I vividly remember learning about 10b5-1 plans while in practice: they struck me then as an elegant and sensible way to insulate yourself from insider trading liability.  Even when I don't cover insider trading in Business Associations, I always make sure to mention them.  For those unfamiliar, 10b5-1 plans take the trading discretion away from corporate insiders, either by setting some type of formula or prearranged schedule for when to buy or sell company shares, or by vesting the power of decision with a third party that lacks inside knowledge.  When done correctly, this "set it and forget it" style investing works great.  "I don't know why everyone doesn't set up these plans," I tell my students every year.

Well, apparently many insiders agree--and are doing them the wrong way.  The WSJ had an article last November detailing executives setting up plans and then trading almost immediately--when they likely had material nonpublic information.  Or, rather than "setting and forgetting," modifying the plan repeatedly.  

Today's WSJ has another front page article on 10b5-1 plans, this one focusing on outside directors .  The article implies that nonexecutive directors using these plans is in itself questionable, which seems wrong to me: what's good for the goose is good for the gander, and outside directors should be able to protect their personal trading as well as insiders.  But the chief problematic examples the article cites involve directors who represent hedge funds, with the hedge fund using the trading plan and trading soon after adopting or modifying it. Take this one:

Double-Take Software... adopted a "cautious stance" about its future financial results on Oct. 27, 2009, according to securities analysts' reports at the time.

Shortly before that, the company briefed board members on its business outlook, said a person familiar with the matter. Among those briefed, the person added, was Ashoke Goswami, a general partner of ABS Capital Partners, a Baltimore-based firm that invests in small, growing companies.

On Nov. 11, 2009, ABS amended a trading plan for Double-Take shares, a change Mr. Goswami disclosed in a regulatory filing. The director then reported the sale by ABS of $3.8 million in Double-Take stock, most of it under the revised plan, in trading from mid-December through Feb. 2, 2010.

On Feb. 3, Double-Take released earnings guidance below analysts' estimates. The stock plunged 21% in a day.

Last week Brian Breheny of Skadden posted some thoughts on these plans over at the Harvard Law School Forum on Corporate Governance and Financial Regulation.  He reports that the Council of Institutional Investors recommends that the SEC

• limit the time period for adoption of Rule 10b5-1 trading plans to the issuer’s open trading window;
• prohibit the adoption of multiple, overlapping trading plans;
• require a mandatory three-month or longer delay between plan adoption and the execution of the first trade pursuant to the plan; and
• limit the frequency of modifications and cancellations of trading plans.

Skadden takes issue with some of these recommendations, but the last two make good sense to me.  3 months might be overkill, but requring a delay between adoption and first trade would prevent a lot of of gaming, as would limiting modifications.

I'm not sure where I fall on making the terms of the plans themselves public--I can see that knowing when the CEO has to sell or buy shares would be valuable information, and there might well be good reasons to keep that from the market.  In any event, I expect we'll see more and more about these plans in the future.

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A little Friday reading:

Via CLS Blue Sky Blog, Lawrence Cunningham on the wily Oracle of O vs. Modern Finance Theory:

Threatened by Buffett’s performance, stubborn devotees of modern finance theory resorted to strange explanations for his success. Maybe he is just lucky—the monkey who typed out Hamlet— or maybe he has inside access to information that other investors do not. In dismissing Buffett, modern finance enthusiasts still insist that an investor’s best strategy is to diversify based on betas or dart throwing, and constantly reconfigure one’s portfolio of investments.

Buffett responds with a quip and some advice: the quip is that devotees of his investment philosophy should probably endow chaired professorships at colleges and universities to ensure the perpetual teaching of efficient market dogma; the advice is to ignore modern finance theory and other quasi-sophisticated views of the market and stick to investment knitting. That can best be done for many people through long-term investment in an index fund. Or it can be done by conducting hard-headed analyses of businesses within an investor’s competence to evaluate. In that kind of thinking, the risk that matters is not beta or volatility, but the possibility of loss or injury from an investment.

And NYT's Deal Professor, Steven Davidoff, tells a gripping tale of hedge fund vs family hegemony playing out in Maryland's courts.  CommonWealth REIT is controlled by the Portnoy family, which has made a pretty penny in the process, and 2 hedge funds are trying to get it to change its ways.  

First, the story has implications for the future of shareholder arbitration provisions.  I knew the SEC objects to these puppies at IPO, but didn't think that a board might turn around post-IPO and and adopt amend the bylaws to require arbitration to resolve disputes with shareholders.  Shady.  But apparently that's what happened at CommonWealth REIT.  

And there's more to the story.  

On March 1, CommonWealth’s board passed a bylaw amendment that purports to require that any shareholder wishing to undertake a consent solicitation must, among other things, own 3 percent of the company’s shares for three years. This is an extremely aggressive position that if upheld would stop Corvex and Related in their tracks.

Not satisfied with this attempted knockout blow, CommonWealth appears to have lobbied the Maryland Legislature to amend the Maryland Unsolicited Takeover Act. This law allows companies to have a mandatory staggered board.

CommonWealth already has such a board, but the company has also reportedly lobbied the legislature to make a change that companies opting into this statute would now be unable to have their directors removed by written consent. Again, this would kill Corvex and Related’s campaign. When the two funds got wind of this, they fought back, and the Maryland legislature adjourned without adopting CommonWealth’s proposal.

CommonWealth still announced this week that it had opted into the act. The REIT is claiming that even though the Maryland Legislature did not adopt any amendment, the law still implicitly has this requirement. The funds will now have to sue CommonWealth to force them to change their interpretation.

Go read the whole thing.  Some wacky shenanigans from my home state.  If it does come down to arbitration I'd love to see CommonWealth's arbitrator, allegedly a friend of its controlling family, go toe to toe with the hedge funds' choice-- former Delaware Chancellor Bill Chandler.  

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The stock markets are tanking this morning ... because President Obama won reelection? So when an event that had something like 65%-80% probability actually happens, the markets go crazy? I understand that 65%-80% probability is not the same as certainty, but I am surprised by the size of the movements.

According to the WSJ, the markets are turning their attention to the fiscal cliff, but we have been talking about the fiscal cliff for a long time. Perhaps traders were surprised that the House of Representatives remained in Republican hands? Actually, according to Intrade, that was even more likely than the President's reelection, somewhere around 90%.

Then there was this revelation: "Financial stocks were also sharply lower, as investors fretted about the impact of electoral wins by Elizabeth Warren in Massachusetts and Alan Grayson in Florida." The Warren-Brown race was close at the polls, but Warren's election was trading at over 80% on Intrade in the days before the election, and Grayson won by 25 percentage points!

Triumph of hope over experience?

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The latest edition of The Economist has a fascinating article on “Chilecon Valley” that discusses the emergence of a startup community in Chile. The article focuses on a unique program of Startup Chile (a new Chilean governmental body) that gives grants to entrepreneurs in the United States and elsewhere to move to Chile for several months as they work on building their company and developing their technology. The grant recipients are then expected to network with, speak to, and mentor Chilean entrepreneurs.

The article touches on how law can foster or hinder the growth of a startup community, including by liberalizing immigration laws and allowing failed ventures to get a fresh start in bankruptcy.

Chile is making considerable efforts to diversify its economy beyond extractive industries like mining and agriculture. My spouse is co-organizing a fantastic three-day conference in Santiago from November 28 to December 1st that will focus on social entrepreneurship, sustainability, and innovation. The conference includes a fantastic line-up of speakers, including a keynote address by Al Gore, a pitch competition for social entrepreneurship startup companies, and some awesome music, including Devendra Banhart and Denver’s own Devotchka. Several panels will analyze the contribution of law to developing a entrepreneurial ecosystem in Chile.

You can check out my wife’s newly launched blog and website on the Chilean startup community here.

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Conglomerate readers interested in consumer financial protection should check out the Insurance law Section Program at the AALS Annual Meeting on Sunday, January 6th from 10:30 am to 12:15 pm, which will cover consumer protection issues.  Speakers include:

• Joshua Teitelbaum, Georgetown University Law Center (Moderator); 
• Shawn Cole, Harvard Business School;
• Kyle Logue, University of Michigan Law School;
• Lauren Willis, Loyola Law School (Los Angeles);
• Daniel Schwarcz, University of Minnesota Law School; and
• Orly Lobel, University of San Diego Law School

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This is the third installment of a series of previews of the papers being presented at the AALS Financial Institutions & Consumer Financial Services Section meeting this Sunday from 9 am to 10:45 am at the Marriott Wardman Park.

Anita Krug (Univ. of Washington) authored the third paper in our Sunday Panel, Institutionalization, Investment Adviser Regulation, and the Hedge Fund Problem (forthcoming in the Hastings Law Journal).  Professor Krug looks at the regulation of investment advisers, a corner of financial regulation that has mushroomed in importance in practice, but has not enjoyed enough focus in legal scholarship (for one exception, see Laby).

Her paper remedies that and points scholars to securities law beyond the ’33 and ’34 Act. As scholars focus on longstanding debates, high stakes turf wars have erupted in the world of regulatory practice over the boundaries of investment adviser regulation, the regulation of broker-dealers, and hedge fund regulation generally. At the same time Krug’s work fits into a body of work (e.g., Langevoort) that focus on another seismic shift by examining the regulatory consequences of the fact that capital markets investing is now dominated by institutions not retail investors.

Moreover, Krug’s paper fills a scholarly void at the nexus of securities regulation and financial institution regulation and shows the wide scope of the latter. Here is her abstract:

This Article contends that more effective regulation of investment advisers could be achieved by recognizing that the growth of hedge funds, private equity funds, and other private funds in recent decades is a manifestation of institutionalization in the investment advisory context. That is, investment advisers today commonly advise these “institutions,” which have supplanted other, smaller investors as advisory clients. However, the federal securities statute governing investment advisers, the Investment Advisers Act of 1940, does not address the role of private funds as institutions that now intermediate those smaller investors’ relationships to investment advisers. Consistent with that failure, investment adviser regulation regards a private fund, rather than the fund’s investors, as both the “client” of the fund’s adviser and the “thing” to which the adviser owes its obligations. The regulatory stance that the fund is the client, which recent financial regulatory reform did not change, renders the Advisers Act incoherent in its application to investment advisers managing private funds and, more importantly, thwarts the objective behind the Advisers Act: investor protection. This Article shows that policymakers’ focus should be trained primarily on the intermediated investors – those who place their capital in private funds – rather than on the funds themselves and proposes a new approach to investment adviser regulation. In particular, investment advisers to private funds should owe their regulatory obligations not only to the funds they manage but also to the investors in those funds.

We are fortunate to have Kristin Johnson (Seton Hall) act as discussant for this paper.

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On Sunday, January 8th, the AALS Section on Financial Institutions and Consumer Financial Services will be holding a panel discussing featuring an impressive list of papers selected from an annual Call for Papers. The panel will take place from 9 am to 10:45 am in the Marriott Wardman Park in Maryland Suite B.  It is part of a full weekend of programs by the section, including a Saturday lunch speech by Federal Reserve Governor Sarah Bloom Raskin.

In advance of that panel, let me showcase the papers one by one. (The Conglomerate is all about emphasizing the scholarly aspects of the AALS Annual Meeting.) Each of the four papers deals with a different set of foundational challenges to the regulation of financial institutions. The first paper I will preview looks at three interrelated problems:

• Distintermediation;
• Which regulator should be responsible for consumer/investor protection; and  
• How to allocate regulatory responsibility generally, when innovative financial services do not fit neatly within traditional regulatory silos.

In many ways, the first challenge – disintermediation -- is an echo (an extremely loud one) of an old problem. Starting over 30 years ago the cozy world of depository banking was rocked first by the rise of rival intermediaries – money market mutual funds, deeper bond markets and more sophisticated structured finance, as well as other elements of shadow banking.

Now scholars are looking at another competitive wave coming from radical disintermediation, in which the web facilitates direct connections between lenders and borrowers. This is the subject of the first paper, Regulating On-line Peer-to-Peer Lending in the Aftermath of Dodd-Frank,  by Eric Chaffee (Univ. of Dayton School of Law) and Geoffrey C. Rapp (Univ. of Toledo College of Law). Eric will be presenting the paper, which is forthcoming in the Washington & Lee Law Review. Andrew Verstein (Yale Law School) will serve as discussant. Andrew has also written a fantastic paper on the same topic, The Misregulation of Person-to-Person Lending, which is forthcoming in the U.C. Davis Law Review.  

Chaffee and Rapp outline the business model and current regulatory treatment of peer-to-peer lending, which includes platforms like Prosper Marketplace and Lending Club. They examine how securities laws govern the investment by lenders and banking law regulates the borrower end. The Dodd-Frank Act required the GAO to look at the regulation of p2p lending, and the GAO responded by formulating two alternatives. The first was continued regulation of investors on p2p sites by the SEC and regulation of borrowers by agencies responsible for consumer financial regulation (i.e. the CFPB). The second is assigning regulation to a unified consumer regulator.

In the end, Chaffee and Rapp argue that regulatory heterogeneity is not bad, but actually the way to go. They argue for an “organic” approach to regulating P2P lending, allowing different regulators to govern different aspects of the business. Here is their abstract:

The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act called for a government study of the regulatory options for on-line Peer-to-Peer lending. On-line P2P sites, most notably for-profit sites Prosper.com and LendingClub.com, offer individual “investors” the chance to lend funds to individual “borrowers.” The sites promise lower interest rates for borrowers and high rates of return for investors. In addition to the media attention such sites have generated, they also raise significant regulatory concerns on both the state and federal level. The Government Accountability Office report produced in response to the Dodd-Frank Act failed to make a strong recommendation between two primary regulatory options – a multi-faceted regulatory approach in which different federal and state agencies would exercise authority over different aspects of on-line P2P lending, or a single-regulator approach, in which a single agency (most likely the new Consumer Financial Protection Bureau) would be given total regulatory control over on-line P2P lending. After discussing the origins of on-line P2P lending, its particular risks, and its place in the broader context of non-commercial lending, this paper argues in favor of a multi-agency regulatory approach for on-line P2P that mirrors the approach used to regulate traditional lending.

Verstein comes out the other way and argues against SEC regulation of P2P lending and for unified regulation of p2p lending by the CFPB. Here is his abstract:

Amid a financial crisis and credit crunch, retail investors are lending a billion dollars over the Internet, on an unsecured basis, to total strangers. Technological and financial innovation allows person-to-person (“P2P”) lending to connect lenders and borrowers in ways never before imagined. However, all is not well with P2P lending. The SEC threatens the entire industry by asserting jurisdiction with a fundamental misunderstanding of P2P lending. This Article illustrates how the SEC has transformed this industry, making P2P lending less safe and more costly than ever, threatening its very existence. The SEC’s misregulation of P2P lending provides an opportunity to theorize about regulation in a rapidly disintermediating world. The Article then proposes a preferable regulatory scheme designed to preserve and discipline P2P lending’s innovative mix of social finance, microlending, and disintermediation. This proposal consists of regulation by the new Consumer Financial Protection Bureau.

This should be a lively discussion and of interest to our securities law junkies. Disintermediation is of course a topic a challenge for securities regulation generally, as other platforms are linking equity investors and companies seeking capital. Usha has been blogging about Sharespost and friend of the Glom Joan Heminway is working away on disintermediation too, looking at “crowdfunding” from the securities regulation angle (See her working paper here,  see also, among others, Pope )

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Except for Arizona and Hawaii, the United States ended this calendar's observance of Daylight Saving Time at 2 a.m. local time today. In a fascinating book titled A Time for Every Purpose: Law and the Balance of Life, Harvard University Byrne Professor of Administrative Law Todd D. Rakoff argues that social regulation of time can and should create more room for people to balance time at work with time away from work.

In the article Losing Sleep at the Market: The Daylight-Savings Anomaly, three financial economists document that in international financial markets, the average Friday-to-Monday return on daylight-savings weekends is much lower than expected, with a magnitude 200 to 500 percent larger than the average negative return for other weekends of the year. This finding is consistent with psychological research about how changes in sleep patterns have impacts on accidents, anxiety, decision-making, judgment, reaction time, and problem solving. In this article Winter Blues: A SAD Stock Market Cycle, financial economists found that the lack of sunlight during winter months tends to depress stock prices across international markets. More recently, the article This is Your Portfolio on Winter: Seasonal Affective Disorder and Risk Aversion in Financial Decision Making reported that people with SAD (Seasonal Affect Disorder) exhibited financial risk aversion that varied across seasons because of their seasonally changing affect. SAD-sufferers had much stronger preferences for safe choices during winter than non-SAD-sufferers, and SAD-sufferers did not differ from non-SAD-sufferers during summer.

In two articles, The Psychophysiology of Real-Time Financial Risk Processing and Fear and Greed in Financial Markets: An Online Clinical Study, Andrew Lo and co-authors find traders who respond with too little or too much emotion tend to be less profitable than traders with middle of the range types of emotional responses. Another article Endogenous Steroids and Financial Risk Taking on a London Trading Floor documents that traders tend to make more money on days when their testosterone levels are higher than average.

All of the above differing strands of empirical research share in common the finding that emotions play important roles in how people arrive at financial judgments and financial decisions. Of course, even just a moment of introspection is enough for us to realize that we are like other people in making emotional judgments and emotional decisions. In the article Who's Afraid of Law and Emotions?, the Herma Hill Kay Distinguished Professor of Law at Boalt Hall Kathryn Abrams and Southestern law school professor Hila Keren analyze the ambivalent reactions by mainstream legal academics to law and emotions scholarship and conclude that part of the reason for such responses is the persistence of rationalist tendencies within the legal academy. 

I have often heard after making a presentation about emotions in financial markets and regulation the view that emotions could matter in non-financial areas of life and law, but emotions in general and happiness in particular are not what business and business law are and should be about. Such a point of view strikes as being wrong and closed-minded. As economist Andrew J. Oswald cogently observes in the opening paragraphs of his article Happiness and Economic Performance: 

"Economic performance is not intrinsically interesting. No-one is concerned in a genuine sense about the level of gross national product last year or about next year's exchange rate. People have no innate interest in the money supply, inflation, growth, inequality, unemployment, and the rest. The stolid greyness of the business pages of our newspapers seems to mirror the fact that economic numbers matter only indirectly.

The relevance of economic performance is that it may be a means to an end. That end is not the consumption of beefburgers, nor the accumulation of television sets, nor the vanquishing of some high level of interest rates, but rather the enrichment of mankind's feeling of well-being. Economic things matter only in so far as they make people happier."

I will expand in a later post on decisions to measure happiness by an increasing number of governments of countries, states, and cities as diverse as Bhutan, England, Guandong province in China, Maryland, and Somerville in Massachusetts. For now, check out:

Finally, Glom readers may find this five-day free virtual event of interest: The Enlightened Business Summit which takes place this week November 7-11 and is hosted by Chip Conley, the founder of Joie de Vivre, a two-time TED Speaker, and author of the book Peak: How Great Companies Get Their Mojo from Maslow and the forthcoming book Emotional Equations: Simple Truths for Creating Happiness + Success:

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I recently saw the movie, Margin Call, which is currently playing in theaters and is available on demand at Comcast. There are curretly 34 reviews of it by viewers at imdb, where it has a rating of 7.3 out of 10.

I also just finished reading this paper, Fear, Greed, and Financial Crisis: A Cognitive Neuroscience Perspective, prepared for a forthcoming handbook on systemic risk. This chapter is by finance professor Andrew Lo, who is the director of the MIT laboratory for financal engineering. He also wrote another excellent paper which Glom readers are likely to find of interest, namely Reading About the Financial Crisis: A 21-Book Review, that was prepared for the Journal of Economic Literature.

In the interests of full disclosure, I taught at Temple law school a seminar titled Law, Emotions, and Neuroscience and co-taught at Yale law school with professor Dan Kahan a seminar titled Neuroscience and the Law. The seminars covered some basic materials about affective,cognitive, and social neuroscience before analyzing the potential and limits of applications to business law, conflict resolution, criminal law, ethics,  evidence, morality, paternalism, and social policy. Media coverage of neuroscience and law has a tendency to focus almost exclusively on such controversial issues as free will and responsibility in the criminal law context. Glom readers are more likely to focus on neuroeconomics and neurofinance, two nascent fields that ask how human brains engage in JDM (Judgment and Decision Making) in general and over time and under risk in particular.

Also, as cognitive neuroscientist Michael Gazzaniga recently stated: responsibility, like generosity, love, pettiness, and suspiciousness, is a strongly emergent property, which although being derived from biological mechanisms, has fundamentally distinct properties, just like the case of ice and water. The press and the public also seem to be fascinated with very colorful fMRI brain scans because they like the idea of being as the Wall Street Journal science writer, Sharon Begley, calls them: cognitive papparazi.

My system 1 believes in synchronicity, so this post, as evidenced by its title's homage to Lo's chapter, approaches the movie Margin Call from a cognitive neuroscience perspective informed by Lo's chapter. Lo provides a brief history of what we know about brains. He then explains how fear and the amygdala can exacerbate financial crises. He also demonstrates how the reward of money appears to share the same neural system and the release of the neuortransmitter dopamine into the nucleus accumbens as these rewards do: beauty, cocaine, food, music, love, and sex.

Lo proceeds to discuss a neurophysiological explanation for Kahneman and Tversky's experiment demonstrating people's aversion to sure loss. Lo proposes a neuroscientifically informed view of rationality that differs very much from an economic rational expectations conception, with the key difference being the role that emotion plays in JDM. Lo extends his analysis from individuals to groups by explaining the neurophysiology of mirror neurons, theories of mind, social interactions, and the efficient markets hypothesis. He concludes his neuroscience survey by describing the marvels and limits of the human prefrontal cortex, also known as the "executive brain." Of particular interest to Glom readers is decision fatigue, documented recently among judges rendering favorable parole decisions around 65% of the time at the start of and close to 0% by the end of each of 3 daily sessions that were separated by 2 food breaks (a late morning snack and lunch). This empirical finding that parole rates increased after food breaks is consistent with recent experimental research finding that glucose can reverse decision fatigue and the common adage to not make important decisions when tired. 

Lo provides several practical and reasonable suggesions based upon cognitive neurosciences about how policymakers can engage in financial reform to deal with systemic risk. He concludes by advocating that financial economists utilize the great recession to re-conceptualize, rethink, and revamp neoclassical economics by forging a consilience between the neurosciences and financial economic theory. Building a deeper and better understanding of economic phenomena through improved economic models and intellectual frameworks can and should lead to a more appropriate financial regulatory infrastructure.

And now onto a few comments about the movie Margin Call. Without giving away the plot for those who may want to see it without any knowledge of its ending, this movie raises ethical and moral questions about individual versus social optimality, trading on the basis of private information, panic selling, professional codes or norms of behavior, and the costs a company may impose on society and pay to others to survive. There is certainly lots of fear and greed on display in this film. Set over the course of a day and sleepless night in NYC, the movie viscerally illustrates various forms of JDM and how individuals and groups of individuals can persevere under stress and time pressures. It is a movie that can and should provoke discussion about what could have been done differently by individuals, financial firms, and regulators. It is a film that I'm going to put on the list of movies at the start of the chapter about business law in the text, Law and Popular Culture: Text, Notes, and Questions (LexisNexis Matthew Bender, 2007) by David Ray Papke, Melissa Cole Essig, Christine Alice Corcos, Lenora P. Ledwon, Diane H. Mazur, Carrie Menkel-Meadow, Philip N. Meyer, Binny Miller, and myself that we are revising for a second edition.

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The 7^th Circuit decision in Jones v. Harris, as well as the Supreme Court case that followed, generated a renewed interest in the regulation of the mutual-fund industry, as well as a great Masters Forum on this blog.   

One background issue the case implicated was the role of the fund board in policing mutual-fund fees.  Although I’m not convinced by Easterbrook’s free market analysis of the pricing of mutual funds, I’m also unsure that a board of directors is a useful regulatory mechanism for monitoring fees.

Mutual funds typically have a rather odd structure.  A mutual fund has a board of directors, but the fund itself is essentially a shell, whose sole asset is its portfolio of securities.  The fund’s affairs are handled by its investment adviser, and the board’s main role is to make sure that the adviser isn’t charging fund shareholders an exorbitant fee for its services.

But the board is ill-positioned to serve shareholders in this regard.  In the corporate context, board governance benefits shareholders as a response to collective action problems.  The board can make high-level corporate decisions more efficiently than a diffuse shareholder body.  It can also oversee management better than shareholders, each of whom may be unwilling to bear the costs of management oversight because of the public-goods nature of a well-run company.

Neither of these rationales for board governance applies in the fund context, however.  The board isn’t there to make big policy decisions.  Mutual-fund shareholders choose a fund based on, among other things, the investment strategy that the manager is bound to comply with.  It would be out of place for the board to question this strategy.  Nor is there a public-goods problem with respect to policing fees.  Shareholders are adequately incentivized to monitor fees on their own.

Perhaps, however, investors aren’t paying as much attention to fees as they should, even though it’s in their own best interest.  The board, therefore, can be justified as a mechanism to help protect them from themselves.  This logic, however, is dubious.  The structure of the industry makes it highly likely that board members will be captured by the investment adviser.  Because shareholders are quite apathetic when it comes to board governance, it is really the investment adviser who controls the appointment and tenure of fund boards.  That being the case, the board’s devotion to low shareholder fees may be questionable.

If we are concerned about fund fees, rather than impose an intermediary with dubious incentives, we should take steps to improve the operation of the fund marketplace.  As I have argued elsewhere, this would include, among other things, steps such as requiring better disclosure of fund fees and other aspects of fund investing.

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The efficient markets hypothesis has come under heavy attack in the last couple of years.  For defenders of EMH, the fallback position appears to be that, even though the theory may not be technically correct, it is the best approximation of market behavior.  The implication is, therefore, that it is still a useful descriptive tool.

I’m not sure this position is sustainable, however.  EMH says that stock prices are right—not in some absolute metaphysical sense, but at least in that they represent society’s best guess based on available information.  Behavioral finance scholars point out, however, that there are ubiquitous limits to arbitrage that stand in the way of the market reaching this happy equilibrium. 

We can’t, therefore, merely look at a stock’s price and assume it is accurate.  What behavioral finance tells us is that what we see is the result of the interaction of a complex set of factors.  A better description of market prices, therefore, may be that they are inaccurate, with the extent of the inaccuracy (anywhere from mild to wild) being a function of how constraints to arbitrage are interacting with and influencing market trading at any given time.  

On a related point, even if EMH were correct, I think its usefulness can be questioned.  EMH claims that stock prices represent society’s best guess based on available information.  But what does that tell us?  Nassim Taleb’s work would suggest not very much.  Today’s stock prices are based on predictions of future events, specifically how future events will impact corporate profits and dividends.  But if the future is dictated by “black swans” that are unpredictable a priori, then stock prices can only be accurate in an impoverished sense of the word.  And even if we are not fully convinced by the black-swan metaphor, it still stands to reason that even if stock prices were rational, they would merely represent guesses regarding a cloudy future. 

Most broadly, what all of this suggests is that we should adopt a more modest and skeptical view of market prices, rather than casually assuming market perfectionism.

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In my last post, I suggested that government insurance of market returns was a theoretically attractive way to provide a more equitable vehicle for retirement savers.  I have concerns, however, about how it would work in practice.

It seems that to move in this direction would be to swap market risk for political risk.  Rather than face market volatility alone, individuals would face the risk that government would renege on its guarantee obligations if it felt such action was necessary.  This strikes me as a real possibility.  Who knows what market returns will be in the future.  If they are not as forecasted, our government would find itself in a bind, and a politically attractive way out might be to alter pension obligations.  This concern seems particularly trenchant in light of our treatment of social security.

The central problem appears to be that a return guarantee imposes a long-term static obligation in connection with something that is dynamic, namely market returns.  As the divergence between expectations and reality inevitably builds, political and economic concerns may take precedence over earlier commitments.

Perhaps a guarantee could be designed so that it is flexible over time.  But too much flexibility and the guarantee becomes meaningless.  This strikes me as a difficult balance to strike. 

The design problems and political risk associated with government guarantees leave me to wonder whether reforms should focus on improving, rather than abandoning, the current paradigm, where government makes no promises.  It seems to fall far short of egalitarian ideals, but perhaps it is the best among imperfect alternatives.

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As I noted in my last post, the arbitrariness of the stock market poses both fairness and efficiency concerns.  Out of concern for fairness, there may be a role for government in protecting investors from arbitrary and disparate market outcomes.  Efficiency concerns point to policies that would dampen the appeal of actively managed mutual funds.

Disparate market returns stem from market volatility.  If the market just went up by the same amount every year, everyone would earn the same thing.  To bring about greater equality of returns, therefore, regulation could seek to dampen the market’s swings.  Indeed, our current disclosure regime has been shown to reduce market volatility, and I have argued that this provides some justification for the regulatory structure. 

Government could also enact measures directly targeted at protecting retirement savers from market turbulence.  A range of proposals could be envisioned along these lines:  from the least intrusive—better education about market risk and risk management—to the most—replacing the 401(k) retirement paradigm with a funded government system.  What I think is most interesting is the prospect of government insurance of stock-market returns.  A study done by the Center for Retirement Research at Boston College showed that in retrospect the government could have guaranteed investor returns of 6% (investors in this case would have forfeited any returns above 6% in exchange for a guarantee of at least that amount).  Looking prospectively, the study concludes that under certain assumptions, the government could offer a 4% return guarantee with a 6% cap.  I have my concerns about the feasibility of this structure, which I’ll discuss in my next post, but at least in the abstract, it looks like a promising way to make saving more equitable.  

A range of policy options is also available for addressing the inefficiency of actively managed funds.  The least interventionist measures would involve better disclosure.  My suspicion is that part of the popularity of actively managed funds stems from their branding.  A 401(k) investor may not realize that a “growth” fund is actively managed, and charges a high fee for its services.  Therefore, better disclosure of both fund strategy and fees may be justified.  In a step in the right direction, the Department of Labor recently adopted new and improved fee disclosure regulations for 401(k)s. 

More interventionist steps are also imaginable.  For instance, 401(k) defaults could be set to index funds.  Because 401(k) investors tend to stick to default choices, this would likely have a material effect in channeling fund flows away from these instruments.  More thought is necessary about the type of regulation, and, indeed, whether any is advisable.  But a variety of alternatives seem to be available to make the allocation of investor resources more efficient.

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In my last post, I talked about the arbitrariness that pervades both passive and active investing.  Today, I’ll talk about why we might care about this as a policy matter.

For one, the arbitrary nature of investing potentially poses fairness concerns.  Intuitively, it seems unjust that some should be rewarded by chance market moves while others are victims. 

This intuition can be fleshed out by appealing to Rawls’s notion of the veil of ignorance.  Behind this veil, those drafting the social contract do not know whether those whom they represent will be fortunate or unfortunate.  As such, he posits that these individuals would design society so that those who benefit from morally arbitrary good fortune, such as being born with high intelligence or to a wealthy family, share with those who are less lucky. 

This notion of egalitarianism can be applied to stock-market investing.  As discussed last time, to a great extent, stock-market gains and losses similarly represent morally arbitrary good and ill fortune.  Therefore, it seems that society would benefit to the extent that the chance gains and losses the market conveys are equitably distributed.  This line of thinking seems to have particular merit in the retirement context, where an intuitive conception of what is just tells us that the amount of one’s contributions rather than arbitrary market swings should determine the balance of one’s retirement account. 

Government intervention to effectuate the sharing of chance market returns, particularly in connection with retirement savings, may, therefore, be justified based on fairness grounds.

The arbitrariness also seems to suggest that the allocation of resources to actively managed mutual funds is inefficient.  Welfare economics tells us that we want resources to flow to their best use.  If returns that result from stock-picking are largely the result of chance, then expending resources in this pursuit may not be justified.  Why would we expend resources to arbitrarily distribute wealth?  This concern seems particularly poignant when one considers that market trading is zero sum in the sense that for every trader who bets correctly there is a counterparty who is not so fortunate.  Thus, chance gains and losses are simply reshuffled among investors without any moral claim to them, while fund managers extract fees for their efforts.

The above may overstate the case against active mutual fund management.  Some benefits do accrue to investors in the form of more accurate stock prices and a more liquid market.  Nevertheless, it seems probable that society is spending too much on the search for market-beating returns.  Thus, some type of regulatory intervention may be justified.

In my next post, I’ll talk about some potential responses to the fairness and efficiency concerns raised by the arbitrariness of the stock market.

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One issue I’ve been thinking about recently is the arbitrary nature of investing and how that relates to securities regulation and retirement savings.

Investors owe much of their stock-market returns to chance.  This is particularly true for retirement savers who contribute to passively managed index funds each month.  These investors have no control over what will happen in the market; they essentially take it as a matter of faith that their money will grow.  Due to chance alone, however, different investors will have different results.  And over time disparities can become dramatic.  A striking study by the Brookings Institution, which assumed steady contributions to a pure equity portfolio over forty years, found that different investors had vastly different savings as a result purely of the market’s performance during their investing lifetimes.  The luckiest investors had 7x more savings than the unluckiest.

Returns from active investing are also greatly influenced by chance market moves.  For example, a long-only equities mutual fund will usually do well when the market is on an upswing irrespective of the manager’s stock-picking skill.  Moreover, many of those managers who earn market-beating returns in any particular year will owe their excess returns to chance.  With so many mutual funds searching for diamonds in the rough, some will succeed merely as a result of luck. 

Indeed, both theory and empiricism suggest that luck accounts for a great deal of excess returns.  Both EMH advocates and critics agree that market volatility follows a highly unpredictable walk.  If this is the case, scant few will be able to skillfully outmaneuver the crowd.  This conclusion is backed up by a recent study by Eugene Fama and Kenneth French, which searched directly for the presence of skill in actively managed mutual funds.  They found little. 

Thus, retail investors who happen to be in successful actively managed funds likely owe their returns to chance.  Moreover, if retail investors find themselves among the fortunate few who participate in funds run by managers with true skill, it’s likely their fund choice was a lucky guess.  Fama and French used complex statistics to separate the wheat from the chaff, whereas ordinary investors must rely mainly on past returns, which are a dubious measure of skill owing to their problematic entanglement with luck.

Thus, we have chance, layered on top of chance, layered on top of chance.  I think that recognizing this aspect of investing has policy implications, which I’ll turn to in my next posts.

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