Primary capital market corporate governance in the US needs tweaking?

The Dealbook reports a potential primary market corporate governance loophole in the United States. In a recent piece, Deal Professor Steven Davidoff flags off concerns to this effect pointing to the "locked-in" staggered board provision (that may only be repealed with a 80% vote-- a very high threshold to beat) in the constitutional documents of LinkedIn as exhibit A that go with dual class shares as part of its capital structure. This is because proxy advisory services like the ISS dont rate companies' corporate governance at the IPO stage, and because subscribers to the IPO subscribe only to flip their shares at the listing and could not care enough to monitor it's corporate governance.

It could be argued though, that the corporate governance risk that these issuers present is likely already priced into the cost of capital for them and that LinkedIn stock was bid for at the IPO at a slight discount to its fair value to account for this latent risk. This is likely an empirical question and we may receive some guidance from comparing the costs of capital for issuers like LinkedIn having "anti-corporate governance" clauses in their charter documents, with peer group companies not having such clauses to see if the investors apply any "corporate governance discount". If they do, then the risk is priced in and the regulators need not care. If the difference is negligible though, we may have to think of appropriate policy responses.

RCB v. DC--- Or a Story of another triumph for the unsung

What a game we had last night! One of the greatest sights in any sport, is a come from behind win for an underdog. And thats what DC's win showed us last night.

And who got them there? Not Gibbs or Sharma or Gilchrist and Symonds in substantial measure, it was the unsung, Suman. In many ways, this past week's results are showing how, for all the Pollards and Kohlis, small town guys are the ones that are winning matches. We saw Naman Oza do that for the Royals consistently and with a Bond-like understatedness, we saw the minnow Dinda castling Warner (another of those (over?) hyped possessions and now we have Suman joining the party.

These unexpected results have thrown the third ed. wide open-- Rajasthan Royals' run in particular brought back memories of Senegal's giant-killing Football team. Remember Pape Diouf or Henri Kamara!

I am rooting for these underdogs as the IPL moves in its final leg. Lets hope the media gets a lesson from their triumph. And we learn to celebrate sport for what it teaches us---- Underdog is just a word.

Interesting Reads

I have been following the blogosphere with great enthusiasm lately-- posting comments etcetera, and I must recommend two of those--- truthonthemarket and the conglomerate

And while @ the Glom, as the Conglomerate is affectionately known as, do read Christine Hurt. She is amazing. And so are Josh Wright and Thom Lambert at truthonthemarket.

Of LLM Markets, Tragedy of the Commons and Elinor Ostrom

Phew! The silly season of LLM admissions is behind me now, (where I gave generally a good account of myself, offers from Chicago, Columbia, and wait list at Stanford law being the highlight of this campaign. Was not offered @ Yale. Surprising results from Cambridge, Mass. though :)!) (Guess you guys know who the offerees this year from Government Law College are). No Comments.

Anyway, now that the season has ended, I want to blog about Elinor Ostrom and the tragedy of the Commons and the solutions that she proposed for the same.

Elinor who? Yeah, you could be forgiven for this question. After Elinor won the Nobel memorial prize in Economics in 2009 for her work on the global commons, mainstream Economists, that usually throng the lobbies of such universities as Harvard, Chicago, Berkeley asked the same question. So, that question is not unusual for law students to ask. Answer: Elinor Ostrom is a political scientist from Indiana University, Bloomington and sth of a pioneer in solving the tragedy of the commons.

Tragedy of the Commons? Gareth Hardin writing in 1966(?) spoke about the problems faced in conserving common pool resources. He wrote that common pool resources are likely to suffer from sth like the race to the bottom where every individual consumer will have the incentive to exploit the resource to the hilt (whereas collectively they all stood to benefit from conserving the same). This race to the bottom, Hardin prophesied, will destroy the common pool resource and that he termed as "tragedy of the commons".

Free market proponents argued that the tragedy of the commons could be averted by creating private property rights in the resource so that persons have appropriate incentives to conserve the resource (and so that the Coase theorem may operate to "push " the resource to the person that valued it the most). Others termed it a patent case where Government ought to step in to nationalize the resource and conserve the same (This is because there are no private incentives to conserve the resource as the costs of conservation are concentrated on the one party and the benefits that derive from the conservation are diffuse; the so called public goods problem in Economics and a classic case of government intervention).

For decades, private property and government intervention were supposed to be the only solutions to the tragedy of the commons. Elinor however had a different perspective to offer. She believed in the market hierarchy but not to the extent that Chicago did and being a political scientist she was aware of the public choice and political economy literature (indeed, she served as the Chair of the Public Choice Society for a while) to believe that government intervention could be a solution to the tragedy.

Using tools including qualitative empirics and game theory, Elinor proved that locally created governance solutions could solve the collective action problems that lead to the tragedy of the commons. Her solution is basically a model of how public goods could be provided privately and it tends towards a "non-government" model of managing the commons. "Polycentric Governance" as her team termed it. View her Nobel lecture here.

More Interesting Read

Barack Obama on the The Financial Crisis Responsibility Fee "to be imposed on major financial firms till the American tax payer is fully compensated" of the $117 billion bailout cost.

Read on!

Interesting Reads

Nobel Laureate Paul Krugman on "Bubbles And The Banks" In The New York Times. Krugman says its high time reform takes on financial industry's compensation practices. Elsewhere, Thomas Friedman wonders if going short on China really makes sense in Whether China Is The Next Enron?.

Why the Class Action Remedy Proposed In the New Companies' bill Will Fail

The "Economic times" recently published a debate on the efficacy of the class action remedy proposed by the new Companies' Bill on January 6, 2010. (Found Here and Here).

In a nutshell, the pro/con seems to be,

1.) Yes; Class actions may be useful but possibilities of the misuse of the device ought to be foreclosed. Class Action remedies ought to be coupled with statutory prescriptions that limit speculative litigation.

2). The counterview, posited by the President of a regional investor association seems to be that class action is a remedy whose time has come and "defaulting promoters" ought to be held accountable.

Seems to be me that debaters missed a vital dimension; the incentive structure in the legal services market.

If one factors in this dimension, the class action remedy will most likely be under-utilized, and therefore fail, in most respects.

Here is a capsule low-down:

The Class action remedy is one of the latest transplants that India has borrowed from Anglo-Saxon corporate law and more particularly, the US. But while engaging in this eclecticism, precious little thought has gone into the peculiar institutional design that makes the class action remedy favourable in the US market.

The reason why class actions were successful in the US (in fact so, successful, that speculative litigation abounded, prompting the House to enact the PSLRA, 1995, to regulate causes of action and standi) was the incentive structure of the legal services market. In the US, unlike India, as most of us might be well aware, the incentive structure is characterized by contingency fees.

In their design, contingency fee arrangements replicate the risk-sharing model where the attorney of the plaintiffs takes an "equity interest" in the "litigation venture". Consequently, while the lawyer stands to reap windfall gains should the class action succeed, the returns may be substantially lesser if the action fails.

These rules of the game in the legal services reduce transaction costs, agency risk and result in a robust market for class actions; With her incentives aligned to those of the class acting plaintiffs, the lawyer is much more pro-active in faster "turn around" times.

Contrast this market design, with the "lodestar rule" prevalent in India that de-links the attorney's incentives from the outcome of the litigation to its process--the hours that she dedicates for the client/appearance that she makes for the clients in courtrooms. To make matters worse, institutional rules of the game forbid "opt-out" of this inefficient rule by foreclosing contingency fees as an option.

With the lode-star rule in place, I doubt that aggrieved investors will have appropriate motivations to pursue class action remedy. Admittedly, the class action device reduces the cost of litigation for the plaintiffs. However, the disincentives created by the lode-star rule will make it highly unlikely that the law firm that they engage, will advise them correctly as to which actions to pursue to trial and which actions to settle. And if so, they will prolong most actions that they should have settled earlier, adding to the cost of litigation. Class actions in securities fraud cases are likely to be complex (causation is notoriously difficult to prove, unless the rules of evidence are changed to reverse the burden of proof) and this information asymmetry between the principal(plaintiff investors) and the agent (attorney) coupled with the perverse incentive structure make this scenario much more likely.