent with the contracting parties' expectations. Incorporating in Delaware indicates the parties' intent to apply Delaware law to all corporate-governance-related matters notwithstanding a contrary choice-of-law clause in the shareholder agreement.

The later shareholder agreement in Rosenmiller arguably trumps the earlier agreement implicit in forming the firm. Here the conflict apparently was present from the beginning, although one might argue that the parties were focusing on choice of law in their agreement, but perhaps not in forming the firm in Delaware.

There's another layer of analysis beyond the parties' expectations. As O'Hara and I note in our book:

Delaware arguably can protect its significant investment in its corporate law infrastructure only if it can restrict the privilege of using Delaware law in Delaware courts to Delaware corporations, which have paid the full incorporation fee. This suggests that Delaware would hesitate to let parties circumvent the fee by incorporating elsewhere and agreeing to apply Delaware law.99 To prevent firms from choosing Delaware law without incorporating there, Delaware's courts set a valuable precedent by disallowing a Delaware firm from doing the reverse by contracting for an alternative state's law.

The footnote refers to my earlier analysis in Delaware, Lawyers and Choice of Law, 19 Delaware Journal of Corporate Law 999, 1022-1025 (1994).

In any event, the court sidestepped the choice of law issue by saying that the relevant law was the same in both Delaware and NY. This is far from clear. The court refers to Delaware's very clear freedom-of-contract provision in Section 1101(c) of its act, and then says that "under New York law, parties are free to contract as they wish, so long as the terms of their contract are neither unlawful, nor in violation of public policy." However, there's nothing in the NY statute comparable to the Delaware provision. Instead, as Mr. Mahler points out, §409(a) of the NY LLC act requires a manager to "perform his or her duties as a manager . . . in good faith and with that degree of care that an ordinarily prudent person in a like position would use under similar  circumstances." 

In other words, the court would seem to be reading a freedom-of-contract provision into the NY statute. That might be ok under another case Mr. Tzolis was involved in (at least Mr. Mahler says it's the same Tzolis). As I said recently, NY continues to pay for the uncertainty created by that infamous case.

The court also may have erred in interpreting the present agreement as a waiver, at least under Delaware law. The operating agreement in a section titled "Other Activities of Members," provided that "[a]ny Member may engage in business ventures and investments of any nature whatsoever, whether or not in competition with the LLC, without obligation of any kind to the LLC or to the other Members." This seems to refer only to dealings outside the LLC (i.e., the "corporate" opportunities doctrine), and not to a transaction like the one in the case involving a buyout of co-members' interest without disclosing negotiations to sell the LLC's only property. This intent seems to be clarified by the title referring to "other activities." To be sure, as the court notes, the agreement says that "headings. . . shall be given no effect in the interpretation of this Agreement." But even if the court insists on applying this provision strictly, it's still the case that the substance of the provision refers to matters "in competition with the LLC."

Although the court's interpretation arguably also makes sense, the question is whether the agreement is a clear enough fiduciary waiver to justify dismissing the complaint. As I discussed recently, Delaware law, which the court purported to apply, imposes an obligation of clear drafting of fiduciary waivers in order to take advantage of the statutory license to contract freely. See Ribstein & Keatinge §9:4, The Uncorporation and Corporate Indeterminacy, DirecTV Latin America, LLC v. Park 610, LLC, 2010 WL 305201 at *27 (S.D.N.Y., January 26, 2010) (Del. law), Kelly v. Blum, 2010 WL 629850 at *10, n. 70 (Del.Ch., February 24, 2010), and Bay Center Apartments Owner, LLC v. Emery Bay PKI, LLC, 2009 WL 1124451 (Del.Ch., April 20, 2009). If NY law is interpreted as allowing the same freedom of contract, this arguably should come with the same rule of interpretation.

In general, any appeal of this judgment should be interesting.

Weather to go to college

Tis the season for college tours. Uri Simonsohn's Weather to go to College work on the projection bias suggests that parents trying to guide their children's choices better check the weather reports. Here's the abstract:

Does current utility bias predictions of future utility for high stakes decisions? Here I provide field evidence consistent with such Projection Bias in one of life's most thought-about decisions: college enrolment. After arguing and documenting with survey evidence that cloudiness increases the appeal of academic activities, I analyse the enrolment decisions of 1,284 prospective students who visited a university known for its academic strengths and recreational weaknesses. Consistent with the notion that current weather conditions influence decisions about future academic activities, I find that an increase in cloudcover of one standard deviation on the day of the visit is associated with an increase in the probability of enrolment of 9 percentage points.

Incorporating the Hendricksons

This week I moved quickly from law firms at Georgetown to discussing marriage at the "love or money" conference at Washington University. There were lots of varied and interesting ideas at this conference.

My paper, which I plan to disseminate in the next couple of months, and which has the title of this blog post, discussed whether business association standard forms are appropriate for domestic relationships. Short answer: no. This follows my earlier work on choice of law for marriage, also discussed in Chapter 8 of The Law Market, and more directly domestic relationship standard forms. The paper also enables me to make some productive use of my television watching.

Law firm evolution at Georgetown

As previously noted, I presented Death of Big Law at Georgetown last Monday. Here is the schedule and some of the papers and presentations, including my presentation.

There were also some journalists present, and I'll let them summarize my own take. Aric Press (American Lawyer), said the question at the conference was whether "Mega Law [is] a Dead Man Walking?"

For Larry Ribstein, a University of Illinois law school professor, the answer was clear. "My hypothesis is that for the big law firm we'll see a downhill slide that the horse drawn carriage experienced," he said at the start of his presentation. Later, he turned really pessimistic, asking, "what can firms do? Nothing. They're dead...what sustains them is regulation" that thwarts the entry of natural competitors into the market.

In his view, the law firm business model, however it's defined, is inherently fragile and crumbling under client and labor market pressures. He said that until recently he had some hope for the future of large law firms, largely because of what he called "their reputational capital." But he'd backed away from that view because clients can now essentially build their own sets of outside providers and law firms have been busy shedding the very traits that had built their reputational capital. The death of lockstep compensation, the rise in lateral partners, the end of vicarious liability among partners, and the sharp cuts in associate recruiting and training have all conspired to devalue the firm's unity and reputational capital.

From Legal Times:

The most dire prediction unsurprisingly came from Larry Ribstein, associate dean for research at the University of Illinois Law School and author of "The Death of Big Law," when he posited the most dire assessment of the future of large law firms. Ribstein said that if the economic crisis showed anything, it was that the large law firm business model is unworkable.

"The business model is inherently fragile and is crumbling under pressure. Unlike 20 years ago when I first started thinking about this, I no longer think that the tweaks we have been seeing are going to save anything," Ribstein said.

Ribstein said that large law firms trade on what he called "reputational capital." That reputational capital, Ribstein said, was damaged during the economic downturn by the defensive strategies implemented by Big Law firms, including associate and staff layoffs.

Ribstein predicted that law firms, especially those that are based in the U.S., will devolve by hiring far fewer associates and pressing to change ethical rules that bar investment in law firms by outside financiers. That approach will soon go into effect in the United Kingdom under the Legal Services Act, which allows for non-lawyer investors, such as private equity firms, to invest in law firms.

Law firm managers such as Robert Ruyak of Howrey, William Perlstein of WilmerHale, Bruce McLean of Akin Gump, admitted the need for significant change in the model. That attitude was clearly driven by clients, as indicated by the in-house lawyers at the conference.

The general refrain, though, uttered as a mantra throughout the conference, is that Big Law is not dead. The speakers generally took comfort from the need for the kinds of services Big Law provides.

The problem for Big Law, as my paper discusses, is that it faces a number of threats to its basic structure and business model. To begin with, the Big Law model is based significantly on services that a legion of other providers already can provide better and more cheaply. One of the most important threads at the conference and threats to Big Law is the array of make-or-buy choices that law firms and clients confront from legal outsourcing and other alternatives. Interesting work on these decisions was presented by Mark Chandler of Cisco, Jeff Carr of FMC Technologies and Mari Sako of Oxford, and in a paper by Mitt Regan and Palmer Heenan. More generally, Stephen Mayson of the College of Law, London noted that Big Law's survival depended on its ability in the new era of figuring out where it can add value in managing a multiplicity of resources – not just lawyers.

The Big Law model is also threatened by the coming of outside financing. At the conference the focus was on outside funding of litigation. Anthony Sebok presented the current regulatory structure, while Timothy Scrantom of Juridica Capital Management provided a glimpse of the market reality – the large and growing demand and market for law market capital.

Another angle on the future of outside financed law firms is to look at the other professional service industries that, like Big Law, are based on client relationships and mobile people but have successfully turned to outside capital, resulting in significant consolidation. Andrew Von Nordenflycht of Simon Fraser presented a paper on the evolution of global advertising. It seems that ad agencies were able to do this via financial intermediation through holding companies. This enabled firms to deal with conflicts, grow, diversify, attract more capital, provide liquidity for owners and achieve some economies of scale. One wonders if this or some other organizational innovation could accomplish similar results for legal services in the post-regulatory world.

What does all this say about the future of legal education? Tom Morgan (whose new book about all of the above developments, The Vanishing American Lawyer, is must reading) suggests that legal education needs to move toward a variety of models to fit the multiplicity of roles future law graduates will play. The ABA is seeking to impose constraints, but these constraints are simply feeding the "chaos" by moving in opposite directions – trying to implement the MacCrate ideal of training law students to be sole practitioners, while also recognizing that law schools can adopt a variety of models, each with its own, probably unworkable, metrics. Morgan said this creates an opportunity for risk-taking entrepreneurial deans.

The current Big Law model is preserved by a rapidly weakening regulatory shield that cannot survive in the long term in a global economy. The race may go to the countries like the UK and Australia whose regulators seem so far to have been much more nimble and responsive than those in the U.S. Anthony Davis suggested that the explanation for this regulatory responsiveness in the UK is the existence of a single regulator instead of the cumbersome U.S. system which requires coordinating 51 regulators. My paper proposes an alternative for the U.S.: a choice of law rule that enables law firms to choose who regulates their internal governance, similar to the system for other U.S. firms.

What happens if U.S. law firms don't respond to these pressures? Well, Peter Sherer had one of the more interesting presentations, which looked at the rankings of top law firms from 1920 to 1940, using data from Martindale-Hubbell and firm histories. How many firms do you recognize from 1920 (slide 11)? The list in slide 15 from 1940 is a bit more recognizable. Slide 18 suggests that firm "competencies" changed (specifically, from boom advising to bust advising) for firms that had a "critical mass of flexible young partners" who were willing and able to innovate. In other words, the firms that ended up dominating in the late 20^th century were made during this critical period of financial turmoil, when firms had to innovate or die.

In the end, in global markets, survival, or not, will be the driver of change.

LLCs rule

New data on firm formations 2004-2007 presented by Rodney Chrisman in LLCs are the New King of the Hill: An Empirical Study of the Number of New LLCs, Corporations, and LPs Formed in the United States between 2004-2007 and How LLCs Were Taxed for Tax Years 2002-2006, forthcoming in the Fordham Journal of Corporate and Financial Law, shows "that LLCs are by far and away the predominant choice of business structure for newly-formed entities." For example, the numbers for LLCs, corporations and limited partnerships in 2007 (and percentage of the total) were, respectively, 1,375,148 (63.58%), 747,533 (34.56%) and 40,229 (1.86%).

The article documents another interesting fact – LLCs are increasingly choosing to be taxed as S Corporations. The increase in LLCs therefore isn't just a function of their liberation from the corporate tax. It's about better and more flexible statutes, increased learning of lawyers and business people, and improved case law.

The numbers suggest a shift in transactional work from corporations to uncorporations. So you lawyers and legal academics need Ribstein & Keatinge and Rise of the Uncorporation more than ever. And you law professors need to finally think about giving up on that tired old corporate stuff (wouldn't you rather think about creative ways to contract for compensation than just moan about how it's too high?) and switch to Unincorporated Business Entities.

Death of Big Law at Georgetown

I'll be presenting my paper at this conference tomorrow (Monday, March 22). Plenty of Big Law people there to tell me why I'm wrong. Should be interesting. I plan to report on my observations and reactions.

Sharks or pirates?

On the eve of the great ObamaCare political immolation, Kim Strassel asks us to imagine the plight of Pennsylvania Democratic Congressman Jason Altmire "bound, at the end of a plank, a band of Democratic pirates behind him, a swarm of constituent sharks circling below."

It might seem that Mr. Altmire and others in his situation would find the choice easy. Given death either way, and at the same time (November), do the right thing: the hell with the pirates. After all, didn't the sharks elect them? Don't the sharks legitimately expect a loyal vote by "their" representative? And if Mr. Altmire doesn't care about the voters at all he would find the choice even easier: given death either way, just do the "right" thing, whatever that is.

I wonder if Citizens United made the choice even easier. Strassel refers to the Democrats' ability to withhold dollars from defectors. But doesn't CU open up some other potential funding? And if it doesn't, then why all the fuss about that case?

In any event, the stories about tomorrow's vote have given me a sort of perverse joy. It used to be hard to explain to somebody who didn't like markets that the political process wasn't any better. No longer will that be a problem.