Corporate Fraud Is Common

White collar crime is a huge problem. It is more than seven times as big of a problem, for example, than all shoplifting in the country combined.

We provide a lower-bound estimate of the undetected share of corporate fraud. To identify the hidden part of the “iceberg,” we exploit Arthur Andersen’s demise, which triggered added scrutiny on Arthur Andersen’s former clients and thereby increased the detection likelihood of preexisting frauds. 

Our evidence suggests that in normal times only one-third of corporate frauds are detected. We estimate that on average 10% of large publicly traded firms are committing securities fraud every year, with a 95% confidence interval of 7%-14%. Combining fraud pervasiveness with existing estimates of the costs of detected and undetected fraud, we estimate that corporate fraud destroys 1.6% of equity value each year, equal to $830 billion in 2021.

Dyck, I.J. Alexander and Morse, Adair and Zingales, Luigi, "How Pervasive is Corporate Fraud?" George J. Stigler Center for the Study of the Economy & the State Working Paper No. 327 (January 2023) (Available at SSRN: https://ssrn.com/abstract=4590097 or http://dx.doi.org/10.2139/ssrn.4590097).

Small Business Ownership Disclosure

Under a new U.S. law that took effect January 1, 2021, new small closely held business entities that aren't otherwise regulated businesses (basically corporations and LLCs) once regulations are enacted but no later than January 1, 2022, and by January 1, 2023, existing small, closely held business entities that aren't otherwise regulated businesses, must file an annual federal disclosure of their beneficial owners and if a regulation requires it, after certain changes in ownership. 

As of November 3, 2021, however, according to the Financial Times, however, the regulatory process was stalled:

A new law that will stop US businesses using shell companies to hide from tax authorities has run into delays at the Treasury department, senior Congressional Democrats have warned, with a key legal deadline set to be missed. Congress passed the Corporate Transparency Act in January with the intention of forcing businesses to declare for the first time who their true owners are — a key weapon for US tax officials. The bill came after more than a decade of political wrangling, and was meant to come into force by January 1 2022. 

On Wednesday, however, the three Democratic committee chairs who shepherded the bill through Congress wrote to Janet Yellen, the US Treasury secretary, expressing disappointment at the slow pace of implementation. The letter, which has been seen by the Financial Times, was signed by Sherrod Brown, chair of the Senate banking committee, Maxine Waters, chair of the House of Representatives financial services committee, and Carolyn Maloney, chair of the House oversight committee. In it, the three Democrats warn: “We are disappointed by delays on this important rule, but recognise that . . . a final rule is now not likely to be issued by the implementation deadline.” 

They urged Yellen to move faster with the rulemaking process. “We hope that as the department’s leader, you will do everything that you can to ensure swift action on the rule, including urgently providing additional staff and resources as necessary to achieve the effective and timely issuance of a proposed and subsequent final rule,” they said. . . .

It is deliberately broad in its scope, covering corporations, LLCs and any other state-registered or foreign-registered business that transacts in the US. Anti-tax avoidance campaigners have previously called the move “the biggest anti-money-laundering update that we’ve had in 20 years”. . . .  

The legislation required the Treasury to create the new rule, setting out more detail on which companies would be covered and how it would be monitored and enforced. But the department only published a request for public comment in April, and is still going through hundreds of responses to that, many of which come from organisations that opposed the law in the first place. The bill’s backers say it would have been quicker to publish a proposed rule before requesting comment. 

Other hurdles have been the chaotic transition between the Trump and Biden administrations, and the fact that Congress has not yet passed a measure increasing the Treasury’s budget to enforce it. 

A Treasury spokesperson defended the process, saying: “The insights and views of stakeholders — including federal agencies, states, tribes and the private sector — provided in response to [a request to comment] are invaluable to the rulemaking process, and help inform both the [proposed rule] and the final rule.” The person added: “FinCEN has a substantial and proactive agenda, and one of our highest priorities is the implementation of the beneficial ownership requirements of the Corporate Transparency Act.”

All nonexempt entities, or “reporting companies,” must submit beneficial ownership information to FinCEN, which will hold that information in a secure, nonpublic database once forms are drawn up and regulations are in place.

The full text of the law is available here.

Who Is a “Beneficial Owner” for the Corporate Transparency Act?

Under the Act, each of the following is a “beneficial owner:”

* A natural person

* Who directly or indirectly (through any contract, arrangement, understanding, relationship, or otherwise)

* Exercises substantial control over the entity, owns 25% or more of the equity, or receives “substantial economic benefits” from the assets of the entity 

What Information Is Required for Each “Beneficial Owner?”

* Full legal name

* Date of birth

* Current residential or business address

* The unique identifying number from a valid U.S. passport, personal identification card, state driver’s license, or if none of those are available, a valid foreign passport (subject to some fussy detailed requirements).

What Are the Consequences of a Failure to Comply?

Failure to comply with the new CTA reporting requirements will result in serious penalties. An individual who fails to meet the reporting standards may face civil penalties of up to $500 per day. An individual who willfully provides or attempts to provide false or fraudulent information, or willfully fails to provide FinCEN with the requisite information, may face criminal fines up to $10,000 and/or imprisonment for up to two years.

Moreover, the statute imposes penalties for individuals who engage in unauthorized use or disclosure of beneficial ownership information collected under the CTA. The civil penalty is up to $500 per day, and the criminal penalty includes fines up to $250,000 and imprisonment for up to five years.

The Act does provide that civil or criminal penalties shall not apply in the case of negligent non-compliance, although it remains to be seen how “negligence” will be interpreted. 

Who Is Exempt? 

Not a “beneficial owner”

* A minor child

* A nominee, custodian, or agent

* An employee “whose control over or economic benefits” from the entity “derives solely from” employment status

* A person whose interest is through inheritance

* A creditor (unless that gives the creditor control)

Excluded entities

* An entity whose securities are registered with the SEC
* An entity chartered under an interstate compact
* An FDIC depository institution
* A credit union
* A bank holding company
* An SEC-registered broker/dealer
* A securities exchange or clearing agency
* An investment company or an investment advisor registered under the 1940 Acts or described in one of the Acts
* An insurance company
* An entity registered with the Commodity Futures Trading Commission (“CFTC”)
* A public accounting firm registered with the Public Company Accounting Oversight Board (“PCAOB”)
* A financial market utility designated by the Financial Stability Oversight Council (“FSOC”)
* An insurance producer
* Certain pooled investment vehicles
* A public utility
* A church, charity, or non-profit with tax-exempt status

* A business concern with 20 or more full-time employees in the U.S.; $5 million in gross receipts or sales as shown on U.S. tax filings; and an operating physical presence at an office in the U.S. 

* Dormant companies which have been in existence for more than one year, are not engaged in “active business,” AND not owned (either directly or indirectly) by a non-U.S. individual

* Any corporation or LLC formed and owned by an excluded entity

FinCEN has express authority to remove types of entities from the excluded list or to add new exclusions. In relation to that authority, FinCEN is charged with continuing to study “beneficial owner” issues.

Could Corporate Finance Manage Without Securities Laws?

In the late nineteenth century Britain had almost no mandatory shareholder protections, but had very developed financial markets. We argue that private contracting between shareholders and corporations meant that the absence of statutory protections was immaterial. Using approximately 500 articles of association from before 1900, we code the protections offered to shareholders in these private contracts. We find that firms voluntarily offered shareholders many of the protections that were subsequently included in statutory corporate law. We also find that companies offering better protection to shareholders had less concentrated ownership.

From here via Marginal Revolution.

I would also observe, however, that while private corporations were a fairly new and unregulated area in Britain in the 19th century, that Britain did have a very substantial body of private law and, in particular, commercial law, by the time that private corporations started to emerge. Corporations emerging in a context in which there was a large and well established class of urban merchants who were used to being regulated legally by a strong state that had very predictable approaches to resolving business disputes with long pedigrees of case law and economic practice behind them. It also had a substantial community of lawyers with business oriented practices who had a good understanding of what protections were important to have for shareholders in corporations, and a large class of sophisticated and experienced investors who were cognizant of the details enough to insist on corporate governance document provisions necessary to adequately protect their investments.

In contrast, in many countries that are economically developing or that have "Third World" economies, the country itself has only been independent of colonial rule since 1960 or later, there have been multiple post-independence regimes interrupted by successions of coups or civil wars or insurgencies, the country's boundaries often don't coincide with the geographic distribution of people who share of a common ethnic or national identity, the current regime is quite weak, and neither the leading economic actors nor the common people are accustomed to operating in a Western style elected government which implements its policies via a substantial bureaucratic structure and pervasive regulation of all facets of life by the courts.

It is one thing to have a laissez faire approach to high level business regulation, when at the local level, there are courts and sheriffs and police and local governments that enforce contract and property rights, sanction people who don't respect the rights of others, keep water and sewer systems operating smoothly, keep local roads in good repair, confirm that construction activity adheres to safety standards both in terms of what is built and worker safety, funds schools that provide universal education and a literate public, and so on. And, where, corruption in local government administration is not pervasive.

It is another thing to try to manage without formal business regulation without such a sound foundation and the norms reflected in securities laws and corporate law are already widely shared by the people who are affected by them. In Albania, for example, one of the very early problems it faced economically when it converted from Soviet style communism in its purest autarkic form to a market economy, was that its securities laws were inadequate to address the needs of the many newly privatized enterprises. Russia also faced serious problems in its privatization process that have caused it to develop a corrupt crony capitalist system run by oligarchs.

The study itself should also be taken with a grain of salt. Consider this comment to the Marginal Revolution post linked above:

clockwork_prior February 19, 2019 at 8:39 am

Always look at the generally carefully chosen dates for such studies, as that way, they avoid discussing things like this - 'Railway Mania was an instance of speculative frenzy in the United Kingdom of Great Britain and Ireland in the 1840s. It followed a common pattern: as the price of railway shares increased, more and more money was poured in by speculators until the inevitable collapse. It reached its zenith in 1846, when no fewer than 272 Acts of Parliament were passed, setting up new railway companies, with the proposed routes totalling 9,500 miles (15,300 km) of new railway. Around a third of the railways authorised were never built – the companies either collapsed due to poor financial planning, were bought out by larger competitors before they could build their line, or turned out to be fraudulent enterprises to channel investors' money into other businesses.' https://en.wikipedia.org/wiki/Railway_Mania 

Bubbles come and go, but that fraudulent diversion just might have made a certain impression on both law makers and investors in the UK. Along with laying a lot of rail, of course.

Similarly:

Donald Pretari February 19, 2019 at 12:43 pm

We have financial oversight to protect the interests of average citizens, not to protect James Grant or George Selgin. Do you really expect the average citizen to be able to monitor banks, when experts can't agree about MMT? You need to keep up with current events. The recent crisis involved massive fraud and deception on the part of financial and investment concerns. Read "The Chickenshit Club: Why the Justice Department Fails to Prosecute Executives" by Jesse Eisinger. And don't mention other countries unless you allow mention of them when it doesn't suit your purposes. I actually find comparing our country today and 18th Century Britain disturbing, although I agree its historically interesting. In any case, expecting banks and investment services to be trusted nowadays is not likely, nor should it be.

Along the same lines that I have suggested, see also this comment to the Marginal Revolution post (emphasis added):

jack February 19, 2019 at 8:58 am  

Britain still has almost no statutory shareholder protections and no governmental regulator like the SEC. Its companies law is is way less bureaucratic than the US's with far less lawyer involvement. It does have perhaps the best commercial courts in the world with judges not juries deciding commercial cases and cost shifting. It also has a culture that values probity -- perhaps more than the US.

Indeed, even the word "probity" is so uncommon in the U.S. that I feel the need to provide this definition of it (the featured one in a Google search):

pro·bi·ty

/ˈprōbədē/

noun 

FORMAL

the quality of having strong moral principles; honesty and decency.

"financial probity" 

synonyms: integrity, honesty, uprightness, decency, morality, rectitude, goodness, virtue, right-mindedness, trustworthiness, truthfulness, honor, honorableness, justice, fairness, equity . . .

Britain does have a "Financial Conduct Authority" (the FCA) whose role is somewhat analogous to the SEC and state securities regulators in the U.S., but it regulates with a lighter hand.

Inefficient By Design

I am inclined to think that the article's analysis is correct. But, I am also skeptical that any of the leading economic theories on offer could have predicted this phenomena before the fact. 

The angel capital market poses a puzzle for search theory. Angel investors (“angels”) are often described in the literature as if they were hiding from entrepreneurs that seek angel capital investment. Such behavior by angels forces entrepreneurs to engage in costly search for angels. In our model, a separating equilibrium exists in which hiding by angels discourages search by low-productivity entrepreneurs who would inundate any visible angels. Only high-productivity entrepreneurs incur the time and effort costs of search to signal their type and avoid the lemons problem in the visible capital market. As the search market generates higher quality, hence more profitable matches, social surplus may increase despite the costs of hiding and searching. Hide and seek search contrasts with standard search theory where agents choose strategies to mitigate inherent physical and informational search frictions.

Merwan H. Engineer, Paul Schure, Dan H. Vo, "Hide and seek search: Why angels hide and entrepreneurs seek" Journal of Economic Behavior & Organization (December 6, 2018).

Yet More SCOTUS Rulings

There were five new merits decisions from the U.S. Supreme Court on Monday which combined with orders entered today, wraps up the year (the October 2016 session) for the court.

* CALPERS v. ANZ Securities. The three year statute of repose for a suit alleging false statements in a registration statement is not tolled for individual claims while a class action lawsuit is pending. The decision is 5-4 involving the usual suspects. The dissent argues that individual claims of people who opt out of a class action are effectively part of the same civil action and hence are not untimely. But, the court takes an anti-class action stance once again.

* Davila v. Davis. A trial lawyer for a defendant convicted and sentenced to death preserved an arguably valid legal objection at trial, but the appellate lawyer for the defendant failed to raise the issue on appeal in conduct that arguably constituted ineffective assistance of counsel. The habeas corpus lawyer then failed to timely raise the issue of the appellate lawyer's ineffective assistance of counsel, which was arguably a second distinct instance of ineffective assistance of counsel. But, SCOTUS holds that ineffective assistance of habeas counsel in failing to point out ineffectively assistance of counsel by appellate counsel, is not sufficient to overcome the usual deadline for complaining about ineffective assistance of counsel by the appellate counsel. If the mistake had been made by trial counsel and habeas counsel, rather than appellate counsel and habeas counsel, review would have been available. The decision is 5-4 involving the usual suspects. Justice Thomas emphasizes the fact that there is no constitutional right to a criminal appeal (which is true, but generally irrelevant when there is a statutory right to a criminal appeal as there is in every state).

* Trinity Lutheran Church of Columbia, Inc. v. Comer. A state constitutional provision barring any public assistance for religious schools is held unconstitutional as applied to a religious school seeking a grant for rubberized surface material upgrades in a playground. The Court distinguishes between being denied benefits because one is a religious institution and being denied benefits because it would use the benefits for religious purposes (which the Court has previously held is permissible). The decision is 7-2 with Thomas and Gorsuch providing one concurring opinion and Breyer concurring in judgment only.  Thomas and Gorsuch would overturn Locke which held that denying funds that could be used for religious purposes is permissible. Breyer focuses on a narrow ruling limited to "a general program designed to secure or to improve the health and safety of children.", that has no religious content. Sotomayor and Ginsburg, in dissent emphasize that the Court is "holding, for the first time, that the Constitution requires the government to provide public funds directly to a church." This is contrary to state constitutions in more than 30 states including Colorado. It isn't clear if the conservatives have the votes to extend this to voucher cases like the one arising in Douglas County, Colorado's schools that would have allowed high school vouchers to be used for private religious schools at the K-12 level whose instruction would be explicitly religious, which were remanded for reconsideration by the Colorado Supreme Court in light of this opinion. A New Mexico case involving closer facts was also remanded to be reconsidered in light of this opinion. This case could portend a major change in establishment clause jurisprudence, or could involve only a narrow exception to existing law with little material impact.

* Hernandez v. Mesa, per curiam. The case is a Bivens action against a border guard is shot and killed a 15 year old Mexican boy on the other side of the border from the U.S. for no justifiable reason. The legal standard to determine if a Bivens action is available was clarified in a recently decided SCOTUS case (which is generally favorable to the government and was decided with a four justice plurality that might not have had the same result if all justices participated) and the high court disagreed with one aspect of the Court of Appeals' analysis of the facts (which is generally favorable to the Mexican boy's estate). The Court remanded to the Court of Appeals to reconsider the case in light of the new law and a differently applied factual issue before SCOTUS addresses the merits of the case, with procedural issues to be decided first in order to avoid the substantive law question if possible. It is quite likely that the Court of Appeals, on remand, will deny the boy's estate a right to bring a Bivens action and that the case may return to the U.S. Supreme Court for further review, either way.

* Trump v. International Refugee Assistance Project, per curiam. The Court grants cert with regard to the Trump administration's Muslim ban on an expedited briefing schedule, sustaining the stay of the ban as to some people affected by it, while terminating the stay as applied to people with "no connection to the United States at all", pending resolution of the case by SCOTUS. This effectively reinstates the ban as to many refugees who had been fully vetted and has visas in place in a manner that will probably render their case moot by the time that the Court can hear it on the merits (since the ban was proposed to be for 90 days). But, since the stay was in place for a significant period of time pending this order, many such people will have already entered the United States at this point.

Five More Unanimous SCOTUS Rulings

The U.S. Supreme Court issued five unanimous opinions today, which I summarize below with my commentary in italics. 

Justice Gorsuch has now participated in three U.S. Supreme Court decisions, but, because all three were uncontroversial and none involved an opinion written by him, we still have no useful actual information about how he will behave as a Justice. These decisions only confirm the already expected conclusion that he is unlikely to become a gadfly who fights otherwise consensus rulings in the way that Justice Thomas has sometimes tended to be.

* A three judge panel's decision on an injunction related to election districts in a special election in the wake of racial gerrymandering was remanded in a per curium opinion because the trial court's analysis of the equitable issues involved in fashioning a remedy was only perfunctory. The case is North Carolina v. Covington.

While the decision doesn't presume a particular outcome on remand, the Supreme Court disavows a rule that injunctive relief is almost always available to prevent an election in a racially gerrymandered district as a remedy. The decision feels like a consolation prize in the wake of the Court's recent affirmation of a racial gerrymandering decision on the merits in North Carolina.

* ERISA plans established by hospital systems owned and controlled by a church are "church plans" for purposes of ERISA. The decision was 8-0. The case is Advocate Health Care Network v. Stapleton.

The language of the new statute expanding the definition of church-plans, which are exempt from many ERISA regulations, from true churches to certain church-controlled entities was far from clear on its face, but the Supreme Court's resolution is an expansive bright-line rule that will have wide effect in the health care industry (and probably in church controlled educational institutions as well).

* Civil forfeiture is not available as a remedy from someone who received no profits from the crime in question, even if that person was convicted as a co-conspirator in the crime. The decision was 8-0. The case is Honeycutt v. United States.

This ruling provides a very meaningful limitation on the civil forfeiture remedy with broad application in a situation where the statutory scheme could plausible have permitted either result.

The Sentencing Law and Policy Blog has an interesting insight on this ruling:

The opinion's first footnote indicates that a majority of circuit courts embraced a broader view of the federal forfeiture statute, which in turns further reinforces my long-standing view that SCOTUS these days is generally more pro-defendant on a wide range of sentencing issues than most lower federal courts.

* The SEC can seek disgorgement (i.e. a surrender of profits obtained from securities fraud), but the applicable statute of limitations was unclear. The Supreme Court holds (per the official syllabus) that "Because SEC disgorgement operates as a penalty under §2462, any claim for disgorgement in an SEC enforcement action must be commenced within five years of the date the claim accrued." The decision is 9-0. (This decision and the next constitute the second and third decisions of Justice Gorsuch in his service as a Supreme Court Justice).  The case is Kokesh v. SEC.

In yet another example of Congress not doing its job to make the law clear in a situation where there would inevitably be litigation over the issue, Congress failed to clarify whether and what statute of limitations applies to SEC claims for disgorgement of securities fraud proceeds in one of multiple plausible ways (a different one of which was chosen by the judges of the Second Circuit). The practical effect of the decision is to increase the amount of fraud profits that securities fraud perpetrators can hold onto in the face of SEC litigation, with the benefit of allowing people whose conduct might be challenged as securities fraud (but who are not charged by the SEC in the vast majority of circumstances) clarity about when they are in the clear.

* An individual developer brought a takings claims related to a zoning dispute and his real estate company sought to intervene in the federal court action. Was the real estate company required to have Article III standing? Per the official syllabus: "an intervenor of right must demonstrate Article III standing when it seeks additional relief beyond that requested by the plaintiff. That includes cases in which both the plaintiff and the intervenor seek separate money judgments in their own names." The decision was 9-0.  The case is Town of Chester v. Laroe Estates, Inc.

It is remarkable that this basic question of civil procedure that has potentially been an issue under the federal rules of civil procedure since the 1930s is only being resolved now. The outcome, however, makes perfect sense and is pretty much compelled by prior case law, which may help to explain why it took so long to be considered by the U.S. Supreme Court. The case is remanded to determine the correct resolution on the merits under the correct legal standard.

Supposed April 11 ISIS Attack In Germany May Have Actually Been Securities Fraud

German police arrested a man on Friday suspected of detonating three bombs that targeted the Borussia Dortmund soccer team bus in the hope of sending the club’s shares plummeting and making a profit on an investment, prosecutors said. 

In a statement, the federal chief prosecutor said the 28-year old man, a dual German and Russian national identified as Sergei V., had bought options on Borussia Dortmund’s stock before the attack. 

The team bus was heading to the club’s stadium for a Champions League match against AS Monaco on April 11 when the explosions went off, wounding Spanish defender Marc Bartra and delaying the match by a day. 

Prosecutors last week expressed doubts about the authenticity of three letters left at the site of the attack that suggested that Islamist militants had carried it out.

The prosecutor’s office said the suspect had bought 15,000 put options, or contracts giving him the right to sell Borussia Dortmund’s shares at a pre-determined price, on the day of the attack, using a consumer loan he had signed a week earlier.

From here.

Insider Trading Liability Broadened

Last week, prosecutors rejoiced when the U.S. Supreme Court decided an insider-trading case called Salman v. United States, and in doing so clarified that leaking confidential information so that friends and relatives can make money in the stock market is a crime, even when the leaker doesn’t get an economic benefit.

From The New Yorker with local color related to the jurisprudence of the trial judge whose legal theory was adopted.

The decision was, however, quite a narrow one.

Securities Class Actions Are As Targeted Or More So Than SEC Enforcement Actions

Tort reformers who dislike class action litigation and who, in particular, are skeptical of securities law class action litigation frequently argue that we should prefer administrative agency enforcement of the securities laws, on the theory that they are driven by the merit of the suit, over private class action litigation which is allegedly brought indiscriminately following a sudden plunge in the price of a company's shares.  The empirical evidence, however, does not support this claim.

Using actions with both an SEC investigation and a class action as our baseline, we compare the targeting of SEC-only investigations with class-action-only lawsuits. Looking at measures of information asymmetry, we find that investors in the market perceive greater information asymmetry following the public announcement of the underlying violation for class-action-only lawsuits compared with SEC-only investigations. Turning to sanctions, we find that the incidence of top officer resignation is greater for class-action-only lawsuits relative to SEC-only investigations. Our findings are consistent with the private enforcement targeting disclosure violations at least as precisely as (if not more so than) SEC enforcement.

Stephen J. Choi and A.C. Pritchard, "SEC Investigations and Securities Class Actions: An Empirical Comparison", Journal of Empirical Legal Studies (March 2016).

Is Throwing Back Undersized Fish Spolation Of Evidence?

On Wednesday, November 5, 2014, at 10:00 a.m., the U.S. Supreme Court will hear oral argument in a criminal case, Yates v. United States. 

The Court will decide whether to overturn the conviction, under the Sarbanes-Oxley Act, of John Yates, a commercial fisherman who allegedly directed his crew to throw undersized fish back into the sea after receiving a regulatory citation for catching them. 

Washington Legal Foundation filed a brief in the case urging reversal of Yates’s conviction, arguing that the broadly worded statute failed to provide Yates with requisite “fair warning” of what conduct would run afoul of the law. WLF Senior Litigation Counsel Cory Andrews, who authored WLF’s brief, will be available following oral argument to discuss the case and assess whether the justices’ questioning suggested any particular outcome. 

The case raises important questions about the permissible scope of the Sarbanes-Oxley Act, a law passed in 2002 to restore integrity to and faith in public companies’ disclosure and accounting practices in the wake of corporate scandals at Enron and WorldCom. Yates was convicted for violating the Act’s so-called anti-shredding provision, 18 U.S.C. § 1519, which makes it a crime to destroy or cover up “any record, document, or tangible object” with the intent to obstruct an investigation. 

Treating fish as “tangible object[s],” federal prosecutors indicted Yates under § 1519. The U.S. Court of Appeals for the Eleventh Circuit affirmed his conviction. 

Ahead of oral argument, WLF issued this statement by Senior Litigation Counsel Cory Andrews: “Overcriminalization occurs when vague, ambiguous language in a criminal statute deprives citizens of the appropriate ‘fair warning’ needed to comply with the law. The Eleventh Circuit’s overbroad interpretation of the Sarbanes-Oxley Act’s ‘anti-shredding’ provision would radically transform that law into a trap for the unwary. It takes the investigation of a civil offense (catching fish that were too small) and converts it into a criminal matter without notice and for no good reason.”

From the Washington Legal Foundation via Professor Bainbridge.

The statute states:

Whoever knowingly alters, destroys, mutilates, conceals, covers up, falsifies, or makes a false entry in any record, document, or tangible object with the intent to impede, obstruct, or influence the investigation or proper administration of any matter within the jurisdiction of any department or agency of the United States or any case filed under title 11, or in relation to or contemplation of any such matter or case, shall be fined under this title, imprisoned not more than 20 years, or both.

I have to say that using law designed to prevent securities fraud to criminally prosecute improper fishing practices that would otherwise be subject to a civil fine does seem excessive, and the extremely conservative 11th Circuit's take on the issue seems inappropriately crabbed.

Notably, the law enforcement officer boarded the ship, measured the fish, and found 72 were too small.  Then, when the ship landed, only 69 were found to be too small and the difference between the two measurements is the evidence for a charge brought three years after the citation, that the small fish were thrown overboard (not a very impressive effort, given that more than 95% of the small fish were not destroyed).  The legal size is 20 inches measured in a very technically precise way.  The first measurement allegedly found a few fish as small as 18 inches.  The second found fish as small as 19 inches.

He was sentenced to 30 days in prison and three years of supervised release, and argued at trial in addition to this argument, that the discrepancy was due to a measurement error in the first set of measurements by the fishing officer.  The felony conviction also has many collateral consequences, such as prohibiting him from voting in Florida.

A discovery sanction judicially imposing an adverse inference that the small fish were caught in the civil fine action would have been more than sufficient to address the issue and would have been the normal course of action in a situation like this one.  Indeed, the criminal trial outcome was also influenced by a quite harsh discovery sanction excluding an expert witness who had been endorsed and qualified by the government the same morning because the defense had inadvertently failed to name that person as a witness.

Also, it isn't as if the fish were thrown out to prevent being caught.  A regulatory citation was issued, and there is no clear indication that there was some sort of clear court order to preserve the small fish as evidence.  Presumably, selling the undersized fish would also be illegal, so there was no economic value apart from the court process in preserving them, and old fish get stinky much more quickly than the court process in regulatory cases moves forward.

The amount of discretion that the statute itself allows for imposition of the penalty is also breathtakingly broad.

Against Freedom of Contract

American law affords people great freedom to determine the nature of their legal liabilities to each other by entering into contracts.  Indeed, it very nearly approaches an ideal that is not just libertarian, but anarchist, despite the fact that neither of these political ideologies had wide political support in the general public.

Contracts can alter the extent to which liability is imposed as a consequence of negligent acts that caused injuries and can change the measure of damages that will be imposed upon them in the event of a breach of a legal duty or modify statutes of limitations to enforce rights.  They can determine whether or not a party will be entitled to attorneys' fees in the event of a dispute that is litigated.  They can eliminate a right to punitive damages, despite the fact that such damages can only be imposed in cases of the kind of misconduct for which liability itself cannot be waived as a matter of public policy.  Promissory notes routinely impose higher interest rates for the time value of money when the notes are in default than when they are not, and very little law limits the size of the penalty rate imposed after a default.  The parties to a contract can also agree to a great variety of matters concerning the manner in which disputes between the parties will be resolved - waiving a right to a civil jury trial, waiving access to the federal courts, waive a right to pursue a claim as part of a class in a class action, authorizing someone not involved in the underlying transaction to bring suit based upon it, or even waiving access to the court system entirely in lieu of only minimally regulated arbitration systems.

General Mills would like to impose an arbitration agreement on anyone who likes their Facebook page in the event of a lawsuit arising from a purchase of Cheerios or Chex.  Home inspectors routinely try to insist that a lawsuit against them for any harm suffered by their failure to do their job properly is limited to a refund of their fee and that even that remedy can be secured only in arbitration.

Freedom of contract is not absolute.  Statutes and public policy considerations impose certain limitations.  They generally prohibit waivers of liability for intentional misconduct, willful and wanton misconduct and gross negligence.  They prohibit liquidated damages clauses in circumstances when actual damages are easily determined or when the penalty is grossly disproportionate to a difficult to quantify harm.  They must afford some means of resort to a third party for dispute resolution or contract enforcement that meets certain minimum standards.  Interest rates cannot exceed rates defined as constituting usury.  Consumer defendants cannot be bound to respond to debt collection lawsuits in geographically distant venues.  Outside highly regulated sports and medical contexts, one cannot consent to not sue someone for intentionally causing you physical harm, for example, in the context of a duel.  Contractual limits on the grounds upon which a married couple may obtain a divorce are generally void, as are agreements in advance concerning post-separation or post-divorce parental responsibilities or child support payments, although there are only modest limitations on contractual agreements regarding property division and maintenance upon a divorce.

Closely akin to the issue of freedom of contract is the impact of disclosure on legal liability.  Products liability law is unduly focused on failure to warn, rather than on the merits of whether a product is dangerous or defective.  Medical malpractice litigation tends to focus on whether a patient was told that something really bad could happen even in the absence of negligence, rather than on whether the physician took appropriate steps to reduce the likelihood that those bad outcomes would actually occur. Securities fraud law permits firms to avoid liability by formally warning investors of risks that all of the other conduct of the sellers pushes buyers to ignore.

As an attorney, it is my stock in trade to draft contracts that do all of these things, and to litigate in light of these terms when they exist.

But, I am deeply skeptical of the proposition that freedom of contract with regard to the nature and extent of tort liability, or with regard to dispute resolution details and terms, does not do more harm than good.

The firms that are sophisticated enough to systemically enter into contracts that minimize their legal liability are often the very same firms that would be in the best position to take the necessary care to prevent negligent harms from occurring in the first place and to refrain from taking actions that would breach their contracts.

Provisions that inflate remedies for contractual defaults, like late fees and high default interest rates, usually have the practical effect of unfairly preferring those contractual debts vis-a-vis third parties who did not agree to that contract who have debts for the same principle and non-default interest amount in bankruptcy, rather than influencing how much is paid by the defaulting party to the contract who often can't pay the principal amount of the debt and non-default interest, let alone the late fees and default interest amounts that are owed.

The overwhelming majority of cases in which there is an arbitration clause is one in which the clause was included to discourage the non-drafting party from asserting that party's substantive rights in the event of a breach of contract or tort, or to otherwise provide an inferior forum to that party to obtain a fair remedy for wrongdoing by the drafting party, rather than out of any legitimate concerns regarding privacy, litigation costs, delay or a potentially unfair public court forum.

It is not at all obvious to me that our economy would be less healthy, or less efficient, if all contractual agreements provisions regarding tort liability, damages in the event of breach of contract or tort, or dispute resolution process were per se void as a matter of public policy.

An immense amount of dead weight loss transaction costs in our economy is devoted to paying people like me to game the system, that would be better spent on funding insurance purchases and reserves for contract liabilities when torts and breaches of contract inevitably happen.  The notion that securing express consent to contractual terms via shrink wrap agreements, liability waivers, terms of service, and the other pervasive contracts of adhesion that fill our lives is dubious at best and often outright absurd.

For example, even if it makes sense to hold swimming instructors liable only for willful and wanton misconduct, gross negligence or intentional conduct, rather than for mere negligence, there is no reason at all to believe that doing so on a transaction by transaction basis with non-negotiable liability waiver contracts signed by parents on behalf of their children is a more efficient way to address this issue than it is to address it with a generally applicable statute concerning swimming instructor liability or common law rule applicable to that situation.  Hundreds of thousands of dollars of liability for a personal injury sustained by a child learning to swim in connection with that student's instruction, should not primarily depend upon whether or not the administrative employee in the front office remembered to have that student's parent sign a form or not.  The amount of legal and administrative expense that goes into the process of preparing, executing, and maintaining records of those waivers of liability for negligence is not insubstantial and is wildly inefficient.

Of course, these terms are also found in vigorously negotiated, individualized contracts involving sophisticated commercial firms that are bargaining at arms length.  There is often no question in those cases that there has been the kind of meaningful and knowing consent to these terms that the legal theory of contract law contemplates when it justifies its freedom of contract principles.  But, even in these circumstances, the desirability of this freedom is questionable.

The transaction costs involved in this part of the negotiations relative to the stakes involved in the transaction are often much higher than the transaction costs involved in consumer contracts of adhesion.  The negotiation process over these terms inevitably prevents a not insignificant percentage of large scale economically valuable deals that would otherwise have been entered into from being concluded.  The way that issues addressed by these provisions are resolved when contracts contain provisions that differ greatly from the default rules of law are present are often unfair and create systemic incentives for misconduct by the party whom the negotiated contracts tend to favor (the notion that parties to a contract are economic equals is almost never true).  And, there is virtually no meaningful empirical evidence to show that business would not be capable of proceeding efficiently and productively in the absence of a decent set of universally applicable default rules.

Of course, to the extent that we have bad default rules of law, an inability of private parties to negotiate around them encourages legislators to fix the problems, which benefits not just those who would otherwise have put the changed new rules that apply in absence of an agreement into their contracts, but only benefits those who weren't savvy enough to draft contracts with better rules regarding how disputes regarding breaches of contact are resolved both in terms of process and substance.

Of course, given the race to the bottom federalism considerations involved, implementing such policies would require federal law intervention under the commerce clause power and/or bankruptcy power of Congress to be viable to implement without creating intense choice of law problems.

What would the rules look like?

* The prevailing party in disputes involving express contracts would have a right to recover their attorneys' fees and costs (something that is already a default rule as a matter of law in the case of leases in Colorado).

* Default interest rates in excess of the non-default rate would either be prohibited as a penalty against public policy.  An intermediate position would be to subordinate those debts in bankruptcy to all other debts, but that would still disadvantage third party creditors to the extent of pre-petition payments of default interest that reduce the size of the pie.  Another intermediate position would be to impose a certain interest rate in addition to the contract rate, for example, four percentage points per annum or the prime rate, in addition to the contract rate in the event a default.  Thus, the default interest rate on a contract with no stated interest rate would be 4%, while the default interest rate on a contract with a 5% stated interest rate would have a default interests rate of 9%.  If all creditors got the same default interest rate relative to the non-default status quo, in and out of bankruptcy, the prejudice to third party creditors would be eliminated.

* Late fees might be capped at a one time fee of 5% of the payment then due and would not apply to accelerated balances until their non-default due date.

* A variety of boilerplate terms might be implied as a matter of law into certain kinds of written agreements unless otherwise provided, e.g. regarding contract interpretation, definitions, etc.  Colorado does this already, for example, in the case of powers of attorney and other grants of fiduciary powers.

* The right to a civil jury might be eliminated in most breach of contract claims based upon written contracts that do not involve allegations of fraud.  (There is already rarely a right to a trial by jury for fact and credibility intensive rescission claims.) Common law already makes contract interpretation a matter of law in most cases, and breach is generally well defined in such cases, so the main shift would be in giving judges the more authority to determine contract damages.  Contract claims already make up only about 25% of civil jury trials despite the fact that the number of written contract claims litigated vastly outnumbers the number of personal injury tort claims litigated on court dockets.

* Statutory law would draw clearer lines regarding the measure of damages in a variety of particular industry contexts such as defective software, inaccurate home inspections, etc.

* The circumstances under which arbitration clauses would be permitted would be greatly narrowed, the conduct that could submit someone to an arbitration agreement would be greatly formalized along the lines of recent uniform legislation on marital agreements, and the occupational activity of arbitrating disputes would be much more heavily regulated to insure neutrality and fairness in the process.

* Waivers of liability for negligence would be void as against public policy, but a set of statutes would outline circumstances where there would not be liability for negligence (e.g. volunteer emergency assistance and inherently dangerous activities).

* Punitive damages waivers would be prohibited.  But, punitive damages and statutory damages ought to be subordinate to all other claims in a bankruptcy, or in the event of a dispute between judgment creditors over the same income or assets in bankruptcy.

* In some cases, like medical malpractice, a negligence based tort process could be replaced by a no fault regime of strict liability for bad outcomes with strictly compensatory damages and mandatory insurance to cover that liability, rather than a fault based regime that covers non-economic damages, with exceptions of willful and wanton or reckless or intentional misconduct, and with automatic referrals for disciplinary action on a license in cases of gross negligence.

* Contractual terms giving rise to a default in the absence of a breach of the substantive obligations of the parties to perform the contract ought to be disfavored.

* Failure to warn liability ought to be reformed, both to make unreasonable or unlikely to be read warnings ineffective particularly if rebutted by other communications or advertising, and to make warnings of obvious dangers unnecessary.

* Some minimum substantive securities regulation standards ought to be imposed, so that certain kinds of offerings are prohibited even if investors are warned about the risks in question.  Alternatively, a doctrine that subordinates formal written disclosures to other communications with investors might apply.

* In part to discourage venue shopping and in part out of the federalism notion of subsidiarity, I would favor the elimination of federal court jurisdiction in all ordinary diversity cases involving U.S. citizens (for diversity of citizenship jurisdiction purposes) (currently allowed when the amount in controversy exceeds $75,000 and the parties are diverse in state citizenship) and in all federal question cases involving private parties who are U.S. citizens (for diversity of citizenship jurisdiction purposes) (currently allowed in all cases with a federal question).  Thus, almost all employment litigation involving private parties (now federal question litigation), almost all contract disputes involving private parties, and almost all personal injury cases involving private parties would be limited to the state courts.  Cases with international diversity of citizenship (e.g. between a non-U.S. company and a U.S. company), special diversity of citizenship cases (e.g. multi-state class actions, and interstate interpleader cases), and special federal question cases that don't come under the general federal question statute (e.g. intellectual property and civil rights cases), as well as cases involve the U.S. government as a party, would remain in federal court.

The Economics Of An IPO

Goldman Sacks made more money in kickbacks from clients who were given a shot a getting underpriced IPO stocks than they did from their fees to the company itself.  This is a quite troubling business model and was probably pervasive.

Who Killed J.C.?

Who killed J.C.?

J.C. is in critical condition.[1][2]  You could argue that it is premature to investigate a person's murder before a body can be presented to establish that there was a death.[3]  Indeed, in the case of J.C., a prophet has foretold that J.C. will die and then that J.C. will be raised from the dead.[4] 

But, you would be wrong.  Dying declarations and contemporaneously recorded impressions of witnesses have been critical evidence in investigations to determine a cause of death for thousands of years in cases like this one.[3][4]

Initial efforts to assign responsibility for killing J.C. have been directed at a man who has a history with an apple that had a bite taken out of it that can provide access to the secrets of the tree of knowledge.[5][6]  And, I can't deny that he may deserve some of the blame.

But, honestly, I think that this case is more like Agatha Christi's Murder On The Orient Express, even if someone who is beyond the reach of justice is fingered as a scapegoat.  J.C. was probably killed through the combined actions of a group of people, not just by one man acting alone.[2][7]

The truth of the matter is that even I am partially responsible for killing J.C.[7]  I saw but ignored J.C. in the marketplace.[8]  I did not use my worldly wealth when asked to use them to glorify J.C. and gain access to the treasures that J.C. had to offer.[9]  I succumbed to the temptations offered by others.[10]  What can I say? 

How Do Publicly Held Firms Set Compensation?

The basic liberal and academic criticism of the way that compensation for related parties, including senior corporate officers, is set in modern American big businesses was set forth succintly by Judge Posner, of the United States Court of Appeals for the 7th Circuit, one of the most distinguished judges in the nation in law and economics matters, in a case where a major mutual fund advisor was sued for gouging investors in its captive mutual funds with fees much higher than what it charged mutual funds that negotiated their fee agreements with it at arms-length. 

Notably, his dissenting opinion and the U.S. Supreme Court's unanimous reversal of the majority opinion, came after the financial crisis in a case that was argued before the appellate courts just a couple of days after Lehman Brothers filed for bankruptcy.  The timing favored a narrative of corporate malfeasance over the opinion of the majority of the appellate panel which called for blind reliance on the workings of an efficient marketplace.

In particular, this criticism of American corporate governance notes that directors of publicly held companies are almost always chosen by Soviet style proxy ballots with a slate of names hand picked by insiders and no meaningful way for alternative candidates to compete for shareholder support, notwithstanding the legal fiction that directors are elected by and meaningfully accountable to shareholders of public companies through the internal director nomination and election process. 

Typically, directors only meaningful discretionary role is (1) to leniently adjudicate the incompetence of a CEO who has already been shown to be manifestly unable to act due to scandal, unbalanced mental health, illness, or utterly disasterous company collapse due to mismanagement, or (2) to fill an unexpected vacancy when the incumbent CEO has not designated a successor.  Directors sometimes also participate in negotiations over share prices when someone seeks to acquire the company in an unsolicited take over bid.  In all other respects, directors act as little more than a self-perpetuating collective ceremonial monarchy in a corporation, sustaining it symbolically, but exercising little genuine power over the management of the company.

[E]xecutive compensation in large publicly traded firms often is excessive because of the feeble incentives of boards of directors to police compensation. Directors are often CEOs of other companies and naturally think that CEOs should be well paid. And often they are picked by the CEO. Compensation consulting firms, which provide cover for generous compensation packages voted by boards of directors, have a conflict of interest because they are paid not only for their compensation advice but for other services to the firm—services for which they are hired by the officers whose compensation they advised on. Competition in product and capital markets can’t be counted on to solve the problem because the same structure of incentives operates on all large corporations and similar entities, including mutual funds.  

Mutual funds are a component of the financial services industry, where abuses have been rampant, as is more evident now than it was when Coates and Hubbard wrote their article. A business school professor at Northwestern University recently observed that “business connections can mitigate agency conflicts by facilitating efficient information transfers, but can also be channels for inefficient favoritism.” She found “evidence that connections among agents in [the mutual fund industry] foster favoritism, to the detriment of investors. Fund directors and advisory firms that manage the funds hire each other preferentially based on past interactions. When directors and the management are more connected, advisors capture more rents and are monitored by the board less intensely. These findings support recent calls for more disclosure regarding the negotiation of advisory contracts by fund boards.” The SEC’s Office of Economic Analysis (the principal adviser to the SEC on the economic aspects of regulatory issues) believes that mutual fund “boards with a greater proportion of independent directors are more likely to negotiate and approve lower fees, merge poorly performing funds more quickly or provide greater investor protection from late-trading and market timing,” although “broad cross-sectional analysis reveals little consistent evidence that board composition is related to lower fees and higher returns for fund shareholders.”

A particular concern in this case is the adviser’s charging its captive funds more than twice what it charges independent funds. According to the figures in the panel opinion, the captives are charged one percent of the first $2 billion in assets while the independents are charged roughly one-half of one percent for the first $500 million and roughly one-third of one percent for everything above. The panel opinion throws out some suggestions on why this difference may be justified, but the suggestions are offered purely as speculation, rather than anything having an evidentiary or empirical basis. And there is no doubt that the captive funds are indeed captive. The Oakmark-Harris relationship matches the arrangement described in the Senate Report accompanying § 36(b): a fund “organized by its investment adviser which provides it with almost all management services.” Financial managers from Harris founded the Oakmark family of funds in 1991, and each year since then the Oakmark Board of Trustees has reselected Harris as the fund’s adviser. Harris manages the entire Oakmark portfolio, which consists of seven funds. The Oakmark prospectus describes the relationship this way: “Subject to the overall authority of the board of trustees, [Harris Associates] furnishes continuous investment supervision and management to the Funds and also furnishes office space, equipment, and management personnel.” Recall Professor Kuhnen’s observation that “when directors and the management are more connected, advisors capture more rents and are monitored by the board less intensely.”

The panel opinion says that the fact “that mutual funds are ‘captives’ of investment advisers does not curtail this competition. An adviser can’t make money from its captive fund if high fees drive investors away.” 527 F.3d at 632. That’s true; but will high fees drive investors away? “[T]he chief reason for substantial advisory fee level differences between equity pension fund portfolio managers and equity mutual fund portfolio managers is that advisory fees in the pension field are subject to a marketplace where arm’s-length bargaining occurs. As a rule, [mutual] fund shareholders neither benefit from arm’s-length bargaining nor from prices that approximate those that arm’s-length bargaining would yield were it the norm.”

- Judge Posner's dissenting opinion in Jones v. Harris Associates, L.P., 527 F.3d 627 (7th Cir. May 19, 2008) in the United States Court of Appeals for the Seventh Circuit.  The decision was subsequently unanimously reversed by the United States Supreme Court at 130 S. Ct. 1418 (2010).

The Control Market Case For Lassiez-Faire Oversight

The leading criticism of the poor governance argument works better in the marketplace in which the equity shares of publicly held corporations are traded than it does in the context of mutual fund fee setting.  The critics argue that poorly managed companies become undervalued relative to their potential under better management, and that someone who knows how to manage a company better will be able to buy control of the company for a premium price while still making a profit in a tender offer with funds from investors who are willing to back up that person's bravado with money that they could lose if the share price of the acquired company does not improve with better management.

This approach to insuring competent management may be a far cry from optimal, and its methods may be crude and costly, but they provide some comfort that there is at least some check on the kind of mismanagement for which excessive compensation packages are a symptom.  A faster and cheaper system of procuring better managers could dramatically improve the health of the economy in a sustainable way.  But, one can hold some comfort in the notion that the current system at least vests decision making in people whose sincerity is insured by the huge sums of money that are at stake.

The practice of selling shares of poorly managed companies and thereby driving down the price of those shares, rather than using the corporate governance process to elect directors who would replace the current management team while continuing to hold shares in these companies, is called the "Wall Street Rule."

Resistance to the Wall Street Rule and a push for better corporate governance has been driven to a great extent by the reality that institutional investors own such a large share of the total capitalization of the U.S. equity markets that they have no choice but to buy some ill managed companies as part of their portfolios.

The Case That Good Hiring Mitigates The Harms Of Poor Director Control Of Incumbents

Another important criticism of the poor governance argument is that not just anybody gets hired to be the CEO of a large publicly held company.  The governance problems in the CEO hiring and compensation process are far less serious than those in the process of firing bad CEOs and controlling CEO compensation.

CEOs, who typically have large ongoing stakes in their former employers, have an interest in picking successors who seem like they will be competent.  A meaningful share of CEOs personally brought their companies to the point where they could go public or personally turned a minor public company into a dominant one - so they had an important role to play in creating the profits that their fat pay packets plunder.  In the rare situations where there is an open CEO seat due to untimely events that create a vacancy for a CEO who doesn't have a successor lined up, the Board of Directors generally makes a sincere effort to pick a competent successor from a pool of very qualified applicants.  Social norms make meaningful prior proven performance a prerequisite for anyone who will be seriously considered for the job.

Some CEOs do a dismal job, but few could have been clearly identified as poor managers by a well intentioned person evaluating them knowing only the information available at the time that the CEO was hired.  The CEO who is hired may not be the most qualified or the best value for the compensation package sought, but the CEO who is hired is rarely an applicant of below average competency either.

Unlike a system of hereditary inheritance of rulership of the kind practiced at some stages of the ancient Roman empire and in many European monarchies (and many modern small and medium sized businesses), idiot black sheep who have nothing to recommend them but their lineage do not get hired to be modern CEOs.  Some more than minimal merit evaluation is involved in these appointments.

Should The General Public Care About Excessive Compensation Per Se?

It is also worth remembering that while excessive CEO compensation for bad CEOs is a problem because it rewards people who are harming the overall economy, excessive CEO compensation for par for the course or reasonably good CEOs aren't really a matter of public concern.  Setting the compensation of decent or good CEOs basically involve distributive disputes between dumb money and the people whose management contributed greatly to their money generating profits.  If dumb money is swindled out of profits they have done little to contribute to personally (and often did little to earn in the first place, in the case of inherited money), the fact that decent management that is making an economic contribution gets a large piece of those profits isn't terribly troubling from a larger civic perspective.  These are fights between rich people on terms that the combatants have agreed to in advance that have little or no negative impact on the larger economy if management is competent.

Many criticisms of excessive executive compensation are directed at the way it creates a class of superrich people in the economy and leads to unequal income distributions.  But, in a world where pre-CEO compensation profits were the same, but investors received larger shares of profits relative to senior managers, there would still be vast inequalities of wealth in our economy, and the middle and working classes would not be much better off.  It would just be distributed among members of the American upper class somewhat differently.  Essentially, the divide between the merely rich, and the superrich senior managerial class (particularly in the financial sector) would be smoothed out somewhat.

The assumption of critics of excessive executive compensation who believe that lower executive compensation would translate into higher compensation for other employees fundamentally misunderstand the nature of the problem.  The factors that cause non-executive employees to have the salaries that they receive are almost entirely separate and divorced from the factors that cause senior executives in big businesses to receive the salaries that they receive.  The process by which middle managers or rank and file employees negotiate salaries with their employers is predominantly a function of the workings of a highly segmented labor market and the alternatives available through self-employment, not a product of deeply flawed self-dealing between senior managers and the directors who are supposed to represent the interests of equity investors. 

Incompetent CEOs can depart from the labor market reality, but since they work in a world constrained by labor market realities, it is far easier for an incompetent CEO to overpay the company's employees than it is to underpay them - a result few reforms are worried about.  An incompetent CEO who doesn't offer high enough salaries will soon find that the company doesn't have enough workers who are able to carry out the company's business.  And, companies that started from a baseline of having bad compensation practices in the first place never get big enough to go public in the first place.

If one believes that workers are undercompensated, despite reasonable free and fair markets for labor, this belief reflects either (1) the systemic effects on the labor market of a lack of collective bargaining (generally by unions) leading workers to accept offers when isolated when the markets could afford to pay more for their collective services if they could organize themselves to get a fair price for them (since in most cases there is a gap between the minimum a worker would work for and the maximum that a firm would pay for that work and employers can capture most of this gap if workers are disorganized), or (2) a sense that workers (or at least some class of permanent important workers) should have both a contractual debt interest in the company's well being and a non-contractual equity interest in the company's performance reflected in some sort of profit sharing plan in the way that Japanese salarymen, or German unionized employees do.  Reforms of either type would require major, institutional changes that go far beyond calls for more democratic shareholder governance of the publicly held companies that they own.

Thus, while good CEOs who are overcompensated at the expense of investors are a concern for the investors themselves, the general public cares only that bad CEOs are fired promptly.  Even overcompensation of bad CEOs is bad mostly not because investors are cheated by management.  After all, if the abuse gets too great, investors will start to favor debt investments over equity so  they have a legally enforceable right to a fair return on their investment.  Overcompensation of bad CEOs itself is bad mostly because this is a symptom that the bad CEOs are unlikely to be fired when they should be fired, which does hurt the overall economy.

 

There Is A Shortage Of Ideas, Not Money

The strongest argument that the biggest current barrier to new capital investment is a shortage of good ideas, and not a shortage of investment capital, is the revealed preference of "technology" companies like Google, Microsoft and Apple that have huge stockpiles of cash, and effectively zero percent interest rates at a time of very low inflation, to horde that cash rather than investing it in new technology projects.

[Discussion moderator] ADAM LASHINSKY: You have $50 billion at Google, why don’t you spend it on doing more in tech, or are you out of ideas? . . .

ERIC SCHMIDT [of Google]: What you discover in running these companies is that there are limits that are not cash. There are limits of recruiting, limits of real estate, regulatory limits as Peter points out. There are many, many such limits. And anything that we can do to reduce those limits is a good idea.

[Discussion participant] PETER THIEL: But, then the intellectually honest thing to do would be to say that Google is no longer a technology company, that it’s basically ‑‑ it’s a search engine. The search technology was developed a decade ago. It’s a bet that there will be no one else who will come up with a better search technology. So, you invest in Google, because you’re betting against technological innovation in search. And it’s like a bank that generates enormous cash flows every year, but you can’t issue a dividend, because the day you take that $30 billion and send it back to people you’re admitting that you’re no longer a technology company. That’s why Microsoft can’t return its money. That’s why all these companies are building up hordes of cash, because they don’t know what to do with it, but they don’t want to admit they’re no longer tech companies. . . .

ERIC SCHMIDT: So, the brief rebuttal is, Chrome is now the number one browser in the world.

One exception to the rule of lack of innovation that was identified in the discussion was Amazon.com, which it was noted, is less profitable than the companies that are hording their cash.

Google has tens of thousands of the smartest people in the world working for it. Microsoft and Apple do too. If those companies don't have the collective brainpower to come up with capital investment that make economic sense in a time of zero percent interest rates, when they have large hordes of cash that they don't need any banker's permission to spend, how can we expect less well positioned economic players to be making new capital investments?

Notably, commercial banks also have far more of a capacity to lend money profitably at low interest rates than they are utilizing. There are far more ways to explain their activity than there are to explain tech companies that horde cash. But, the behavior of commercial banks is certainly consistent with the theory that banks are lending money to support capital investments because would be borrowers have failed to identify them. And, I've seen blog posts from the Federal Reserve Bank of Atlanta's economist's blog that likewise make the point that the banks it gathers data from in its Federal Reserve district aren't making as many business loans in substantial part because businesses aren't coming to the banks asking to borrow money for business investment.

While Schmidt reiterates a number of potential non-cash limits to business investment stated by another participant in the discussion, "limits of recruiting, limits of real estate, regulatory limits" suffice it to say that limits of real estate can almost always be solved with enough cash. Recruiting and regulatory limits are far more serious obstacles.

This is pretty depressing.

There are a number of quite well understood tax policy and fiscal policy options for improving the availability of money to firms that want to make capital investments in ways that are consistent with a belief by the firms using the money that the capital investments will be profitable, at least in the medium to long term. A shortage of money to invest is a problem that government can solve.

The problems associated with a shortage of ideas of ways to make profitable capital investments is muddier territory. There are policies that can address these problems as well. But, economic policy makers have become wedded to the notion that economic growth policy in the developed world begins and ends with the operation of the capital markets.  Other options have gotten dusty from sitting on the shelf and lack the kind of broad based political and academic support that they need to be implemented. For example, there are several measures one can take to address recruiting limitations, which either have a sound theoretical basis in economics and logic, or strong empirical support, or both. You can:

* Make it easier for highly skilled people to immigrate.  Free trade in labor markets is the last bastion of free market economics that economic policy makers in the United States have failed to adopt.

* You can weaken the legal effectiveness of non-competition contracts. This has been empirically identified as a key component of greater tech company competitiveness in California relative to Massachusetts.

* You can make a bigger and more effective public investment in education.

Similarly, while the universe of potential regulatory barriers to technological information are conceivably so many that they can't be numbered.  But, a company like Google isn't very concerned, for example, about the Clean Air Act regulations that regulation opponents have consistently identified as the most costly of recent new federal regulations.  From the perspective of an Internet technology company look Google, some of the principal regulatory barriers to innovation are:

* Excessively protective copyright, patent and trade secret laws that infer that can create "gridlock" in the process of trying to combine old ideas in new and profitable ways, or to better implement old ideas.  Many of Google's potentially most profitable concepts that it has developed to date are limited materially by the way that copyright laws and weak policing of new patents have shrunk the public domain and expanded the breadth of intellectual property protection via doctrines like the protection of "derivative works" under copyright law.

* Privacy protections and confidentiality rules that prohibit useful data from being shared at a low cost without considerable advanced planning by the sources that collect the data.  Securities laws also impair dissemination of "insider information" and create a risk that for the sharing of ideas for addressing corporate governance by a select subset of investors could be prohibited as a form of market manipulation of as some form of "civil conspiracy."

* Securities laws requiring costly disclosures before public offerings of investment opportunities can be advertised and offered to the general public that prevent companies like Google from getting into the investment brokering business for small capital firms where disclosure costs are material relative to the amount of funds that could be raised. 

Even more depressing, of course, is the possibility that a lack of ideas is due not to governmental barriers to innovation but due to "the end of science," i.e. to the fact that we are close to mastering the a whole host of scientific disciplines and hence have fewer innovations that can arise from new scientific discoveries.  To the extent that this is the case there are fundamental reasons, indifferent to government policies or business policies that we can expect greatly diminished long term economic growth, i.e. "the Great Stagnation."

Thursday Brain Dump

* Denver's proposed camping ban would essentially make it a crime to be a vagrant. What are they thinking? After all the years of progress under Mayor Hickenlooper (who actually had stronger ties to the Downtown Business Improvement District that is its biggest backer in the city than Mayor Hancock does), it is a real pity to see Denver on the verge of backsliding. Putting 300 to 600 more people a day into Denver's jail instead of on the streets is not a sensible solution to Denver's vagrancy issues.

* Good bills to expressly authorize county clerks to send ballots to inactive voters and to curtail prosecutor's authority to charge juveniles as adults without judicial approval for midgrade felonies are making progress in the general assembly, while a bad bill to require photo identification to vote is dead.

* The former sheriff after whom Arapahoe County's jail is named will be spending thrity days there followed by two years of probation and paying a tiny $1,100 fine. He used his influence to great a large scale meth for gay sex ring, and some of the prostituted or extorted young men may have been minors. On the upside, who knew that Arapahoe County would be the first county in Colorado to have an openly gay sheriff, even if the announcement did come only after he had retired, and the sentence certainly doesn't reflect any sentencing premium for gay prostitution over opposite sex prostitution.

* A female Jefferson County jail guard has been charged with felonies including having a romantic relationship with a female prison inmate formerly residing at the Jeffco jail and then lying and covering up.

* Some seriously convoluted messes in police discipline, like a female officer who was allegedly raped by fellow deputies who then covered up the incident who is also accused of fraud and blabbing too much on social media about the internal affair process who was recently fired by the Denver Police Department.

* Four cops who killed members of an innocent, unarmed family in the wake of Hurricane Katrina in New Orleans were sentenced to 38 to 65 years for the killings by a federal judge. Another cop who wrote a deceptive report that purported to clear the cops and recommended prosecuting two of the surviving family members was sentenced to six years. Quite a few other cops who plea bargained in exchange for cooperation received shorter obstruction of justice sentences, the longest of which was eight years. The federal civil rights charges can't be commuted by a Louisiana Governor and are subject to less direct and collateral appellate review than state convictions.

* It is a pity that the first time I heard of perhaps the only private college in the nation catering primarily to Koreans was when six of it students and receptionist were killed (and three other people were injured) by a 41 year old ex-nursing student who had been trying to get a full tuition refund. He turned himself in shortly after the shooting at a local Safeway and was charged with crimes that could draw the death penalty in California.

* The employment situation in the United States is slowly but surely improving with seven months to go until the Presidential election. Advantage Obama.

* College basketball is over, nobody care nearly as much about the NBA's boring post-season play, and opening day for the Rockies is just around the corner.

* The Volokh Conspiracy blog is a wasteland of libertarian bloggers arguing in an endless parade of posts that it is obvious that health care reform is unconstitutional and praying for a return to pre-Lochner constitutional rights for business interests. While the anti-insurance mandate campaign has made it further than most liberals and moderates, myself included, had dreamed that it would, my bet is still for an end result that will be decidely underwelming, narrow and technical. Congressional commerce, taxation and spending powers may take a slight dent in their near plenary status quo, but don't expect a clear ideologically coherent sea change from a court where Justice Kennedy hold the swing vote. At any rate, the only nine votes that count have been preliminarily cast and we'll see in a few months what the opinions in the several cases at issue look like. Throw in a bunch of posts on the scope of the right to deadly self-defense under the Model Penal Code and that's all they wrote. Boring.

* Nokia has finally concluded that maybe letting other companies grab huge amounts of its market share in the mobile phone business is not a good idea and planning on offering a new and improved model of smart phone to win it back.

* One of the little known regional airlines that provides small plane connector flights for a couple of major airlines went bankrupt; the story of the industry for the entire post-deregulation era. Why don't investors instinctive flee for the hills when they hear the word airline? The only worse investment I could imagine these days would be print newspapers, or sovereign debt from less affluent Euro countries.

* There should be a pretty steady stream of DSM-5 driven mental health studies and stories coming out over the few months as deadlines on its ponderous timeline march relentlessly towards its print publication date. For a lot of ordinary people, this decision will make more a difference in their daily lives than anything that the legislatures are doing these days.

* President Obama signed a mildly diluted bill banning insider trading in Congress with bipartisan support. Research conduct and promoted by Professor Bainbridge, a conservative corporate law academic, which demonstrated convincingly that there is rampant insider trading going on in Congress was pivotal in the bill's progress through the legislative process, a somewhat ironic result given Bainbridge's own ambivalence (nay, hostility) to the laws against insider trading generally, at least as currently structured.

* Five alleged participants in the planning of the 9-11 attacks, including the alleged mastermind, are facing renewed military commission trials which will be hard pressed to be completed eleven years later. An early version of military commission trial had to be overhauled when its was determined that sentencing people to death based on evidence obtained through torture didn't promote American soft power. A civilian federal jury in Virginia or Pennsylvania would have been faster, cheaper, more credible internationally and domestically, would have dampened rather than incited the movement behind those attacks, and would have probably more reliably produced a hoped for death sentence than the military commission process. The case simply has not been made that military commissions are a more effective way to deal with terrorism than the tried and true criminal justice system where most people suspected of plotting terrorist attacks in the U.S. or supporting terrrorists abroad are charge, convicted and sentenced to very long sentences.

* A pullout from Afghanistan and the effective date of the main provisions of the health care reform act are both scheduled to happen in 2014 and whether these dates are realistic are both still anyone's guess.

* Japanese and Korean television is much more comfortable with fictional portrayals homosexuality and tween/early teen sexuality than American culture, and is also far less concerned about versimilitude. But blessedly, their television networks also don't feel compelled to run every B+ grade idea for four to eight seasons.

* Why do people like reality TV? My kids love it and I just don't get it. I also don't get the appeal of long, meandering, unstructured talk radio and DJ talk segments. If I'm going to listen to someone talk, I'd prefer to listen to someone who knows what they are talking about and has put some real thought into what they are going to say. Maybe that elitists, but elites earn that designation for a reason.

* The Arkansas Supreme Court found that an eighteen year old student in a consensual sexual relationship with a much older teacher at her high school had a constitutional right not to be prosecuted criminally for their love affair. He had been convicted of statutory rape and sentenced to a many decades long prison sentence. Similar prosecutions in Colorado under the sexual assault by a person in a position of trust statute have been upheld, but those convictions carry dramatically shorter sentences, so the conflict has not been as stark.

* An interesting law review article has pointed out that if a sexually aggressive teenage boy rapes an adult female teacher, that the teacher may have no valid legal defense to a statutory rape charge. The issue hasn't been salient until recently because historically only men having sex with girls could be prosecuted for statutory rape and historically the age of consent was too low to make the possibility a the younger person in the relationship committing rape was vanishingly unlikely.

Yes, I know, there are no links in this post. Maybe later, maybe not.