It's possibly (I would say "probably") the best legal fellowship out there.  A year in the leafy confines of Princeton University, time for research and plenty of workshops, all in the company of a very distinguished set of legal scholars.  It's the LAPA Fellowship program, and you should get your application in very soon.

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I hustled down to Wilmington yesterday to see Steven Davidoff present his fascinating paper on why so many private equity deals collapsed when the market went south.  Didn't the targets negotiate binding contracts?  Steve showed how these deals evolved in ways that allowed the PE firms to walk and analyzed the contribution the legal market made to the failure of targets to lock in their purchases (the five repeat-playing firms in go privates largely represent the acquirer in these transactions). 

If Davidoff focused on the lawyering, Vice-Chancellor Leo Strine was particularly interested in the way that the financial institutions bankrolling the leveraged takeovers were able to get out of their commitments.  Both he and Davidoff then suggested where they thought private equity contracts might be reformed.  And both agreed that, like much else during this financial crisis, the evolving shakiness of the deal contracts was probably ignored because nothing failed until 2006, and the parties to these transactions were probably disinclined to worry about eventualities that surely wouldn't come to pass.

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• Here's a gloss on the Federal Circuits new limits on business method patents.  Here's a good one too, from Michael Risch.
• The usual timeline is collapse, congressional hearing, criminal investigation, civil suits.  Good to see that Bear is following the script.
• Speaking of politics, Washington DC and environs account for 15 of the 20 zip codes that donate the most of House members.
• Parade!

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(posted by Shubha Ghosh)

In the past few posts, I have discussed various aspects of IP3.0, the current focus within intellectual property law on transactional practice and uses of IP, the recognition of IP as a business asset. Today, I examine the implications of IP 3.0 for IP policy.

My appreciation of IP 3.0 arose from the need for IP reform. Like other law professors and practitioners, I have watched the ongoing debates over the past fifteen years or so (roughly when I formally entered into the area of IP with coursework in law school) and the debate over ownership and access and the role of each in promoting innovation. I have watched as these issues were worked out at the statutory and constitutional levels. My continuing concern, however, has been with IP practice in its many ways, in other words, how do the policies of IP become reflected in practice. Of course, practice means different things to different constituencies. For the IP bar, it often means how to ensure that one's patent is granted and not challenged (even seemingly at the expense of whether the patent covers a valuable invention or at the expense of future inventors or users). The IP bar, for obvious reasons, is concerned with strong IP protection even if such protection is not conducive from a broader perspective for innovation. Users and follow-on inventors, creative and inventive people of many stripes, are often ignored in the balance. One needs to recognize IP practice pretty broadly, especially the way in which it is used by and affects wide sets of constituencies, not just ones represented within the IP bar.

The response in these IP debates has been one of balance, which often means find some utilitarian, highly principled way to define legal rights to reach the correct policy result. I have actually become skeptical of this notion of balance, not just in the area of IP, but perhaps more broadly. Focusing on IP policy here, I want to suggest that reaching the right result is not a matter of balance in the abstract, but in recognizing the practices affected by a legal rule and coming up with an approach that attempts to be the least disruptive to the broad set of practices that arguably tend to promote innovation. I want to suggest that recent Supreme Court decisions in the field of intellectual property pursue this goal by implicitly recognizing what I have called IP 3.0 and has been largely successful, especially when compared to reforms pursued by Congress and the USPTO. I want to emphasize this last point: my argument is about relative institutional success as opposed to absolute success. The latter is rarely possible in a world with a large set of often irreconcilable interests.  From the perspective of incremental change and relative competence, Supreme Court patent reform has done a good job.

I will touch on three cases in which the Court has implicitly recognized IP 3.0, the role of IP as a business asset, and make the point for the success of the decision. In eBay v. MercExchange, a 2006 decision, the Court ruled that patent injunctions were discretionary. The Court split three ways on how this discretion was to be exercised, with one group of three supporting traditional equitable principles, another group of three supporting principles based upon patent policies, and a third group supporting principles based on the business effects of the injunction on the defendant. In KSR v. Teleflex, a 2007 decision, the Court attempted to raise the standard for nonobviousness in patent law, in response to concerns over low-quality patents issued by the USPTO that potentially affected the integrity and reputation of the patent system. Finally, in Quanta v LG Electronics, a 2008 decision, the Supreme Court applied the principle of patent exhaustion, specifically the first sale doctrine, to strike down certain licensing practices that allowed the patent owner to control use and distribution by downstream users of the patented technology. Each of these decisions, as well as others I could have mentioned, were shaped by the business use of patent law and potentially its disruptive effect on markets and competition. These cases are examples of IP 3.0 in action.

 As I have stated before, these cases are not examples of perfection. Members of the IP bar and business practitioners are often up in arms about these decisions. But these cases illustrate how to pursue patent reform narrowly, and IP reform more broadly, by giving attention to the use of IP as a business asset. I would suggest that these are examples of practical reforms, ones that attempt to align IP law more effectively with its goals of promoting innovation and shaping markets.

 At a recent conference, a speaker described the Court's treatment of IP as an example of neoconservative appeal to markets and resulting skepticism of IP. I am not sure if this is completely the case. Perhaps there are Justices who are influenced by neoconservative ideology. I am not sure if that is the case for the more liberal justices on the Court. Perhaps, IP 3.0 reflects a neoconservative consensus in the political arena that in turn affects the legal system. I am not convinced of that either; one can identify support for IP from both conservative and liberal camps. A better explanation is that the Court is engaged in common law decision making to resolve what is viewed as the anti-competitive effects of intellectual property law. The eBay decision, with its defense of judicial discretion, is a good example of common law reasoning in action. In their interpretations of the Patent Act, so are the KSR and Quanta decisions.

 Skeptics of my interpretation of the Supreme Court decisions, particularly the appeal of IP 3.0, may point to two decisions in which the Court perhaps supported business interests too readily. In Eldred v Ashcroft, the Court upheld Congress' extension of the copyright term for already created works by 20 years. In Grokster, the Court found a P2P network potentially liable under a novel theory of secondary liability. Arguably, each of these cases reflect how the Court bends too readily to business interests. I have two responses to this argument. First, the cases can be understood under other terms than business ones. In Eldred, the Court was deferring to Congress' legislative judgments, which is admittedly a selective decision by the Court, but one that is ostensibly based on deeply-rooted institutional grounds. In Grokster, the Court was following the logic of its 1984 Sony decision, which was correctly decided (within the terms of IP 3.0) for upholding disruptive technologies, but was fundamentally misguided in reading a broad secondary liability taken from the Patent Act into copyright law. Second, and more importantly, these two cases illustrate the need for what I have called IP 3.0 because in each of these two cases the Court ignored the business implications of the rule at issue and, as a result, decided cases that were antithetical to the principles of competition and innovation that is at the heart of IP 3.0.

 I may already have crossed the line from blog post to (god forbid!) law review article.  So, let me end my writing at this point. For those who read all this, thanks for the attention and I welcome any response. Most importantly, thanks to Gordon Smith and the other members of Conglomerate blog for sharing  this virtual real estate this week.

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Two items of interest: a series of reactions to Anupam Chander's 2003 essay comparing minority protections in corporate law and constitutional law (Stephen Bainbridge weighs in, among others). Also, the Pocket Part is seeking submissions for a legal ethics symposium. I remember my law school Professional Responsiblity class as being hyper-litigation focused, but colleagues here at Georgia tell me that's changed post-Enron.

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In an earlier post I endorsed the adoption of restrictions on margin lending as an imperfect, but fundamentally sound, legislative response to the stock market crash of 1929.  This endorsement relied on the claim that investing on margin destabilized market prices in precisely the same way that the widespread adoption of portfolio insurance led to the stock market crash in October 1987.  In this post I will explain why restricting margin lending is consistent with the three principles I offered for regulating portfolio insurance: do not panic, supervise the sale of insurance products, and do not rely on the sophistication of investors. 

My first regulatory principle based on a review of portfolio insurance and its role in the ’87 crash was: “don’t panic.”  An important lesson from the ’87 crash is that stock market prices can drop (or rise) dramatically for reasons that have nothing to do with the usual suspects, which include, but are not limited to, complexity, fraud, fear, greed, illiquidity, and failed corporate governance (in deference to Gordon).  Dramatic price changes may solely be a consequence of the widespread adoption of an investment strategy in which stocks are sold as prices fall.  While such an investment strategy may be potentially destabilizing, the dramatic price drop alone does not justify regulatory intervention.  The crash of ’87 made institutional investors keenly aware of the fact that the cost of creating a synthetic put to “protect” their portfolio’s depended on future volatility.  As a result, the problems that led to the 1987 crash were largely self-correcting.  Most investors learned the shortcomings and expense of portfolio insurance.  As with portfolio insurance, the widespread use of borrowed funds to purchase stock can lead to a situation where the aggregate demand for equities is upward sloping, creating Giffen goods, disparate equilibrium prices, and leading to market volatility.  But margin lending does not require regulatory intervention just because it may contribute to market volatility.

The second regulatory princple I espoused in the context of portfolio insurance was the need to regulate insurance products. Insurance products need not cause a market failure; however, history has shown, when left unregulated, those selling insurance products often misjudge the necessary amount of reserves.  To understand the relevance of insurance regulation to margin lending, we need to return to the decomposition of a margin loan.  Recall that a margin loan actually involves the sale of two different financial instruments: a loan, and the “writing” of a put on the collateral which backs the loan.  The put component of a margin loan results from the fact that if the price of the collateral falls below the loan value, then the bank takes ownership of the collateral (in many circumstances).

My recommendation in the context of portfolio insurance was that the insurance component of that product should be regulated to insure accurate pricing and the maintenance of adequate reserves.  The case for regulating the insurance component of the margin loan is even stronger than the case for regulating the insurance component of portfolio insurance.  When an investor adopts a portfolio insurance trading strategy, the put is also written by the investor.  If an investor “purchases” portfolio insurance and prices decline suddenly, the investor bears the increased cost of pursing this strategy.  But when an investor purchases a risky asset using borrowed funds, the put is written by the lender.  In the case of a margin loan, the costs of asset price volatility are borne by the lender, and it has proven difficult for lenders to properly price the value of the put embedded in a margin loan.  Peter Fortune, an economist at the FED who studies lending practices, concludes that even today, most banks do a poor job of pricing the put embedded in the loans they make [link].  To price this put the banker needs to correctly estimate the volatility of the underlying asset; however, the typical, mistaken assumption is that the price of an asset will rise or fall steadily, rather than occasionally jumping between disparate equilibrium prices.  Restricting the percentage of funds that can be used to finance the purchase of risky assets, such as stocks, is one way to limit the extent to which lenders misprice the insurance component of their loans.

The third regulatory lesson I inferred from the market crash of ’87 is that a regulator should not rely on the sophistication of investors.  This regulatory principle also supports the ’34 Act restrictions on margin lending.  A prohibition on high margin loans is not as draconian as it might appear, because there are other means by which investors can create leveraged investments in equities.  A prohibition on high margin loans would work more like a strong nudge, rather than an outright ban on highly leveraged investments in risky assets.  A strong regulatory nudge is appropriate once it is recognized that a highly leveraged investment in risky assets is unwise for most investors.  A regulator need not facilitate the practice of buying stock mostly with borrowed funds just because investors are eager to link the amount of risk in their portfolio to small changes in the nominal value of certain risky assets.

The three principles I offered for regulating portfolio insurance (do not panic, supervise the sale of insurance products, and do not rely on the sophistication of investors) support the margin regulations established in the ’34 Act as a response to the Crash of 1929.  In the next post I’ll show how these regulatory principles apply to the current financial crisis.

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In an issue that is right up Christine’s alley, this election day, voters in several states will be considering ballot initiatives involving gambling or lotteries.  Indeed, my own state of Maryland has proposed such an initiative, which would add a new constitutional amendment approving up to 15,000 “video lottery terminals” in five locations throughout the state.  Like other states, Maryland’s initiative aims to raise money to cover its significant budget shortfall—a shortfall of about $430 million.  As one can imagine, these initiatives have sparked considerable debate, and that debate seems to be heightened when viewed in the context of the current financial and economic crisis. 

Proponents of the Maryland measure contend that the initiative could potentially raise $600 million, a significant portion of which would go to fund public education.  From this perspective, in a time when states are strapped for cash and thus not only have had to increase taxes, but also have had to take measures such as slashing budgets and instituting hiring freezes and/or mandatory furloughs, it is hard to argue with a proposal designed to inject $600 million into the state’s coffers.  As the Baltimore Sun noted in its recent endorsement of the measure, while raising revenue from gambling is not ideal, it may be better than the alternative choices of higher taxes or allowing public education and health care to suffer if budget cuts continue unabated.  Proponents also point out that many Marylanders travel out of state to nearby states like Delaware or West Virginia where gambling is allowed, and hence we might as well enable these Marylanders to spend those funds in their own state. 

Opponents first question whether gambling initiatives can be counted on to raise significant revenue.  Given recent reports indicating that revenue has fallen sharply in many casinos, this is not an idle question.  These reports reflect the reality that people no longer have discretionary funds to spend on activities like gambling.  Then too, opponents insist that gambling has costly secondary effects because, as studies suggest, it is addictive, leads to increased alcoholism and otherwise negatively impacts other businesses and the surrounding community.   Moreover, opponents express concern that gambling measures will prove especially harmful to lower class communities, imposing what some describe as a regressive tax on those communities.  Again, such an argument has particular salience in these economic times.  Indeed, if more people are living paycheck to paycheck, can or should we pin even part of our economic recovery on the hope that they will use part of their paychecks to gamble? 

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The latest move by the government would dedicate $50 billionish of the bailout money to guarantee some distressed mortgages.  The Post gives you some of the as yet unclear details, I'll note only:

• The deal is between Treasury and the FDIC, the White House is skeptical ... trust the Post to outline the politics of the deal first.
• But since we're in the world of politics, it's worth noting that FDIC head Sheila Bair is doing very well out of this crisis; better, I would warrant, than Christopher Cox, in that it looks like she's actually participating in shaping the government response.  I suspect that DC veterans wouldn't have thought that the flacks and politicos at the FDIC, the sleepiest government agency, had it in them.
• The FDIC isn't really charged with playing a part in the TARP by the bailout statute (in section 126 of that statute it got some anti-fraud authority unrelated to the crisis given to it, there's the increase in deposit insurance in section 136 to $250k, and that includes the ability to borrow money from Treasury if necessary, to meet obligations), and it guarantees deposits in banks, not mortgages for banks, so there's lots more to learn about how this program will be structured and why the outfit is even involved.

Also, those worried that banks are getting too good a deal on the bailout money are wondering why they're using that money to pay shareholder dividends, rather than make loans.

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Today, I will discuss how to integrate a transactionally oriented IP course into the law school curriculum. Some of the ideas here are based on my experiences writing and teaching a co-authored casebook on this subject, Intellectual Property in Business Organizations: Cases and Materials (Lexis-Nexis 2006).

For more reading and a different perspective, I highly recommend, Sean M. O' Connor, Teaching IP From an Entrepreneurial Counseling and Transactional Perspective, 52 Saint Louis U. L. J. 877-90 (2008). I know many schools have implemented a transactional IP course, and I apologize for not mentioning these efforts in more detail.  But I hope people will chime in with their own experiences in this area.

Let me first address the issue for the law school with the lean curriculum where faculty and administrators may view a transactionally oriented IP course as too exotic or impractical to offer. There are ways to integrate a transactional IP component to lean curricula, beyond hiring an upper level adjunct to teach a specialized course to a handful of students. First, transactional concepts can be introduced into a basic IP course with some attention to licensing and employment issues. Second, IP issues can be integrated into a business organizations course, especially one that discusses start-ups. IP issues may also be raised in a discussion of securities and due diligence, to the extent that these topics are addressed in the business curriculum. Such inclusion can enrich the discussion of these fields and introduce contemporary topics.

For a school with a slighter bigger curriculum, there is of course more room to integrate transactional IP courses into the set of electives available for students. A third year capstone course on transactional intellectual property would be a desirable way to introduce business students to intellectual property and intellectual property students to business. Ideally, a survey IP course or a basic Business Organizations course could be prerequisites for the course, or you could require one of these two as a prerequisite. The course could be open to business school students, permitting classroom assignments allowing business and law schools to work together. As a third year capstone course, the focus would be on integrating skills learned during the previous two years of law school and for laying a foundation for future practice.  Such a capstone course would complement courses on law and entrepreneurship like the ones taught and developed by Gordon Smith, Darian Ibrahim, and others. Furthermore, for law schools that are associated with universities with technology transfer offices, such a course might benefit students employed by these offices or might serve as a basis for a clinical IP component in the curriculum, very likely connected to a technology transfer office.

Thinking more globally, a transactional IP course might alter how IP and business transactions are taught. In most schools, IP is introduced through a survey course. There is some ongoing controversy over whether an IP course is necessary, but my sense is that the debate is over with most serious schools offering a survey IP course that presents the four big areas of IP (trade secrets, copyright, patent, and trademark) in an integrated and comprehensive way. The idea behind such a course is to lay a foundation for more advanced courses. While this survey course has traditionally been doctrinally focused with an eye towards litigation practice as the norm, there is no reason why the basic survey course could not be taught as a transactions-oriented course. The two principle themes of the course would be identifying IP assets (that is, identify what can be the basis for trade secret, copyright, patent, or trademark protection), learning how to secure rights in these assets (use of NDA's and non-competes, the basics of patent and trademark prosecution, an introduction to work-for-hire and other employment issues), and learning how to realize value through licensing practice. Personally, I have not taught the survey course primarily in this way when I have taught it. I do touch on some of the business issues raised by IP, but my course has been fairly traditional. There is no reason, however, why the survey course could not taught with a transactional slant as opposed to the traditional litigation or constitutional policy slant. I should point out here that my co-authors Richard Gruner and Jay Kesan have an IP survey casebook with Thomson-West (on which Robert Reis is also a co-author), and we have tried to integrate transactional concepts into that book, partly to lay a foundation for our IP and Business Organizations course and casebook (previously mentioned).

In addition, transactional IP might alter how we think of the traditional business organizations course. Intellectual property is an important tool for business organizations, a mechanism for codifying knowledge within a firm and for defining its boundaries. Scholarship by Paul Heald, Dan Burk and Brett McDonnell (as well as myself) have explored this issue. In terms of teaching, the links between IP and the firm would shift the focus of the traditional business course to start-ups, employment, and licensing issues. For those who cover business taxation, the intersection of IP and tax could also be introduced. Some reading this may view my suggestion as just adding more to an already bulging course. My suggestion, however, is not to add to the set of materials out there, but to propose an alternative way of teaching transactional skills that recognizes how intellectual property issues inform current practice and shape the legal regulation of business activity.

Tomorrow, I turn to this last point, legal regulation, and show how IP 3.0 reflects and shapes how IP policy has evolved over the past few years, especially as seen in Supreme Court decisions.

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Jeff's post and rant has spurred me to think by writing about the role of the business lawyer. I'm plumping for lawyer-as-translator, and here's why, in no particular order:

-Legal language is impenetrable to laypeople. I remember vividly my first Torts assignment, struggling through the tangle of appellants, appellees (wait, who's suing whom?), summary judgments, and the like. A lot of what business lawyers do is explain legal terms and concepts to nonlawyers. Sometimes the listener is a client, sometimes it's the investing public or the participants in a stock option plan or a private placement. In each case, our job is to communicate clearly and accurate what's at stake legally.

-As my neighbor Joe Miller suggests, the translator metaphor resonates with the lawyer-as-priest connection one of Jeff's commenters brought up. Our presence adds "officialness" to transactions because we are initiates of a sacred realm, with its own accompanying language.

-The quarterback metaphor, as the comments to my original post make clear, is about communication. We need to "talk accountant" enough to understand the green eyeshade types, interpret that information into legal terms, and then speak to both accountants and clients in terms each can understand. Ditto for the bankers and for IP, although, as Shubha Ghosh points out, we law schools can do a better job training our transactional lawyers here.

-Translators can add value, as Gilson's paradigm demands. But they can also substract value, if they translate inaccurately or create unnecesary costs and needless complexity. They can promote understanding or create more confusion. This captures the love/hate relationship many clients seem to have with their lawyers.

-It explains why what's going on in the financial world right now has me occasionally paralyzed, and why I admired Gordon's confession so much. My language--legal language--seems inadequate for the task of explaining what's happening.

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The automakers want a federal bailout, and the WSJ has a story on the currently ineligible bank-like institutions (private banks, most notably) hoping to get their bit of the $250 billion.  A sign that things really are bad?  John Carney suggests otherwise:

When thousands of otherwise healthy banks are lining up for the funds, willing to give up equity stakes and pay dividends to the government, we know that the price extracted for the bailout bucks is too small.  Healthy banks wouldn’t be eager to get on the gravy train if it was priced correctly.

We've noted that if there are downsides to this money, Treasury hasn't gotten around to enacting them very carefully, and as the injections go forward, it's going to be difficult to put onerous new conditions in place - that would look like, and might even be, the sort of retroactive administrative regulations disfavored by the courts.

We may, in short, be seeing a real shift in regulatory philosophy here, from punishing bailouts of financial institutions to pleasureable ones (for them, at least).

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In the previous post, I talked about IP 3.0, the latest version of IP teaching and scholarship that focuses on transactional issues in intellectual property. Today, I want to talk about why IP provides an excellent vehicle for conveying transactional skills and thinking in law schools.

The main reason, and this is more serious than it appears, is that intellectual property can often make the bitter pills of law school go down more smoothly. That is not a slam on transactional courses or on law school. I am just amazed how raising intellectual property issues into the law school classroom can turn a student's attention away from Facebook, Bejewelled, Expedia, or whatever web page may be up on his laptop at the moment. Want to teach about dreary subjects like common law process or tort damages? Let me pass on some cites to right of publicity cases to you. If your experience is like mine with these cases, classroom discussion will exponentiate with previously inert hands rising to attention and undifferentiated faces suddenly become attached to a voice. The concept of a contract not getting through? Let me suggest a couple of IP cases involving licenses and transfer of copyrighted works or trademarks. Constitutional decision making unusually opaque today? Try talking about Eldred to show deference to Congress and the bending of constitutional language in action. Analogously, some of the inert concepts of transactional practice can be better appreciated when seen through the lens of intellectual property.

There is something more than window dressing going on here. After all, legal doctrine can be spiced up in other ways. There are many substantive points where IP overlaps with the goals of a transactional law curriculum.

There are five areas where intellectual property and transactional legal skills overlap: (1) formation of a business, (2) licensing, (3) employment, (4) identifying sources of transactional value, and (5) securities disclosure and due diligence. Transactional skills are most critical at the formation stage of a business. The formation stage also raises numerous intellectual property issues: trademark registration and protection, patenting, the identification and clearance of IP rights. Businesses, at various stages, have to decide between making or buying, a decision which affects the negotiation and drafting of licenses. The internal organization of a business also hinges on employment decisions, the choices of whether to use independent contractors or employees and the terms on which these parties are hired. The choice of type of worker and terms may be shaped by the intellectual property strategies of the firm. Finally, intellectual property is a source of transactional value within a firm, and the identification of IP sources of value would affect disclosure requirements and the due diligence of a seller and purchaser of a firm's securities and other assets.

These five practical areas of overlap translate into a distinct set of transactional skills that can be effectively conveyed through the teaching of intellectual property. The first is identifying business assets. Understanding intellectual property law and institutions is critical in identifying the sources of value for a business and the types of business assets which can be the basis for realizing value. Identifying what is a patent, copyright, and trademark as well as what can be protected by patent, copyright, or trademark is foundational for recognizing and valuing business assets. The second skill is understanding how background common and statutory law serve as defaults for contractual negotiation in some instances and as immutable rules in others. In other words, law shapes the contours of a business asset and affects its value. The final skill is negotiating rights over intellectual property in order to realize and transfer these sources of value and to avoid litigation over these assets. Intellectual property provides a basis for teaching business planning and organization skills.

Today's post highlights the overlap between intellectual property and the transactional curriculum in law. Tomorrow, I discuss how this overlap can be implemented in the curriculum.

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In my continuing effort to explore the connection between the financial crisis and fiduciary duty (see here and here for initial steps), I was interested to read David Rosenberg's paper, Supplying the Adverb: Corporate Risk-Taking and the Business Judgment Rule. In this paper, David explores the effect of judicial review of corporate decision making on the willingness of corporate managers to take risks, and he concludes that "courts are perfectly well-equipped to hear cases in which aggrieved shareholders claim that directors took improper risks in ways that ought to result in liability for those directors."

Note the key word in that sentence: improper.

The crux of David's argument is that the business judgment rule should not shield directors from liability for all risk taking, only appropriate risk taking. The Delaware courts routinely justify the business judgment rule on the ground that it is designed to encourage managerial risk taking, but David argues that the Delaware courts ignore their own standards if they insulate directors from liability for excessive risk taking. Obviously, the big question then becomes, what is "excessive risk taking"?

To answer that question, David turns to Stone v. Ritter, arguing that the standard of bad faith articulated there includes "knowing lack of care." David cites an excellent recent article by Claire Hill and Brett McDonnell on the subject, Stone v. Ritter and the Expanding Duty of Loyalty, 76 Fordham L. Rev. 1769 (2007). In that article, Claire and Brett imagine fiduciary duty cases as lying along a continuum of disloyalty. On the one end are classic loyalty cases, in which a director steals from the corporation. On the other end lie "classic duty of care cases[, which] also involve a director taking for herself something which should otherwise be the corporation’s: her attention and diligence." Under this version of Stone, loyalty has become an expansive concept that would permit a court to impose personal liability on directors in the following circumstances (quoting from David's paper):

Operating in an environment in which it is accepted that risky decisions often end in failure, corporate directors can still take those kinds of risks without fear that such failure will result in personal liability for them. What they plainly cannot do is choose a risky course of action knowing that the decision is a bad one or knowing they have not taken care to evaluate whether or not the risks involved will benefit the corporation.

This seems like a perfectly acceptable reading of Stone, though I suspect the number of cases in which directors would, as a factual matter, be found to have acted with a "knowing lack of care" is close to zero. This is not the sort of case in which Delaware courts seem inclined to lean toward the plaintiffs because the costs associated with a false positive -- chilling future boards from taking risks -- is much higher than the costs associated with a false negative -- failure to compensate plaintiffs in a particular case.

Returning to the issue that animates this series of posts, could we do better under a federal corporate law regime? I don't see how. David is calling for a very precise evaluation of board action, and the evaluation would not become easier just by transferring decision making power to a federal agency or court.

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Tomorrow the SEC will host a roundtable required by the recent bailout legislation to discuss mark-to-market accounting.  My guess is that much of the talk will focus on the costs and benefits of accurate reporting, concentrating on the potentially damaging effects of having to make financial reports based on temporarily “distressed” market prices.  Such a discussion will entirely miss the point.

The SEC needs to consider market-to-market rules in the broader context of the various types of investment practices that can either increase or decrease market instability.  We need to acknowledge that this is more than just an accounting issue.  While mark-to-market, as with margin calls, can cause severe market declines, their proper regulation should focus on modifications which make it less likely that both the price of and demand for risky assets will fall together in the future.  In 1934 Congress saw the problem deeply enough to avoid shooting the messenger, and increased margin requirements rather than restrict margin calls.  Let’s hope that the discussion at the SEC roundtable will lead to a similarly thoughtful response.

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Treasury sent one of its people to address SIFMA today on the bailout implementation.  Among the standard litany of things the guy (he was an acting undersecretary, and a last minute fill-in for Paulson himself) noted was this:

In order to address the unprecedented and extraordinary disequilibrium and challenges that our financial markets have experienced, the President's Working Group on Financial Markets, or "PWG" as it is known, has been taking proactive steps to mitigate systemic risk, restore investor confidence, and facilitate stable economic growth.

What is this shadowy group?

The PWG may be our future. It was established in 1988 in response to the market break of 1987 by executive order, and includes (1) the Secretary of the Treasury or designee (as Chair); (2) the Chair of the Board of Governors of the Federal Reserve System or designee; (3) the Chair of the Securities and Exchange Commission, or designee; and (4) the Chair of the Commodity Futures Trading Commission, or designee; and their respective staffs.   

The group has recently emerged not just as a studier of prior crises, but as the focus of future efforts to coordinate financial regulation – making it the informal tip of the spear of Paulson-directed regulatory reform. The PWG, for example, has considered how the financial regulators can together promote investor confidence, track credit system issues (like pursuing on-line clearing and same-day trade comparison for all equity and derivative products), develop effective market controls such as trading halts in emergencies and how to deal with large and rapid unwinding of positions, and so on.

But more to the point, the current financial crisis has made reform more likely, but paradoxically reduced the ability of the current administration to shape that reform, because it has been so distracting. But with the PWG playing a role in the bailout itself, Paulson has done a little bit of regulatory reform in the way he likes - centralization, coordination, and one voice from the Fed, Treasury and the SEC - by fait accompli.

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