Given the crucial role debit card “swipe” fees played in causing the recent financial crisis, Illinois Senator Dick Durbin insisted that the Dodd-Frank law (you know, the one that left Fannie and Freddie untouched) impose price controls on debit card transactions.  Ben Bernanke, who apparently doesn’t have enough on his plate, was tasked with determining banks’ processing and fraud-related costs and setting a swipe fee that’s just high enough to cover those costs.  Mr. Bernanke first decided that the aggregate cost totaled twelve cents per swipe.  After receiving over 11,000 helpful comments, Mr. Bernanke changed his mind.  Banks’ processing and fraud costs, he decided, are really 21 cents per swipe, plus 0.05 percent of the transaction amount.  In a few weeks (on October 1), the government will require banks to charge no more than that amount for each debit card transaction.

SHOCKINGLY, this price control seems to be altering other aspects of the deals banks strike with their customers.  The WSJ is reporting that a number of banks, facing the prospect of reduced revenues from swipe fees, are going to start charging customers an upfront, non-swipe fee for the right to make debit card purchases.  Wells Fargo, J.P. Morgan Chase, Suntrust, Regions, and Bank of America have announced plans to try or explore these sorts of fees — “Durbin Fees,” you might call them.

Whoever would have guessed that Mr. Durbin’s valiant effort to prevent future financial crises by imposing brute price controls would have had these sorts of unintended consequences?

Fortunately for me, I can just switch to using my credit card, which will not be subject to the price controls imposed by Messrs Durbin and Bernanke.  Because I earn a decent salary and have a good credit history, this sort of a switch won’t really hurt me.  In fact, as banks increase the rewards associated with credit card use (in an attempt to encourage customers to use credit in place of debit cards), I may be able to earn some extra goodies. 

Of course, lots of folks — especially those who are out of work or have defaulted on some financial obligations because of the financial crisis and ensuing recession — don’t have access to cheap credit.  They can’t avoid Durbin Fees the way I (and Messrs Durbin and Bernanke) can.  Oh well, I’m sure Mr. Durbin and his colleagues can come up with a subsidy for those folks.

Filed under: banking, credit cards, markets, regulation

Zipcar apparently has been the exclusive user of the 84 or so parking spaces D.C. allocates to car-sharing companies until very recently when the District’s DOT put them up for auction:

The city’s department of transportation offers what are now 84 curbside parking spaces to car-sharing companies, which had up until recently been all Zipcar’s. The long-established company enjoyed their free use for years and last year began paying $200 a space. It’s been the only car-sharing service at all in the District since 2007. In 2011, DDOT announced they wanted to open up the District’s car-sharing market by letting companies bid on the parking spaces, with a minimum bidding price of $3,600 per space. Well, bid they did. After interest from Hertz, Daimler, and Enterprise in addition to Zipcar, three of those four companies bid on the District’s parking spots, according to DDOT spokesman John Lisle earlier this month. He couldn’t tell me more then.

The big news is that Zipcar lost a significant fraction of these spaces:

But word is now in — Zipcar went from having all of what were once 86 curbside parking spots to what’s looking like 12 of the 84 that exist now, according to Zipcar consultant John Williams. You hear that? 12. Zipcar only received a dozen of the 84 spaces that have been allocated, it seems, with a slight possibility they’ll be able to increase the number to 14 due to the District’s wishes that all the car-sharing companies operate in all the wards. D.C.’s car-sharing market has just transformed in a dramatic way and more than I ever would have imagined.

But the economic news is what the story reveals about the auction mechanism implemented by the DDOT!

Multiple companies apparently bid the same amount for the spaces, Williams told me, and this morning the car-sharing companies literally drew straws at DDOT to determine how the spaces will be divided. Can you imagine the sight? They actually drew straws!

So all of the firms bid the minimum.  Strategic?  Collusive?  Coincidence?  More importantly, why wouldn’t the DDOT turn to an English auction mechanism with all of the tied bidders in the room?  Well, there’s a rule of course.  Details of the auction are here; tie-breaking rules (yes, drawing lots) are here (see Rule 1543.3).

HT: Steve Salop.

Filed under: business, economics, markets, regulation

There is an embarrassing blind spot in the behavioral law and economics literature with respect to implementation of policy whether via legislation or administrative agency.  James Cooper and William Kovacic — both currently at the Federal Trade Commission as Attorney Advisor Commissioner, respectively — aim to fill this gap with a recent working paper entitled “Behavioral Economics: Implications for Regulatory Behavior.”  The basic idea is to combine the insights of public choice economics and behavioral economics to explore the implications for behavioral regulation at administrative agencies and, in particular given their experiences, a competition and consumer protection regulator.

Here is the abstract:

Behavioral economics (BE) examines the implications for decision-making when actors suffer from biases documented in the psychological literature. These scholars replace the assumption of rationality with one of “bounded rationality,” in which consumers’ actions are affected by their initial endowments, their tastes for fairness, their inability to appreciate the future costs, their lack of self-control, and general use of flawed heuristics. We posit a simple model of a competition regulator who serves as an agent to a political overseer. The regulator chooses a policy that accounts for the rewards she gets from the political overseer – whose optimal policy is one that focuses on short-run outputs that garner political support, rather than on long-term effective policy solutions – and the weight she puts on the optimal long run policy. We use this model to explore the effects of bounded rationality on policymaking, with an emphasis on competition and consumer protection policy. We find that flawed heuristics (e.g., availability, representativeness, optimism, and hindsight) and present bias are likely to lead regulators to adopt policies closer to those preferred by political overseers than they otherwise would. We argue that unlike the case of firms, which face competition, the incentive structure for regulators is likely to reward regulators who adopt politically expedient policies, either intentionally (due to a desire to please the political overseer) or accidentally (due to bounded rationality). This sample selection process is likely to lead to a cadre of regulators who focus on maximizing outputs rather than outcomes.

Here is a little snippet from the conclusion, but please go do read the whole thing:

The model we present shows that political pressure will cause rational regulators to choose policies that are not optimal from a consumer standpoint, and that in a large number of circumstances regulatory bias will exacerbate this tendency. Our analysis also suggests special caution when attempting to correct firm behavior as regulatory bias appears likely more durable than firm bias because the market provides a much stronger feedback mechanism than exists in the regulatory environment. To the extent that we can de-bias regulators – either through a greater use of internal and external adversarial review or by making a closer nexus between outcomes and rewards – they will become more effective at welfare-enhancing interventions designed to correct biases.

Thinking about the implications of behavioral economics at the regulatory level is incredibly important for competition and consumer protection policy (think CFPB, for example).  And I’m very happy to see scholars of Cooper and Kovacic’s caliber — not to mention real world agency experience to bring to bear on the problem — tackling it.   For full disclosure purposes, I should note that I have or am currently co-authoring with each of them.  But don’t hold that against them!  Its a thought provoking paper upon which I will have some more thoughts later on, as well as tying it in to some of the work I’ve done on behavioral economics.  For example, Judd Stone and I explore a related problem of the implications of firm level irrationality — both for incumbents and entrants — in this piece, and find the implications for antitrust policy less clear (and in some cases, absent) than have behavioral antitrust proponents.  See also Stone’s post during the TOTM Free to Choose Symposium on BE and Administrative Agencies.

Filed under: antitrust, behavioral economics, consumer financial protection bureau, consumer protection, federal trade commission

Others have linked to this, but its really a fantastic video of a discussion between Justin Wolfers and Robert Frank discussing happiness and economic growth.

Filed under: behavioral economics, economics

From the WSJ:

The Department of Health and Human Services this month notified Howard Solomon of Forest Laboratories Inc. that it intends to exclude him from doing business with the federal government. This, in turn, could prevent Forest from selling its drugs to Medicare, Medicaid and the Veterans Administration. If the government implements its ban, Forest would have to dump Mr. Solomon, now 83 years old, in order to protect its corporate revenue. No drug company, large or small, can afford to lose out on sales to the federal government, a major customer.

….

The Health and Human Services department startled drug makers last year when the agency said it would start invoking a little-used administrative policy under the Social Security Act against pharmaceutical executives. This policy allows officials to bar corporate leaders from health-industry companies doing business with the government, if a drug company is guilty of criminal misconduct. The agency said a chief executive or other leader can be banned even if he or she had no knowledge of a company’s criminal actions. Retaining a banned executive can trigger a company’s exclusion from government business.

Debarment is obviously a very serious remedy.  The increased use of debarment in this context has been controversial, especially in cases in which the executive has not demonstrated that the debarred individual is actually complicit.  The WSJ story discusses the Forest Laboratories example along these lines in more detail:

According to Mr. Westling, “It would be a mistake to see this as solely a health-care industry issue. The use of sanctions such as exclusion and debarment to punish individuals where the government is unable to prove a direct legal or regulatory violation could have wide-ranging impact.” An exclusion penalty could be more costly than a Justice Department prosecution.

He said that the Defense Department and the Environmental Protection Agency, for example, have debarment powers similar to the HHS exclusion authority.

The Forest case has its origins in an investigation into the company’s marketing of its big-selling antidepressants Celexa and Lexapro. Last September, Forest made a plea agreement with the government, under which it is paying $313 million in criminal and civil penalties over sales-related misconduct.

A federal court made the deal final in March. Forest Labs representatives said they were shocked when the intent-to-ban notice was received a few weeks later, because Mr. Solomon wasn’t accused by the government of misconduct.

Forest is sticking by its chief. “No one has ever alleged that Mr. Solomon did anything wrong, and excluding him [from the industry] is unjustified,” said general counsel Herschel Weinstein. “It would also set an extremely troubling precedent that would create uncertainty throughout the industry and discourage regulatory settlements.”

The issue of debarment also arises in the antitrust context as a weapon in the toolkit of antitrust enforcement agencies prosecuting cartels.  Judge Ginsburg and I have argued, in Antitrust Sanctions, that the debarment remedy in that context, along with a shift toward individual responsibility and away from ever-increasing corporate fines, would result in a shift toward efficient deterrence.   In our case, we discuss debarment for the executive actually engaged in the price-fixing as well as officers and directors who negligently supervise the price-fixers (e.g., with failure to institute an antitrust compliance program).   Without safeguards to ensure that debarment is imposed in cases of actual wrongdoing or negligent supervision, and also in the cases of settlement, that there is a factual basis for debarment, imposition of these penalties runs the risk that enforcement agencies will have arbitrary power to banish executives that are disfavored for whatever reason.  If its application is properly constrained, however, debarment can be a more effective tool in prosecuting antitrust offenses and potentially other white-collar crime than ever-increasing corporate fines which are largely borne by shareholders.  I’ll refer interested readers to the Ginsburg & Wright link above for the more detailed case in favor of adding debarment to the cartel-enforcement toolkit, including a discussion of its application in the antitrust context in a variety of other countries as well as non-antitrust settings in the U.S.

Filed under: antitrust, corporate crime, corporate law, economics

Josh, Berin Szoka and I have a new op-ed up at CNET on why the lessons of Microsoft suggest the FTC’s action against Google might be misguided.  A taste:

Ten years ago this week, an appeals court upheld Microsoft’s conviction for monopolizing the PC operating system market. The decision became a key legal precedent for U.S. antitrust enforcement. It also cemented the government’s confidence in its ability to pick winners and losers in fast-moving technology markets–a confidence not borne out by subsequent events.

Now this sad history seems to be repeating itself: By uncanny coincidence, news broke just last Friday that the FTC had begun an antitrust investigation into Google’s business practices. Unfortunately, there’s no reason to expect the outcome to be any better for consumers this time around.

There is, in fact, no evidence that the case against Microsoft or its settlement contributed to the spectacular innovation in the IT sector over the last decade. Indeed, they may even have solidified Microsoft’s role as the perennial also-ran in this latest wave of technological progress, as the company struggled to keep innovating under the threat of constant antitrust scrutiny in the U.S. and abroad.

The true lesson of the Microsoft case is this: antitrust intervention in information technology has a poor track record of serving consumers. Even Harvard law professor Lawrence Lessig, who was a court-appointed Special Master in that case and has since championed government tinkering with the Internet, finally admitted in 2007 that he “blew it on Microsoft” by underestimating the potential for innovation and market forces to dethrone Microsoft, particularly through the rise of open-source software (which now in part powers Apple’s popular iOS).

Filed under: antitrust, business, error costs, exclusionary conduct, federal trade commission, law and economics, monopolization, technology, tying

Daniel Kahnemann and co-authors discuss, in the most recent issue of the Harvard Business Review (HT: Brian McCann), various strategies for debiasing individual decisions that impact firm performance.  Much of the advice boils down to more conscious deliberation about decisions, incorporating awareness that individuals can be biased into firm-level decisions, and subjecting decisions to more rigorous cost-benefit analysis.  The authors discuss a handful of examples with executives contemplating this or that decision (a pricing change, a large capital outlay, and a major acquisition) and walk through how thinking harder about recognizing biases of individuals responsible for these decisions or recommendations might be identified and nipped in the bud before a costly error occurs.

Luckily for our HBS heroes they are able to catch these potential decision-making errors in time and correct them:

But in the end, Bob, Lisa, and Devesh all did, and averted serious problems as a result. Bob resisted the temptation to implement the price cut his team was clamoring for at the risk of destroying profitability and triggering a price war. Instead, he challenged the team to propose an alternative, and eventually successful, marketing plan. Lisa refused to approve an investment that, as she discovered, aimed to justify and prop up earlier sunk-cost investments in the same business. Her team later proposed an investment in a new technology that would leapfrog the competition. Finally, Devesh signed off on the deal his team was proposing, but not before additional due diligence had uncovered issues that led to a significant reduction in the acquisition price.

The real challenge for executives who want to implement decision quality control is not time or cost. It is the need to build awareness that even highly experienced, superbly competent, and well intentioned managers are fallible. Organizations need to realize that a disciplined decision-making process, not individual genius, is the key to a sound strategy. And they will have to create a culture of open debate in which such processes can flourish.

But what if they didn’t?  Of course, the result would be a costly mistake.  The sanction from the marketplace would provide a significant incentive for firms to act “as-if” rational over time.  As Judd Stone and I have written (forthcoming in the Cardozo Law Review), the firm itself can be expected to play a critical role in this debiasing:

Economic theory provides another reason for skepticism concerning predictable firm irrationality. As Armen Alchian, Ronald Coase, Harold Demsetz, Benjamin Klein, and Oliver Williamson (amongst others) have reiterated for decades, the firm is not merely a heterogeneous hodgepodge of individuals, but an institution constructed to lower transaction costs relative to making use of the price system (the make or buy decision). Firms thereby facilitate specialization, production, and exchange. Firms must react to the full panoply of economic forces and pressures, responding through innovation and competition. To the extent that cognitive biases operate to deprive individuals of the ability to choose rationally, the firm and the market provide effective mechanisms to at least mitigate these biases when they reduce profits.

A critical battleground for behaviorally-based regulatory intervention, including antitrust but not limited to it, is the question of whether agencies and courts on the one hand, or firms on the other, are the least cost avoiders of social costs associated with cognitive bias.  Stone & Wright argue in the antitrust context — contrary to the claims of Commissioner Rosch and other proponents of the behavioral approach — that the claim that individuals are behaviorally biased, and that because firms are made up of individuals, they too must be biased, simply does not provide intellectual support for behavioral regulation.  The most obvious failure is that it lacks the comparative institutional perspective described above.  Most accounts favoring greater implementation of behavioral regulation at the agency level glide over this question.  Not all, of course.

For example, Commissioner Rosch has offered the following response to the “regulators are irrational-too” critique:

My problem with this criticism is that it ignores the fact that, unlike human beings who make decisions in a vacuum, government regulators have the ability to study over time how individuals behave in certain settings (i.e., whether certain default rules provide adequate disclosure to help them make the most informed decision). Thus, if and to the extent that government regulators are mindful of the human failings discussed above, and their rules are preceded by rigorous and objective tests, it is arguable that they are less likely to get things wrong than one would predict. Of course, it may be the case that the concern with behavioral economics is less that regulators are imperfect and more than they are subject to political biases and that behavioral economics is simply liberalism masquerading as economic thinking.24 My response to that is that political capture is everywhere in Washington and that to the extent behavioral economics supports “hands on” regulation it is no more political than neoclassical economics which generally supports “hands off” regulation. On a more serious note, perhaps the best way behavioral economics could counter this critique over the long run would be to identify ways in which the insights from behavioral economics suggest regulation that one would not expect from a “left-wing” legal theory.

For my money, I find this reply altogether unconvincing.  It amounts to the claim that government agencies can be expected to have a comparative advantage over firms in ameliorating the social costs of errors.  The fact that government regulators might “get things wrong” less often than one might predict is besides the point.  The question is, again, comparing the two relevant institutions: firms in the marketplace and government agencies.  “We’re the government and we’re here to help” isn’t much of an answer to the appropriate question here.  There are further problems with this answer.  As I’ve written in response to the Commissioner’s claims:

But seriously, human beings making decisions “in a vacuum?”  It is individuals and firms who are making decisions insulated from market forces that create profit-motive and other incentives to learn about irrationality and get decisions right — not regulators?   The response to the argument that behavioral economics is simply liberalism masquerading as economic thinking (by the way, the argument is not that, it is that antitrust policy based on behavioral economics has not yet proven to be any more than simply interventionism masquerading as economic thinking — but I quibble) is weak.

As calls for behavioral regulation become more common, administrative agencies are built upon its teachings, or even more aggressive claims that behavioral law and economics can claim intellectual victory over rational choice approaches, it is critical to keep the right question in mind so that we do not fall victim to the Nirvana Fallacy.  The right comparative institutional question is whether courts and agencies or the market is better suited to mitigate the social costs of errors.   The external discipline imposed by the market in mitigating decision-making errors is well documented in the economic literature.  The claim that such discipline can replicated, or exceeded, in agencies is an assertion that remains, thus far, in search of empirical support.

Filed under: antitrust, behavioral economics, behavioral economics, consumer financial protection bureau, consumer protection, doj, economics, federal trade commission

Thom‘s excellent post highlights the Ninth Circuit’s recent decision in Brantley and describes its implications both in terms of rejecting Professor Elhauge’s claim that metering ties and mere surplus extraction amount to competitive harm for the purposes of antitrust and also for the future of the quasi-per se rule of tying.   Thom, in my view correctly, observes:

Given this procedural posture, the Ninth Circuit starkly confronted whether, as Elhauge maintains, the price discrimination/surplus extraction inherent in Stigler-type bundling is an “anticompetitive” effect that warrants liability.  In affirming the district court and holding that plaintiffs’ claims of higher prices were not enough to establish anticompetitive harm, it effectively held, as I and a number of others have urged, that there should be no tying liability absent substantial tied market foreclosure.

I want to highlight another very interesting aspect of the decision, i.e. Brantley appears to reject the so-called “Consumer Choice” standard that has been gaining significant traction in the antitrust literature both in the U.S. and Europe.  Averitt & Lande describe the consumer choice antitrust standard as follows:

It suggests that the role of antitrust should be broadly conceived to protect all the types of options that are significantly important to consumers. An antitrust violation can, therefore, be understood as an activity that unreasonably restricts the totality of price and nonprice choices that would otherwise have been available.

The central idea is that the efficiency perspective is hampered by “only” looking at things like prices and output (including quality-adjusted prices), and occasionally innovation.  The fundamental observation of the “consumer choice” framework is that a reduction of “choice” (however defined, but lets come back to that), even if coupled with a reduction in price or increase in output, is a cognizable antitrust injury.

This approach is getting some traction.  For example, Commissioner Rosch has argued both that the consumer choice standard is desirable and that, after the Supreme Court’s decision in Leegin, is the law (“injury to consumer choice (as well as an increase in price) is now recognized as injury to consumer welfare in the United States.”).

I’ve criticized the consumer choice standard, largely because it was likely to lead to systematic error in predicting the impact on consumer welfare.  Indeed, in cases involving tradeoffs like reduced product variety at lower prices, the standard would systematically condemn conduct that is likely to improve consumer outcomes (e.g. competition for exclusives with retail shelf space).    The bottom line is that I do not think there is any basis in either economic theory or empirical evidence to support the view that the consumer choice standard would be a better predictor of consumer outcomes than current tools allow.   Thus, its application is likely to make consumers worse off.

So why does Brantley appear to reject the consumer choice standard?  If I may borrow from Thom’s description of the case:

Brantley, et al. v. NBC Universal, Inc., et al., involved a challenge by cable television subscribers to T.V. programmers’ practice of selling cable channels only in packages.  The plaintiffs, who preferred to purchase individual channels a la carte, maintained that the programmers’ policy violated Sherman Act Section 1.  As the Ninth Circuit correctly recognized, the arrangement really amounted to tying, for the programmers would sell their “must have” channels only if subscribers would also take other, less desirable channels.  (Indeed, the practice is closely analogous to the block booking at issue in Loew’s, where the distributor required that licensees of popular films also license flops.)

The district court dismissed plaintiffs’ first complaint without prejudice on the ground that plaintiffs failed to allege that their injuries (purportedly higher prices) were caused by an injury to competition.  Plaintiffs then amended their complaint to include an allegation “that Programmers’ practice of selling bundled cable channels foreclosed independent programmers from entering and competing in the upstream market for programming channels.”  In other words, plaintiffs alleged, the tying at issue occasioned substantial tied market foreclosure.

After conducting some discovery, plaintiffs decided to abandon that theory of harm.  They prepared a new complaint that omitted all market foreclosure allegations and asked the court to rule “that plaintiffs did not have to allege that potential competitors were foreclosed from the market in order to defeat a motion to dismiss.”  Defendants again sought to dismiss the complaint.  The district court, reasoning that the plaintiffs had failed to allege any cognizable injury to competition, granted defendants’ motion to dismiss, and plaintiffs appealed.

The crux of the complaint, of course, is a reduction in consumer choice.  The plaintiffs argue that a la carte programming would prevail in the absence of bundling and thus increase consumer choice.  The Ninth Circuit describes the plaintiffs’ claim as follows: “the challenged bundling practice limits Distributors’ method of doing business and reduces consumer choice, while raising prices.”  In the absence of allegations of market foreclosure or exclusion resulting in harm to competition, the complaint isolates the claim that a stand-alone reduction of consumer choice is actionable antitrust injury.  The Ninth Circuit ties the complaint to consumer choice directly:

They argue that the sale of multi-channel packages harms consumers by (1) limiting the manner in which Distributors are unable to offer a la carte programming, (2) reducing consumer choice, and (3) increasing prices.  These allegations do not state a Section 1 claim.

The Court is clear to note that “limitations on the manner in which Distributors compete with one another, without more, constitute a cognizable injury to competition,” citing Chicago Board of Trade.  Contrary to Commissioner Rosch’s claims, the Ninth Circuit finds that Leegin explicitly rejects the consumer choice standard, observing that “in Leegin, the Supreme Court made clear that even in the face of clear limitations on distributors’ ability to compete, proof of competitive harm is required to state a cognizable antitrust claim,” and also highlights the fact that “antitrust law recognizes the ability of businesses to choose the manner in which they do business absent an injury.”  Further, the Court points out the mere fact that a common business practice is adopted by many firms in an industry — thus reducing the diversity of business arrangements and consumer choice — is likely a signal that the practice is efficient, not that it reduces consumer welfare.

In addition the Brantley’s implications for tying (and with respect to Professor Elhauge’s claims about non-foreclosure related consumer harm), it is a rather straightforward rejection of the consumer choice standard.   I think this is all to the good for the reasons described above, and in Thom’s post.  A movement to a vague “consumer choice” standard threatens to take the focus off of consumer welfare — and in some cases, is in direct conflict with it.  The consumer choice movement runs counter to the modern trend (e.g. in the Horizontal Merger Guidelines) to directly measure the impact of business practices on consumer welfare instead of indirect proxies like market structure or “choice.”

Filed under: antitrust, business, economics

In a recent Dealbook post, Steven M. Davidoff complains that Delaware’s business judgment rule is too lenient.  Davidoff contends that “[a] Delaware court is not going to find [directors] liable no matter how stupid their decisions are. Instead, a Delaware court will find them liable only if they intentionally acted wrongfully or were so oblivious that it was essentially the same thing.”  He then asserts that a commonly heard justification for this lenient approach — that it is required in order to induce qualified individuals to serve as directors — is “laughable.”

Prof. Davidoff’s pithy summary of the Delaware business judgment rule seems accurate, and I share his skepticism toward the argument that the rule is justified as a means of inducing highly qualified directors to serve.  I disagree, though, with his insinuation that the Delaware approach is unjustified.  The rule makes a great deal of sense as a means of aligning the incentives of directors (and officers) with those of shareholders.

Under Delaware’s business judgment rule, courts will abstain from second-guessing the merits of a business decision — even one that appears, in retrospect, to have been substantively unreasonable — as long as the directors acted honestly, in good faith, without any conflict of interest, and on a reasonably informed basis (i.e., they weren’t “grossly negligent” in informing themselves prior to making the decision at issue).  Courts treat the rule as quasi-jurisdictional, insisting that they simply will not hear complaints about the substantive reasonableness of a decision as long as the prerequisites to BJR protection are satisfied. 

One frequently hears two justifications for this deferential approach.  First, courts sometimes seek to justify it on grounds that they are not business experts.  Second, as Prof. Davidoff observes, directors and officers often defend it on grounds that it’s needed to prevent qualified directors from being scared off by the prospect of huge liability for good faith business decisions that turn out poorly.  

Neither justification works very well.  Courts routinely second-guess the substance of decisions in areas where they lack expertise and might, by imposing liability, dissuade qualified individuals from offering their services.  Consider, for example, medical malpractice.  Courts aren’t medical experts, yet they routinely second-guess the substance of good faith, reasonably informed treatment decisions.  And they do this with full knowledge that malpractice judgments dissuade qualified doctors from providing their services.  (Remember President Bush’s concern that malpractice verdicts were dissuading gynecologists from “practic[ing] their love with women all across this country”?)  There must be something more to the story.

Indeed, there is.  By insulating directors from liability for good faith, informed business decisions that turn out poorly, the business judgment rule encourages directors to take greater business risks.  This is a good thing, because directors and officers tend to be more risk averse than their principals, the shareholders.  I previously explained that point in criticizing Mark Cuban’s claim that shareholders and CEOs “have completely different agendas: Most chief executives want to hit a ‘home run’ — taking big risks for potentially big payoffs — while most mom-and-pop shareholders simply hope not to ‘strike out’ and lose their nest egg.”  I wrote:

… Stockholders would normally prefer corporate managers to take more, not less, business risk.

When it comes to managerial decision-making, rational stockholders prefer greater risk-taking (which is associated with higher potential rewards) for a number of reasons. First, stockholders have limited liability, which means that if a business venture totally tanks and creates liabilities in excess of the corporation’s assets, the stockholders are off the hook for the excess. Since stockholders are able to externalize some of the downside of business risks, they’ll tend to be risk-preferring. Moreover, stockholders are the “residual claimants” of a corporation — they don’t get paid until obligations to all other corporate constituents (creditors, employees, preferred stockholders, etc.) have been satisfied. In other words, they get nothing if the corporation breaks even, and they therefore would prefer that managers pursue business ventures likely to do more than break even. Finally, stockholders are able to eliminate firm-specific, “unsystematic” risk from their investment portfolios by owning a diversified collection of stocks. They therefore do not care about such risk (although they do demand compensation for bearing non-diversifiable, “systematic” risk). …

Compared to equity investors, corporate managers (including CEOs) tend to be relatively risk-averse. Unlike shareholders, they get paid even if the corporation breaks even, so high-risk/high-reward ventures are less attractive to them. In addition, they cannot diversify their labor “investment” so as to eliminate firm-specific risk (one can generally work only one job, after all). Managers therefore tend to prefer “safer” business ventures.

The need to reconcile risk preferences among corporate managers (directors and officers) and their principals (the shareholders) provides a compelling justification for Delaware’s business judgment rule.  Chancellor Allen clearly articulated this point in footnote 18 of the 1996 Caremark opinion:

Where review of board functioning is involved, courts leave behind as a relevant point of reference the decisions of the hypothetical “reasonable person”, who typically supplies the test for negligence liability. It is doubtful that we want business men and women to be encouraged to make decisions as hypothetical persons of ordinary judgment and prudence might. The corporate form gets its utility in large part from its ability to allow diversified investors to accept greater investment risk. If those in charge of the corporation are to be adjudged personally liable for losses on the basis of a substantive judgment based upon what persons of ordinary or average judgment and average risk assessment talent regard as “prudent” “sensible” or even “rational”, such persons will have a strong incentive at the margin to authorize less risky investment projects.

As Geoff has often reminded us, the optimal level of business risk is not zero.

Filed under: business, corporate governance, corporate law, law and economics